Death of a Due Diligence Effort

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.  

Point A to Point B

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.

Diagram A

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.

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.

Profitable Exits

Now that AIM is over four years old, I am getting asked more and more about exits, particularly about profitable exits.  This is only natural, since profitable exits is why we invest— and they are a whole lot of fun!

Given that I am a finance/numbers guy, I’d like to share my the answer to the question about profitable exits.  But first, we need to review the industry statistics that drive angel investing. These are the same statistics we have been quoting in our new member orientation/Angel Investing 101 seminars since the beginning.

Industry wide, 3 or 4 out of 10 angel investments crash and burn and the angels lose their entire investment. 3 or 4 out of 10 investments break-even and angels make a profit on 3 out of 10 investments. Of the 3 investments that make money, at least one of them is usually a home run.  A home run is where angels get 4-5 times their original investment in 3 years or 8-10 times their money in 5 years.

We also know that the average holding period for profitable angel investments is 4.3 years. For my calculations, I am assuming that 10% of profitable exits occur 3 years after investment, 40% after 4 years, 40% after 5 years and 10% after 6 years. These are just my best guesses and yield an average holding period of 4.5 years.

Now we need to review how many companies we invested in each year. In 2012, we invested in 7 companies; in 2013, we invested in 6 new companies; and in 2014, we invested in 7 new companies. We are on track to invest in 6 new companies this year, giving us 26 portfolio company by the end of 2015. Using all of the above stated assumptions, here is a table that reflects the number of profitable exits we should expect by year if we achieve the industry averages.

                             Projected Profitable Exits

7 companies in 2012.21*.84*.84.21
6 companies in 2013.
7 companies in 2014.21.84.84
6 companies in 2015.18.72
7 companies in 2016. 21
Total Profitable Exits.211.021.771.951.95

* 7 companies X 30% chance of a profitable exit X 10% chance of an exit in year 3.
So what does this table tell us? We have a small chance for a profitable exit in 2015, but we should experience our first profitable exit in 2016. The number of profitable exits should increase each year until 2018 when we should top out at 2 profitable exits per year.  As long as we keep investing in 6-7 new companies each year, then we should maintain the rate of 2 profitable exits per year beginning in 2018.

Remember, this table only reflects profitable exits. There will be just as many exits where we get some or all of our investment back, but no substantial profit. And finally, please remember that these calculations are based on industry averages. Only time will tell what we actually experience.

How To Be A Great AIM Group Member

At AIM, we believe the investing experience we provide is worth every penny of your annual dues. It’s important for each of our members to get the most out of membership. These 8 steps will ensure you do.

Attend meetings: Even if you are not able to invest. You will learn a lot and we love the fellowship.

RSVP for every meeting: You can attend meetings if you don’t RSVP, but it sure helps us in food preparation and meeting room setup.

Build a portfolio of at least 10-15 positions: This size portfolio greatly reduces risk and substantially improves your chances of investing in winners. We suggest that you build your portfolio over three years and fund investments after that with proceeds from exits.

Invite guests: AIM is an invitation only organization. The only way we grow is for you to invite prospective members to join. And there is no better way for a prospective member to understand what we do than to come to a presentation.

Participate on a due diligence team or two: Members make up a majority of every due diligence team and the quality of our due diligence is a key to our long-term success. Remember, it takes 15 hours our your time. Contact your chapter Executive Director and let him/her know of your interest to serve on a due diligence team.

Refer investment opportunities to us: We are always looking for great early stage companies in which we can invest and members are still are valued source of deal flow.

Follow the companies in which you invest: Check the Visible website often for updates. Read the company generated and AIM staff generated reports.

Don’t forget about AIM Growth Fund: Please mention the AIM Growth Fund to any person you know that might be interested in investing in our portfolio but who realistically cannot participate in our network.