AIM report 2005

AIM – launched by the London Stock Exchange in 1995 to be a junior stock market where promising, young companies could raise growth capital – started slowly, exploded during the dotcom boom, then suffered badly when the bubble burst. Its last 12 months, however, have been dramatic.

There have been hundreds of companies floating on it, more than at any time in its past. Larger companies have started to move ‘down’ to it from the ‘official list’ (the main Stock Market). The average company is worth roughly double what it was a year ago, and the average float raised £8m, up from £7m the previous year. Perhaps most significantly of all, many more institutions are now investing in companies whose shares are traded on it, providing AIM companies with access to considerably more capital than before.

All this is basically great news for the market. Sure, there are some concerns about the very large numbers of young natural resource companies (traditionally viewed as very risky) floating, and certainly this sector makes up a large proportion of market capitalisation. Regal Petroleum is a prime example of a company where speculation had forced its share price up dramatically, only for it to come tumbling down upon the announcement of negative results from some drilling tests.

The question for most of you, though, is how that affects you. Whether you’re already running a company on AIM or are contemplating floating on it, how does the last year change things? Many are concerned that the market has now grown to the extent where it is no longer suitable for the very promising, young companies it was originally established to service. Has the market expanded so fast that it needs to pause for a while? What implications would this have for companies keen to come to market in the near future? If there is a bursting of the bubble of natural resource companies, what implications does that have for other types of company on AIM or wanting to come to AIM?

In compiling this, our fourth annual special report into AIM, we have spoken to many entrepreneurs running AIM companies, and the leading experts advising AIM and would-be AIM companies, as well as a handful of institutional investors. We’ll address all the issues described above as well as discussing the role of venture capital trusts (VCTs) with AIM companies, some changing regulations and the recently popular cash shells.

Is AIM right for your company? And if so, when? We can’t tell you specifically, though hopefully we’ll provide you with enough information here to be able to conclude for yourself. One thing that is for sure is that right now, Britain has probably the best stock market for smaller companies in the world. Long may it last.

THE CURRENT CLIMATE

AIM is ‘hot’. It was arguably too hot between November last year and March this year, with admissions to the market ‘getting away’ that wouldn’t in normal circumstances.

The flow of flotations has petered out somewhat and if you monitor activity over the summer months you might wonder why we’ve concluded that it remains hot. The reason is AIM and other stock markets traditionally experience a summer lull. It has undeniably been exacerbated by the effect of too many new admissions over a short space of time – 138 in the first quarter of 2005 – plus fears about the new directive governing prospectuses, but there’s no cause for mid to long-term concern.

The ‘indigestion’ will pass and a pause like this right now is good news for everybody involved, except perhaps speculative, young natural resources companies, which will now struggle to raise finance. It won’t do any harm to have a breather, agrees Anthony Brockbank of law firm Field Fisher Waterhouse.

For companies like yours though it makes sense to be starting the process of floating on AIM now. It’s something that typically takes at least six months and by the time you’re ready we expect the market will be receptive again to new issues.

Another positive thing to note, if you look closely at the new issues that went ahead late last year and early this, is that there were lots of smaller fundraisings outside the natural resources sector. And plenty of them were not cash shells, which had to float before the end of March if raising less than £3m. For those unaware of the rule change that precipitated the rush to float shells, AIM moved to clamp down on inactive, weaker entrants, of which cash shells raising little cash were the main offenders.

There has also been talk that nominated advisers (NOMADs), firms that are required to approve admission documents of all companies listing on AIM, and brokers have switched focus to much larger companies. It has been suggested that many will no longer work on fundraisings of less than £5m and that many of the top brokers have set a minimum of £10m to £15m.

Again, while true in some cases, this trend is not borne out by market data and concerns that your company may not be ‘right’ or that it is too small for the market can largely be dispelled. Dunn-Line, a Nottinghamshire and Durham-based bus and coach operator, raised £2.1m in a placing in December and was capitalised at £6.2m. Admittedly it boasted a turnover of £13.19m to the year end 2003, so is a fairly sizeable example.

