Whether Directors should have a personal stake in the company has been debated for years. There is a growing consensus that in early stage tech companies, Boards perform better if the Directors are personally invested.
Many companies take the view that a Director is only required to act in good faith in the best interests of the company, to be fully informed of the material issues, and to protect the interests of the shareholders. Once appointed, the director is investing his time and expertise, and has 100% of his reputation riding on his performance as a director and the success of the company. If the director is giving his reasonable efforts to the task, nothing more can be gained by requiring him to invest his money as well. Many directors take this point of view and resist investing their own money, whether or not they can afford to.
There is also the argument, although a weak one in my view, that Directors owning shares are in an apparent conflict of interest. Every subsequent issuance of shares or options is dilutive to them and not in their interest to approve. While the conflict is apparent, it is not real. Shares and options are issued for contribution to the growth of the company, subject to the wisdom and approval of the Board.
In small tech companies, the requirements of Boards and Directors are onerous. Because of the inexperience of management, and holes in the management team, directors need to invest more time and energy to bridge the gaps. Inevitably, the company will face a crisis from time to time, whether it is strategic, financial, an issue of governance, or a disagreement among the Board or with management. It is all to easy for a director to resign in the face of seemingly irreconcilable differences, or the challenges of survival and growth in a tech company.
But if the director has made a personal investment that is significant for him, then the stakes are higher. He is less likely to resign, and/or less likely to be forced off the Board. Further, in recognition of the significant investment in time, energy, and personal capital required to be an effective director in a start-up tech company, directors are also compensated higher. Please see related document Director Compensation.
Therefore, a director who resigns not only loses oversight of his personal investment, but also walks away from significant equity compensation. There is a much greater personal onus to weather the storm and continue to resolve the critical issues.
While a committed Board should benefit the company by forcing solutions to difficult issues, it can also backfire. Where there are opposing entrenched positions on important issues, and no one steps aside, the consequences can be severe. Paralyzed by Board fracture, the company often has no conclusive mandate. Often significant time and energy of the management team, the CEO in particular, are spent attempting to resolve Board issues for which they are usually ill-equipped and always at a power disadvantage. Companies have failed in the process.
The arguments for and against Director investment are not clear cut. However, the arguments in favour of requiring Directors to invest are stronger. Companies that institute this practice would likely not be criticized, but companies that do not often are.
Also at issue is the timing of the Director’s investment. Many excellent directors do not want to invest at point of joining a Board but often make a significant investment later on. The issue for them may be to find the optimum point on the risk-reward curve: they may be prepared to risk time and reputation at an earlier, riskier stage in the company’s development than the stage at which they are prepared to risk a capital investment. A later, larger investment might be viewed favourably by other later stage investors, and can anchor a significant financing round.