Ask the VC has a good post on board member compensation in a private startup; I agree with almost all of it. However, I think that outside board members should be paid in restricted stock rather than options. The restricted stock SHOULD have a two to four vesting schedule with a single trigger for change of control just as Ask the VC suggests – but, still, it should be stock and not options.
Generally VCs don’t like outside board members to be compensated except with options. Management tends not to care as long as precious cash is preserved. I care when I’m an outside board member – but I think this arrangement is better for the company as well as for the outside board member.
Outside board members can be very valuable when things are NOT going well. But, if their options are way underwater, they essentially become volunteers. Management gets cash as well as options and may own stock as well; VCs have whatever remains of their equity stake to protect and their compensation from the VC firm. But an outside board member who is realistic has no reason to continue spending time if all her options are way out of the money. Repricing options is dicey and often unpleasant and leads to bad feelings by those who didn’t get repriced. Starting over with a new option grant is also possible but not good policy and leaves the outside director uncompensated for past service.
You as the founder want your outside directors to have interests that are well-aligned with the company. This is never quite possible to achieve with your VC investors as good as they may be; they have another constituency to serve (that’s why Ask the VC says correctly VCs shouldn’t be compensated by the company for board service – they’re paid by their “boss” and it ain’t you).
An outside director with only options will never have an interest in selling the company at a price below her strike price. But, if things go south, that may be the best thing to do. The right outside director may be a big help in finding a buyer and arranging a sale. Or the outside director may think it IS worth hanging on. You just don’t want to have a payment system that distorts her view. BTW, that’s why an ethical outside director resigns when his options are hopelessly sunk. He knows that he is a volunteer and his interests are NOT aligned with the company. Better for him, if he stays on, to have the company hang on and wait for a miracle.
The right strategy for your company in some cases may be to lay low or take a tack that will temporarily lower your equity value. An outside director who shares equity value like VCs and founders do, has interests that align with the company and can afford to be as patient as everyone else.
Options are great when all lines go up and to the right. They shouldn’t be the sole compensation for anyone who is making a substantial contribution nor do they represent the right skin in the game for someone you are counting on in bad times as well as good.