Glen Group, an IT business offering integration services to small and mediumsized businesses across the UK, is another. It also joined via a placing in December and raised just £750,000, was capitalised at £1.5m and managed to get the flotation away at a cost of £188,500, excluding VAT. Its turnover to year-end 2004 was £374,000, proving that providing a company has potential and a strong management team AIM is viable and brokers can be cheap enough.

There are plenty more besides dotted among the mining, oil and gas ventures. The point is that every institutional investor, bar one, now invests in AIM stock. And while the market is launching various indices to increase liquidity in the top 50 and top 100 companies, as well as an ‘all-share’ index, Martin Graham, head of AIM, claims this “will increase the visibility and investibility of AIM as a whole and increase trading volumes and liquidity in AIM companies”.

Equally, the recently published annual AIM survey Taking AIM, which is authored by accountancy firm Baker Tilly and law firm Faegre & Benson, concludes that it is the market of choice for companies with a market valuation of up to £100m and perhaps even as high as £300m. With such strong sentiment in the market’s favour businesses of all sizes can raise money, even if there are more companies seeking it too.

BACK TO REALITY

Nevertheless, there have been failures in the last month or so to temper enthusiasm. Simon Raggett, managing director of Strand & Partners, which acts as an adviser and is also an investor in middle-market companies, claims he’d heard rumours of 34 floats being pulled one week in May. It’s talk that we heard elsewhere too. Like others, he predicted that there will be little IPO activity before September.

Paul Westbrook, who leads the corporate finance team for KPMG on the south coast and also works with the Quoted Companies Alliance adds that institutional investors appear keen to “shed underperforming stocks or take profits to realise liquidity to invest in new opportunities”. This re-grouping of funds will inevitably take some time.

When normal service resumes in September, one of the lasting effects is likely to be the lower valuations placed on companies joining AIM. “Companies are having to make themselves cheaper. Institutions are saying there has to be a discount to encourage them to put money in,” confirms Luke Ahern, director of stockbroking at Corporate Synergy.

A number of brokers and investors we spoke to described the change from a seller’s market to that of a buyer’s. It doesn’t necessarily sound good for companies like yours, but again, it’s possible to put a positive spin on it. Clive Carver of broker HB Corporate feels the lower valuations he is seeing are actually reasonably fair and not out of line with the last 20 years.

And Graham Shore of Shore Capital, a UK investment banking group that focuses on small and mid-sized entrepreneurial businesses and which has recently closed subscription for its Puma VCT, says he and the Shore team are more likely to invest now. He points out that back at the height of the dotcom boom Shore Capital was a company that held back once share prices got unrealistically high and has refrained in recent months too. He believes his company’s approach is consistent with other VCTs. “I went to a seminar of AIM VCTs and they were all saying the same thing – that they’ll be looking for value.”

It’s difficult to illustrate that investors will be looking more to traditional, non-risk companies as this is more a forecast, but there are two factors that support the argument. Far fewer oil, gas and mining ventures are likely to float or raise as much, despite commodity prices remaining sky-high. The aforementioned Regal Petroleum example is one of the reasons for this. Anecdotally advisers and investors agree that that bubble has ‘burst’. Secondly, VCT fund managers we spoke to agree that heavier investment will come via this source over the next 12 months.

VCT MONEY

Venture capital trusts represent a huge opportunity for smaller companies seeking an AIM flotation. They were set up in 1995 as a means of financing the growth of companies too small to join the main Stock Exchange

In 2004/05 VCTs raised more than £500m from about 40,000 retail investors, with around £200m of that total raised specifically by AIM VCTs. Many non-AIM VCTs will also concentrate a good deal of their funds into AIM companies.

Surprisingly, the £500m total fell short of the target of more than £1bn and only a handful of trusts were fully subscribed. Nevertheless, there is a great deal of money – approximately £350m – that has to be invested within three years. In the short to midterm Robin Stevens of accountancy firm MRI Moores Rowland is confident the weight of money will underpin the AIM market if institutional investors pull back through the summer and into the early part of autumn.

