4 Questions to Ask When Evaluating a Potential Investor


Photos by: Corey Horn, AMC G3 APS Operations Underway convoy - Army Vessel ST-904 Green Springs leads a waterborne convoy of small tug, landing craft mechanized and landing craft utility vessels with the 8th Theater Sustainment Command's 10th Support Group, at Yokohama North Dock, Japan, during exercise Pacific Reach '08, June 13-17. Pacific Reach aimed to evaluate the Army's ability to meet watercraft operational requirements for supporting watercraft deployments.

We usually think about what an investor should look for when evaluating a potential investment opportunity. But what about what an issuer should look for when evaluating a potential investor? Obviously, sometimes dollars are dollars. Public companies want to maintain liquidity in the market, but it’s certainly less important who these individuals are that are trading secondaries. The more hands-off an investment strategy, like a passive mutual fund or hedge fund relying on systematic trading, the less important the investor as long as there’s capital.

Certain investors play a significant role in the management and strategic direction of the company. This is apparent in private equity, venture capital, and angel investing. Startup founders usually feel lucky enough to be considered by any outside investors, let alone venture investors that could potentially bring strategic and operational value. Really strong startups sometimes are fought over by the best venture firms. These startups understand that the decision of which venture firm to align themselves with can ultimately determine long-term success.

It’s Never Just About the Capital

Private equity investors pitch prospective target investments by outlining a strategic vision and value proposition to the firm. It’s never only about capital, because in private equity there’s so much that can be done to provide value outside of dollars. For instance, private equity investors can provide operational support and expertise. Sometimes private equity partners take board seats in portfolio companies to establish a presence in decision-making and company vision. These investors can also provide value by finding synergies with other portfolio companies, where there could be potential tuck-in acquisitions or cost savings by sharing certain operational infrastructure or networks. These investors’ professional networks can be a big consideration, where essential business relationships can be created through tapping into networks of potential advisors, vendors, clients, and technical experts. An investor’s intentions also need to be considered, particularly in venture and private equity. Does the investor truly believe in the long-term viability of the company, or is it a play for a potential quick exit? This is determined by the target company’s intentions – what’s the timeline of the target company and how important is an exit as opposed to long-term growth?

Issuers should understand if the investor is technically qualified for the opportunity, if it’s a good strategic fit, if they understand the intentions of the investor in a transparent way, and if there’s significant value to be generated by the partnership created by investor relationships.

While this is not an exhaustive list, here are 4 questions issuers should consider when evaluating a potential investor.

  1. Does the investor meet the qualifications to invest in the opportunity?

In most private equity transactions, investors need to meet a minimum income and sophistication test that determines their accreditation status. Certain hedge fund opportunities require an even more stringent income and sophistication test. Issuers need to have the tools in place to ensure that they are taking funds from investors that qualify. There are quality third-party service providers that specialize in this type of investor verification.

  1. Is there a good strategic fit?

Capital is not always the main consideration for issuers in venture capital and private equity. Strategic fit as determined by industry focus, network, track record, and exit strategies are equally important. At a basic level, when a private company evaluates a potential investor, the investor should have experience in the industry and dealing with the stage of the company. For example, an early stage fintech company in New York would not source investments from a private equity firm focused on later stage Korean consumer companies. Industry and stage fit will ultimately determine the value the investor can bring to the table. With previous industry and stage experience comes a valuable business network.

  1. Do you understand the intentions of the investor?

Alignment of intentions is key in evaluating a potential investor, particularly in venture and private equity. A founder will have an ultimate vision for the company that may not be aligned with a venture firm’s vision. This doesn’t mean that one party is right or wrong. It just means that ultimately, when the founder and investor sign a term sheet, there should be a mutual understanding of the long-term goal. This dynamic is important particularly if a venture firm takes a huge stake in the company and acquires board seats. With investment capital comes the ability to drive strategic change, which will sometimes not align with the interests of the original founders. Activist investing is a burgeoning strategy that attempts to drive change through the acquisition of a substantial stake of the company, and then the aggressive activism involved with campaigning for change that could include a restructuring, the firing of board members or executives, and the spin-off of divisions.

  1. Is there significant value to be gained?

The taking on of venture or private equity should reap more benefits than what can be gained if that company could bootstrap and build on its own. For example, venture funding could be the only way for a technology company to scale while also retaining top engineering talent. Otherwise, the company would not be able to balance the need for good employees with the ability to drive business through technical improvements.

Investors are not all going to help drive success within a private company even if they have massive checkbooks. There are plenty of examples of companies that received a significant amount of capital but eventually failed. Certain investors will be passive looking for long-term gains. Others want to opportunistically seek out companies at a certain inflection point to be able to exit the investment quickly. The overall goal for issuers is to understand these moving parts, and be able to align themselves as closely as possible with investors that have the same long-term vision, but can drive change and ultimate success through expertise and deep networks.



Reprinted by permission.

Image credit: CC by The U.S. Army

About the author: Sang H. Lee

Sang H. Lee is the CEO and founder of DarcMatter, a technology platform providing enhanced capital connectivity between issuers and qualified investors in the alternative securities space. Formerly an investment banker in the energy field at WestLB and BNP Paribas, Sang has accrued a wealth of expertise in financial structuring, credit analysis, documentation and deal execution for complex transactions involving multiple investor groups, institutional investors, and financing products from major investment banks.

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