Screening due diligence #3: Quality of Other Equity Investors

Who are the company's existing investors, and who are the potential co-investors?

Venture capitalists also often focus on the quality of companies' existing equity investors and potential current round coinvestors as a third screening mechanism. They do this for two reasons. First, an impressive investor list is often indicative of a good investment. Simply put, great companies attract high-quality investors. Conversely, a company's inability to find any high-quality investors suggests that an investment may not be a very promising one. Second, high-quality investors often contribute significantly to their companies' success. Depending on the particular investors, they may provide any or all of the following to their portfolio companies: general business knowledge, operating experience, and business reputation. Equity investors may also bring to their portfolio companies extended networks of contacts to mangement recruits, service providers (law firms, accounting firms, public relation firms, etc.) customers, suppliers, strategic partners, venture capitalists, potential acquirers, and/or investment bankers.

A somewhat related point that some venture capitalists examine during due diligence is whether, and to what extent, existing equity investors will participate in the current round of financing. The failure of existing investors to support the company may dramatically reduce interest on the part of venture capitalists because existing investors often have unique information about the companies in which they hold equity. Almost surely, they have more high-quality information than that available to potential investors, even after thorough due diligence. Accordingly, if existing investors choose not to participate fully in subsequent rounds, it may quite possibly be the result of problems not visible to potential investors.