Pay issues for directors of dot-coms.

• Author: AISENDREY, BEVERLY W.

Advice on compensation parameters, option grant terms and amounts, combating the lure of start-ups recruiting your executives, and other comp committee challenges.

THE EXPONENTIAL GROWTH in Internet-related IPOs, combined with a limited pool of experienced directors, often results in dot-com compensation committees with directors who have never served on compensation committees before. Likewise, experienced board members from the "old economy" who are serving on a dot-com board may not be familiar with the realities of Internet businesses. All directors will need to understand the role that dot-com boards take and the parameters for compensation programs in the Internet industry. We think the compensation committees at dot-com companies face several special challenges, which are described in this article along with some ideas for addressing these issues.

Dot-com boards are generally smaller than those seen in other industries. This is partially due to the fact that the dot-coms are looking for directors who are in short supply: They want directors with experience in the Internet industry and/or who have technical knowledge that the dot-com company can learn from. The dot-com board is generally more involved in corporate strategy and provides more guidance than the large boards of the "old economy" companies, where the role is more one of oversight. If the management team is inexperienced, such as in a start-up, the board members may also play a mentoring role. And, management will look to the board for important industry contacts and relationships.

Typically there are only seven board members at a dot-com, with two or three serving on each committee. It is felt that a smaller board can react more quickly to strategic changes and industry developments. Dot-com boards also have fewer independent board members. Generally, about half of the directors on dot-com boards are insiders. Several of the directors may represent the venture capital fund that sponsored the company and still holds a large stake, or may represent strategic partners.

In deciding who should serve on the compensation committee, it is better from a corporate governance standpoint to choose independent outside directors who do not have a relationship with the company that could compromise their judgment or alignment with public shareholders. Investors may overlook corporate governance conventions at a start-up company, but will expect the company to comply with good standards in the near term.

Parameters for the Internet industry

While all board members are aware of the retention and motivation aspects of stock options, shareholders rely on the board to monitor the overall dilutive impact of options. Shareholders approve the shares available for grant, but company management and the board must effectively manage grant amounts. At dot-coms, dilution levels are usually substantially higher than at mature companies.

Pre-IPO employee stakes are typically 15% to 20% of total shares outstanding in the form of stock options. Following IPO, potential dilution from stock options may become as high as 25% to 30% at the peak growth in hiring due to high recruiting grants up front. As hiring eases and the company moves from significant up-front option grants to an annual grant cycle, potential dilution should move back to a 20% to 25% range.

To recruit top talent, companies make large grants to employees when they are hired. This award pattern offers the greatest potential leverage if the stock price continues to rise. However, once the company is public, the stock price is likely to experience wide swings in this highly volatile market. With large upfront hiring grants, employees are taking a chance that their hire date coincides with a relatively low stock price. If not, the bulk of their options could be underwater for some time. A volatile stock price calls for more frequent...