Avoiding Abuse from Emerging Companies: 3 Steps to take for Independent Directors and Advisors
They say that no good deed goes unpunished. This can certainly be the case if you decide to join the Board of Directors or Board of Advisors of an emerging company.
You’ve achieved a lot in your career and you want to help other entrepreneurs make it to the next level, so you consider serving as a director or advisor for an emerging company. This could be an informed and lucrative business decision, however you will want to take these three steps to avoid finding yourself used and abused.
Step 1: Ensure the Company Obtains D&O Insurance and/or Indemnifies You
Don’t sleepwalk into a lawsuit. If you decide to serve on a board of directors, make sure that the company has sufficient directors’ and officers’ liability insurance, and ensure the D&O policy can automatically be renewed as long as the company pays the premium. Otherwise, the company could be left without D&O coverage in the middle of a high-risk fund raise, as the insurance company might not renew the policy due to the company’s low bank balance.
D&O policies are less important to an advisor, who does not have the same fiduciary duties of a director. Both directors and advisors, however, should obtain signed agreements that the company will defend, indemnify and hold them harmless for their work for the company.
Step 2: Understand the Capitalization
Your options will likely never be worth a penny if the company issues you options representing a low percentage of the company’s stock on a fully diluted basis, with an unrealistically high strike price that over-values the emerging company at $100,000,000.
Typical rules of thumb call for independent directors and advisors receiving options representing at least 1/2% and 1/4%, respectively, of a true fair-market value.
Step 3: Secure Fair Option Terms
In addition to obtaining the right number of options with a strike price based on a fair valuation of the company, independent directors and advisors should request (a) a long post-termination option exercise period, and (b) acceleration of vesting upon a change of control.
Under typical option grants, an employee who leaves the company must exercise his or her options within 30-90 days. However, unlike paid employees, independent directors and advisors of emerging companies do not normally receive cash compensation, but rather only receive options. If independent directors and advisors are terminated, they may be forced to decide whether or not to exercise their options within 30-90 days. They therefore must write the company a check when the company has no planned exit or other liquidity prospects, or not exercise and forgo any chance of getting compensated for their work for the company. In other words, they may end up working for free. Asking for a seven-year post-termination exercise period allows the former director and former advisor to wait and see how the company does and perhaps realize something for their efforts.
Having immediate vesting upon a change of control further rewards the director and advisor for helping the company reach that important milestone. Without a change of control acceleration, who knows what the buying company will do?
Protecting yourself from liability, understanding the company’s capitalization, and negotiating fair option terms will go a long way to protecting you as an independent director or officer, allowing you to assist a growing company with the prospect of financial reward while avoiding misuse and abuse.