Wednesday, December 13, 2006

Replacing the Founder CEO: Part II

In the arts world, writers dream of finding a "script doctor", that person who can take good material and make it great. At certain stages of growth, companies also start seeking a "second act messiah" to take business to the next level. I've already discussed why I think there are perils to attempting this too early on in a company's development. But I also want to discuss how compensation for a second act CEO can create issues with execution and the strategic direction of a company.

If you and your investors succeed in finding the ideal CEO candidate, you will need to find a way to provide your CEO with enough equity upside to compensate for the lower than market salary of a startup CEO. Any equity you provide will be at a higher issue price than most of those held by founders and investors, who received the lion's share of their interests earlier and at a lower valuation. Because dilution is always a sticking point with investors, the usual outcome is to provide new CEOs (and the team they bring in) with equity plus a bonus scheme that will trigger golden parachute-like payments if there is a successful sale or change of control of the company. The size of the bonus makes up some ground for the CEO, but rarely all, particularly in the US, where the IRS has implemented a set or rules that make "excessive" bonus payments costly to both the company and the CEO.

Here's where this kind of compensation can be an issue: A CEO who received equity at $10 a share is not incented to pursue an opportunity to sell a company at $7.00 per share. By contrast, the investors and the founders, who hold a large portion of their shares at, say, $1.00, may well wish to forgo the possibility of a home run in the future by taking the lesser return on investment now. The second-act CEO is incented to pursue "bet the farm" strategies only.

This kind of misalignment can always be righted when and if a $7 exit opportunity presents itself, many investors will say. But that kind of "just in time" thinking is based on the flawed assumption that the opportunity will present itself without active care and feeding by management. In my view, time is better spent upfront on designing a comp scheme that aligns all parties to pursue the same strategic direction.

In the coming months we'll have better visibility into best practices for exec compensation when the new SEC disclsoure rules take effect (and, as one of my public clients said, "The whole world will know everything including my underwear size"). Our firm will be holding a seminar on executive compensation schemes for later stage startups in q1; watch for further details soon.

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