By the end of the three years, Puma’s Shore estimates that VCTs are likely to invest between 75% and 80% of their funds in qualifying UK companies. While they only need to invest 70% in that time this will help counter the risk of some investee companies being disqualified before the deadline.

So, overall, this means that up to £400m will be ploughed into companies like yours over the next three years. And Andrew Banks of institutional investor Singer & Friedlander goes as far as saying he thinks £200m is destined for new issues over the next 12 months. Shore on the other hand is slightly more cautious, predicting that between £70m and £100m will go into the market this year.

Fundraising for VCTs in 2005/06 has started fairly well too, and it has been widely predicted that last year’s record total will be surpassed again as investors become more aware of the generous tax breaks. The income tax relief at a rate of 40% of the amount invested in new ordinary shares is likely to be scaled back in 2006/07 so this year may effectively represent the last knockings for private investors.

All this new money is in addition to the money already raised by existing funds. So while VCTs can invest no more than £1m in any tax year in any one company, the more funds an institution manages the more it can invest in total. With some managers now boasting a number of ‘pots’, usually unimaginatively named II and III, the amount that can be invested in individual companies is increased.

The advantages of seeking finance from a VCT include the guarantee that you are taking on mid to long-term ‘holders’ (in order to qualify for the tax relief investors remain tied-in for three years) and the fact that the funds can only invest in new shares. In addition to that the management tend to come from the venture capital arena, meaning they are well-placed to help companies source non-executive talent, find good suppliers and groom them for the next step.

WHAT INVESTORS WANT

So, how likely are you to secure finance via a VCT? Puma VCT’s Shore claims his fund doesn’t feel under any immediate pressure to invest. It is seeing between five and 10 plans a week and as a generalist fund of £20.4m will invest in unquoted, OFEX and AIM companies. He estimates that 60% of its qualifying investments will be deployed on AIM, but adds that “if AIM becomes unattractive we don’t have to put it there”.

Staying true to reports that VCTs are being risk-averse, Shore says Puma prefers solid, asset-backed established businesses, in less racy sectors and is avoiding technology-based companies. This may seem at odds for those who believe VCTs were set up precisely to invest in riskier small companies, but is more a reflection of their attitude towards particular ‘speculative’ sectors, rather than the overall size of investee businesses.

In Puma’s case, there needs to be a guaranteed return within its clearly defined five-year life, providing investors vote to wind the fund up at that time. After five years capital will return to those investors and Puma’s stated target is to double investments.

This is slightly unusual as no VCT has yet wound up, but in its case is indicative of the venture capital-like approach to managing the funds. Another shift from the norm is the fact that Puma will be pursuing greater regional investment. With Shore Capital located in both London and Liverpool, Shore says it will be more inclined to shop around. “If you’ve got a lot of money chasing deals you’ve got to work a little harder to find good ones,” he says.

This is great news for companies outside London and the South East, who typically find it harder to attract investment. And Shore believes that other VCTs will follow suit, particularly as the profile of the funds has been that much higher since the government raised income tax relief from 20% to 40%, so prospects, quite possibly like your company, will be keener to gain a slice of the action.

Unicorn Asset Management is another with highly active VCT pots. Interestingly, the institution itself has not been focused on new AIM issues, yet has made a number of VCT investments in 2005.

Proof that not all VCTs would necessarily be right for you, the average market capitalisation for companies Unicorn AIM VCT has invested in is £25m. Overall, this seems to suggest that it focuses more on slightly larger, established businesses and management teams.

Fund manager at Unicorn Sean O’Flanagan confirms this. Most of the fund’s qualifying investments are led by an entrepreneur or management team that has operated in the public arena or is well-known to Unicorn. “We’ve also tried to identify the entrepreneurs of the next decade,” adds O’Flanagan. Printing.com, run by 2003 Growing Business ‘Young Gun’ Tony Rafferty, and which moved from OFEX to AIM, is one example.

DIFFERING EXPECTATIONS

O’Flanagan also dismisses the suggestion that Unicorn’s VCTs have different expectations from larger institutions. So if seeking VCT finance, make sure research is done on which ones to approach. “The problem is that too many prepare a slick presentation and have rehearsed answers to expected questions. We won’t hand over £1m on that basis. We prefer to work with companies and individuals we know.”

