Smart versus Dumb Money, Why the same value?

Conventional wisdom states that a company who accepts money from a top tier VC firm will receive more value add from these venture capitalists and thus the company should accept a lower valuation for that investment than if another less reputable venture firm offers to invest. Why also do VC co-investors who do not take a board or observer seat get the same terms as the lead venture investors?

I have a different idea about how to reconcile valuation and value-add. Why do they have to be linked? The private market should dictate the value of a company just like the stock markets determines the value of a publicly traded company, by the price per share. The arbiter of value should be in valuation, not various terms which complicates incentives.

Venture capitalists who add the most value should then get additional equity to serve on the board and be incentivized to help the company with equity kickers for introductions to potential partners/acquirers, helping develop clinical development plans, etc. There can and should be a separate way of valuing the value-add, without including it in the valuation and terms. Maybe the VC on the board who adds the most value can have his preferred share convert at a lower price as a reward for adding specific and measurable value. Warrants are another good way of offering compensation. This largely accomplishes the same thing as participation (participating preferred lets the VC get their money back and then divide the remaining proceeds by percent of the company owned) but without the onerous transfer of value from entrepreneur to VC.

The problem with this set-up is it might create a conflict between board members to “add the most value” and in the long run if not held in check, can hurt the company. Independent directors should be responsible for administering this compensation system. There should also be clearly defined roles and potential equity incentives. Likewise if an employee goes beyond their job and creates extraordinary value, they should get an equity kicker. This is the ultimate in meritocracy.

If a VC is not going to add value but is only going to piggyback on the hard work of a top tier VC as a co-investor, why should they get the same investing terms and same value for simply investing their money? I believe this new paradigm would be a much better way. Let me know what you think.