Publicly quoted technology companies have not performed well in the five years following the dot com crash in 2001 compared with the previous five years. As a consequence, options in quoted technology companies are often perceived by candidates as less valuable than they were in the past. But does this mean that options are no longer a powerful recruitment tool for venture backed technology companies? Are options the only option?

It is true that exit prices for venture backed technology companies usually track public valuations. However, candidates who receive options in venture backed technology companies do not need to be as pessimistic about their value compared with candidates joining publicly quoted companies. Actually, times have never been better. Since the dot com boom there has been a spectacular global collapse in average pre-money valuations of private technology companies and there are no indications this will change in the near future.

Take a look at the table which tells the story of a lucky CEO who got a low pre-money valuation, and an unlucky CEO who did not. Both CEO’s were granted 5% in options in companies and both companies subsequently raised €11m in three rounds. Each company was then acquired for €30m. The lucky CEO made €592,000 from the sale of options but the unlucky CEO only made €311,000. The only difference was the valuation of the company when they joined, as opposed to when they exited. Therefore when recruiting a new member of the management team it is worth pointing out to the candidate that he/she is likely to be receiving options at a discount to historic prices.

TABLE 1: THE PERILS OF HIGH PRE-MONEY VALUATIONS

	Seed	A	B	EXIT
Pre-money valuation (m)	€3.0	€9.0	€15.0	€30.0
Cash Invested (m)	€1.0	€4.0	€6.0
Post money valuation (m)	€4.0	€13.0	€21.0
Lucky CEO Options - After Dilution	5.0%	3.5%	2.5%	2.5%
Value (k)	€0	€300	€369	€592

	Seed	A	B	EXIT
Pre-money valuation (m)	€12.0	€15.0	€20.0	€30.0
Cash Invested (m)	€1.0	€4.0	€6.0
Post money valuation (m)	€13.0	€19.0	€26.0
Lucky CEO Options - After Dilution	5.0%	3.9%	3.0%	3.0%
Value (k)	€0	€150	€189	€311

Source: Norman Broadbent International

Restricted stock is becoming an increasingly popular alternative to options, for quoted technology companies, in an attempt to address the issue of “underwater” or worthless options and the mass exodus of talent that ensues. The question for boards of venture backed technology companies is whether restricted stock should be used as a recruitment tool when building management teams. In my experience, restricted stock is perceived to be more like “salary” than “options” because of the size of the grants, which are fairly modest. This factor along with personal taxation issues in many European countries has made it an unattractive choice for private companies. Therefore, to attract candidates to venture backed technology companies the board has to ensure that potential candidates perceive the future value of the company’s shares to be significantly higher than they are today.

History teaches us that valuing a private company has never been easy and it is not a new problem. In 1613 there were no public stock exchanges and the establishment of private companies had just begun. The English East India Company and The Dutch East India Company had both been founded a few years earlier and both companies had fleets of ships which were engaged in a bloody military battle with each other to secure trade in nutmeg and cloves with the East Indies.

Annual consumption of spices had risen to €890,000 in Western Europe by 1613 (reference 2) as people believed that this precious commodity could cure fatal diseases such as the London Plague. Spain and Portugal were about to enter the market and the respective boards of The English East India Company and The Dutch East India Company met in Holland to discuss a merger. The merger would enable both fleets to massively outnumber the Spanish and Portuguese who, as new entrants to the market, were small. The merger was aimed at securing an effective monopoly in what was then the world’s fastest growing technology business.

However, the merger failed because the boards of The English East India Company and The Dutch East India Company could not agree on a valuation. As an aside, The Dutch East India Company had seventeen non-executive directors – a daunting backdrop for negotiations and decision making compared to current day practice.

Today there is evidence that the boards of venture capital backed companies are taking a more realistic view on the value of their portfolio companies compared to their private competitors. A good example of this is the 50-50 merger earlier this year of Video Island (backed by Benchmark, Index and Esprit) and LOVEFiLM (backed by Arts Alliance). The deal gave the combined company more than 400,000 DVD rental subscribers in Europe, a lower cost base, greater efficiencies of scale and a more benign competitive environment.

In private companies, if the perceived value of a company varies from one investor to another it is hardly surprising that the perceived value of options also varies from one candidate to another. However, in my view private companies have rarely been in a stronger position to attract the best talent from quoted companies. The challenge, during the recruitment process, is to ensure that potential candidates perceive the value of the options they are offered to be incredibly valuable. This is more likely to happen if the company has defined its exit strategy, compiled a list of relevant trade sales and prices, identified publicly quoted companies with which it can be compared, and can in this way assist the candidate to value the options being offered. Surprisingly few companies, however, do this before they begin recruiting.

The question of how many options should be made available to attract the right person for the job often arises and the table below is a reference point. Even though average valuations of venture backed companies fluctuate wildly over an economic cycle the amount of options that are offered to candidates joining the management team remains fairly stable. The data below is based on three quantitative surveys, in separate years, of 150 venture backed technology companies (reference 1). In addition Norman Broadbent International has managed the candidate negotiations in over 100 different searches for venture backed companies, which we have also used to compile the table below.

TABLE 2: NORMAN BROADBENT'S GUIDELINES – OPTIONS FOR NEW JOINERS

	Seed	A	B	IPO
Typical Post money valuation (m)	€5	€15	€25	€40
CEO	7.9%	5.5%	3.9%	2.9%
CTO	3.0%	2.1%	1.5%	1.1%
CFO	3.0%	2.1%	1.5%	1.1%
VP Sales & Marketing	4.2%	2.9%	2.1%	1.6%
Non-Executive Chairman	2.0%	1.5%	1.0%	0.5%

Source: Norman Broadbent International

Phil Peters is Director of the Technology Practice at executive search firm Norman Broadbent International and works closely with the Venture Capital community to provide executive search services to their portfolio companies.

Reference 1 : 2003 Survey of Technology Entrepreneurs & their Companies www.normanbroadbent.com/pages/client_specialist_t.htm

Reference 2 : Nathaniel's Nutmeg: How One Man's Courage Changed the Course of History: by Giles Milton