Unicorn avoids biotechnology, mining and property. It manages two generalist funds containing three pots – Unicorn AIM VCT I and II – which have raised a total of more than £70m. Around £50m of that will go into AIM companies and to date it has already made more than 50 qualifying investments. Its preferences include food manufacturing, IT services and media and typically investee companies receive around £1.5m. “We don’t want hundreds of businesses to monitor as we’re not geared up to do that,” he says.

Arguably more flexible and amenable for smaller businesses is Singer & Friedlander, which manages three VCT funds, titled S&F AIM VCT I, II and III. The first fund raised £10m, the second £20m and the third £30m.

In total it has already made 100 different investments and the maximum it contributes to a fundraising is typically between £1.25m and £1.5m in cases where all three funds are used. The reason it is unlikely to go to the £3m limit is because it would almost certainly constitute more than 10% of the company’s shares. The minimum S&F unit size is between £250,000 and £750,000.

Like Unicorn, S&F rarely invests in companies with a market cap of lower than £5m, and typically invests in companies much larger, although fund director Andrew Banks admits that the firm is prepared to be flexible. “We look for established and profitable businesses, with an experienced management team, a sound balance sheet, and a sensible strategy for growth. We avoid biotechnology and start-ups, other than shells,” he says.

Ken Ford of Teather & Greenwood, the largest broker for VCT funds, says companies boasting a £10m plus turnover, with profits of more than £1m and at least a 10% growth rate target, are well-placed to get funding, although the firm’s expectations, as illustrated earlier, are not necessarily representative of all AIM fundraisings.

Beyond VCTs, institutions generally are adopting a ‘back to basics’ approach. “Everyone is focusing on the here and now – profits and visibility of earnings,” says Corporate Synergy’s Ahern. “It’s back to what investors know, such as profits, dividends, cashflow and a strong balance sheet.”

And HB Corporate’s Carver adds that while there’s more than enough cash to go round many of them invest in unit sizes and are not keen on smaller fundraisings. Typically, they don’t want to own more than 3%, yet some refuse to go lower than £500,000 per investment and more again baulk at dropping below £250,000. “They don’t want hundreds of investments as it’s more difficult to manage,” he adds.

THE EUROPEAN PROSPECTUS DIRECTIVE

The investment community breathed a collective sigh of relief at the tail-end of last month. If you’re considering joining AIM you probably should too. For months it has been unclear whether the European Prospectus Directive, the new laws governing public markets in Europe, would have a detrimental effect on the chances of companies raising funds via retail investors.

Any prospectus issued must, from July 1, be pre-vetted by the Financial Services Authority (FSA). Previously NOMADs approved admission documents and this has constituted one of the key differentiators between AIM and the main list, as it saved time on the process and ensured a more commercial, as opposed to bureaucratic form of regulation. Indeed, as research by Baker Tilly and law firm Faegre & Benson (until recently known as Hobson Audley) points out, it was a lack of distinction between USM – AIM’s predecessor – and the main list that led to its demise.

Under the new rules, which are to be implemented by the FSA and the UK Listing Authority (UKLA), a prospectus will only be issued if a company approaches 100 or more investors. Until late May it had not been established whether a private client stockbroker would count as one investor or however many private investors it represents.

Private client stockbrokers have discretionary placing power for a number of investors and place tranches of shares from AIM and OFEX companies with these clients. If each private client had counted as an investor these stockbrokers would almost certainly have been excluded from deals in order for a company to avoid issuing a prospectus and delaying its float by around four weeks as well as incurring the extra legal costs. This would have seriously harmed the liquidity private client investment offers.

The Treasury, though, has now confirmed that private client stockbrokers will only count as one investor and that there will be no requirement for a prospectus, irrespective of the number of clients involved. “This comes as a great relief to all those involved in raising capital for smaller quoted companies,” says Andrew Smith, the Quoted Companies Alliance chairman and director of corporate finance at Collins Stewart. “This ruling is of major importance to the fundraising abilities of companies joining AIM or OFEX and will help maintain private client investments and hence liquidity.”

