Author: clay@aimgr.com

This past Wednesday, our current due diligence effort was terminated when the company under due diligence announced that they had accepted funding from another source. This makes the third such effort this year that has been terminated and the twelfth time it has happened since AIM Group was started 4 ½ years ago. That may seem like a lot, but when you consider AIM Group has initiated 54 such efforts, that comes out to a termination rate of 22%.

So, why are some due diligence efforts unsuccessful?  First, let’s remember that AIM Group receives 30 to 50 applications per month. When one of those applicants is selected each month, Clay and I have committed about four or five hours to reviewing the application and interacting with the management team. Once selected for due diligence, we currently average about 140-150 hours of research by the due diligence team. We find out a lot about the applicant during that 150 hours that you just can’t discover in 4 or 5 hours during application processing.

Reasons for terminating a due diligence vary all over the place. The most common, and definitely the most frustrating, is when the company under due diligence finds funding from another source. This has happened to AIM Group four times out of our twelve terminated due diligence efforts. In every case, the new funding source was a wealthy individual angel investor. These investors are usually not familiar with the current market and often are willing to pay much more than current market value.  

Other AIM Group due diligence terminations were the result of a bad technology review by a subject matter expert; too small of target market; disagreements over the term sheet; and the failure of the company to raise the minimum level of funding required to close.  Probably the most interesting termination was the result of due diligence team getting concerned about the “volatility of the CEO” and his/her ability to get along with other management team members.  

At the end of every due diligence effort, the due diligence team votes  whether to allow the company to present to the network. A simple majority vote is required to approve for presentation. The most unusual vote ended in a tie. Since a majority vote of the due diligence team is required to approve for presentation, the company was not approved. Interestingly enough, Clay and I vote differently —- and I was on the losing end of the vote!
While it almost always saddens and frustrates me to see a company fail due diligence and not be approved for presentation, I also think it is a healthy sign that our process has structure and discipline. Yes, we may not have a presentation two or three months out of the year, but in the long run, I believe our investment portfolio is better off. We do not want to invest in bad technology, small markets, volatile CEOs, or over pay.  

Assume that Point A is the value at which we, as angel investors, originally invest in a company. Point B is the value at which we exit from the investment. In a perfect world, if we were to graph our investment over its lifetime, we would proceed along a straight line from our original investment value to the exit value.  

If we make money, the line is sloping upward until we exit. See Diagram A below. If we lose money, it is sloping downward. Regardless of whether we make money or lose money, both are a straight line. In terms of our scorecard ratings, ratings for a winner would go from “C”, to “C+”, to “B-“ to “B” to “A-“ etc. Losers would go from “C” to “C-“ to “D+” to “D” to “D-“ etc.

But we do not live in a perfect world. Almost every investment that we make seems to have a series of significant events.  Some of those events are positives and some are negatives. And the value of the company rises and falls with each of those events. A graph of the company value  over a period of time resembles a roller coaster rather than a straight line and looks something like Diagram B.

To show how drastically circumstances can change over a short period of time, let’s examine Kredible and Predikto since the Spring.  In late Spring of this year, Kredible was in due diligence  to sell to a large public company for 2½  times our investment value one year earlier. It was one of our highest rated companies in the 1Q scorecard. The deal falls through, Kredible misses on two large contracts, and almost runs out of money in early 3Q.  The ratings scorecard ratings take huge hit in 2Q. In the Spring, Predikto was a major disappointment. The company had failed to produce any significant level of revenue and the 1Q scorecard ratings reflected the disappointing performance. The company signs three huge contracts in July and the ratings skyrocket in 2Q.

MemberSuite, our largest investment, has probably had more swings in valuation that any other portfolio company. After we make our original investment, the company actually exceeds its revenue projections and the scorecard ratings go up for two or three quarters. Then sales dry up and ratings go down. The company raises more money to implement a new sales program. The program initially is a disappointment and ratings fall further. Then the program kicks in big time and revenues along with scorecard rating, increases. Then the company has a disappointing 2Q when it is raising its Series B round of funding in 3Q of this year. The Series B gets completed, but at a lower valuation than anticipation. Our scorecard rating goes down as a result of the dilution. The company is now taking the proceeds from Series B and pumping money into marketing. The sales pipeline is growing and the outlook for 4Q may be the best sales quarter ever. If that happens, scorecard ratings will enter their third period of time where significant increases were happening. But the company has already two periods of time when the ratings were going down. That is five major swings in valuation in less than four years.
So what is the conclusion of all this? Going from Point A to Point B is not a predictable constant straight line. It is more like a roller coaster with all sorts of ups and downs.