Alex Read of law firm Memery Crystal is critical of the time it took to clear up the issue, however, and believes the announcement should have come sooner. “A statement should have been made ages ago,” he says. “I got the distinct impression that the full implications hadn’t been appreciated by the FSA.”

Companies raising less than €2.5m over a 12-month period are also automatically exempt from application of the directive as such low value admissions will not be treated as public offers. However, new issues not falling within the exemptions will still have to issue a prospectus to be pre-vetted by the FSA. That said, open offers on AIM are rare, with the vast majority opting for ‘placings’ with a selected group of institutional investors.

CASH SHELL VS. FLOTATION

Cash shells have been something of an AIM phenomenon. Until March 2005 that is. Since then the market’s rules governing them have been tightened up.

But what is a cash shell? Basically, a quoted company which has no ongoing business activity, but has some cash. These are either new investment companies formed specifically to raise funds via a market listing (‘clean’ shells), or quoted companies which have ceased operating whatever business they were in – perhaps because it didn’t work, or because all operating subsidiaries have been sold off – but still have some cash left (‘dirty’ shells).

They do not operate as businesses, hence the ‘shell’ description. They usually have no real assets bar a cash balance and their stockmarket quote. The quote has no value in the company’s balance sheet, but takes on value in practice since floating a company is an expensive and risky exercise (the risk being that market conditions can change and investors might decide not to invest after all). If an existing quoted company decides to buy another, though, that removes the bulk of that risk.

So these quoted shell companies exist to ‘buy’ one or more other (‘proper’) businesses. They ‘buy’ them by issuing new shares in the quoted company to the shareholders in the private business being bought. This is usually a ‘reverse takeover’ because the number of new shares issued to buy the private company is substantially higher than those existing before the deal, so the private business’s shareholders end up owning the majority of the public company.

Imagine you wanted to float your company on AIM tomorrow, and wanted to raise say £1m in cash to develop the business. By ‘reversing into’ (selling your company for new shares in) a cash shell with that sum of cash already there, you know exactly what cash you will end up with, without needing to pitch to institutions and trying to persuade them to invest. All you need to do is win the approval of the existing shareholders (who, having bought their shares, will usually be keen to find a business to buy) at an EGM.

Sound good? Well, that much is. The drawback is that it can be expensive in terms of dilution – the shareholders in the cash shell will still own some shares after you’ve sold your business to the quoted company. And depending on the deal terms, that may mean your shareholders are left with a smaller percentage of the public company than they would have had had you floated normally. Also, reversing companies have to go through a re-admission procedure with the Stock Exchange. “One has to question whether they’ll gain best value by floating that way rather than directly,” comments Baker Tilly’s Chilton Taylor.

Which of course is the reason why many canny dealers create cash shells: they may end up with a decent percentage of a company, where the shares are worth far more than the initial investment. It’s far cheaper to float a brand new company than one that has been trading for a while, since there is no history to check, and there won’t be any liabilities (threatened lawsuits or whatever), so the legal and accounting bills are considerably lower.

These newly created shells can be flexible in terms of the sector they choose to pursue acquisitions in, though recently many have opted to specify target sectors, such as restaurants, retail, or natural resources. Management teams behind shells, who tend to be serial entrepreneurs and experienced investors, typically identify a sector to grow their venture into, but it’s not unheard of for them to switch with market sentiment, especially if acquisition targets fail to materialise.

Recently more and more cash shells have been created on AIM, some with considerable cash in them, which has led to some businesses being bought by the quoted shell for cash, rather than shares, or a mix of both. This is basically treating the stockmarket as a source of venture capital – the quote itself is less important. The most high profile recent example of this is Clapham House, which was set up by former Pizza Express CEO David Page. As an experienced entrepreneur familiar to the City he was able to raise £15m to acquire restaurant groups. He subsequently bought three restaurant chains.

The Stock Exchange has recently tightened up the rules on cash shells, such that when new shell companies now float, they need to raise a minimum of £3m, and need to make their first acquisition within 12 months of floating. If you choose this route to AIM consider all the implications carefully.