Small companies cross the chasm

Recent tax changes to venture capital trusts are potentially good news for smaller quoted companies looking for a cash injection from large institutional investors – but how can you make sure you stand out as a company that’s likely to generate the best return?

Thanks to Gordon Brown, VCTs are now a much more tax-efficient way of investing money for those willing to take a calculated bet on the UK’s smaller quoted companies.

The introduction of the 2004 finance bill marked a change in the rules for VCTs. The main tax benefit was a switch from capital gains to income tax, making many more private investors eligible for tax breaks if they use VCTs as an investment vehicle.

VCTs may have been around for the best part of 10 years, but the chancellor’s recent actions have made them a lot more appealing to a wider range of prospective investors. In short, many more people pay income tax than pay capital gains tax. Consequently, VCTs are now awash with funds looking for a home in eligible companies.

But the challenge facing AIM-listed companies, and their advisers, is how best to reach a tipping point valuation of over £50m to make sure they catch the eye of large institutional investors.

Like any equity investment, the problem for investors is identifying companies that are going to generate the best returns. The onus is on corporate finance advisers to persuade VCTs that their AIM clients deserve funding and are likely to be strong performers over the next three years, when VCTs look to exit AIM investments made around this time.

Crossing the valuation chasm and growing to a sufficient size – say a market capitalisation of around £50m – in three years will be not just be advisable, but essential. Only when a company has reached this level of valuation is it deemed to have reached a safer haven where the larger institutional funds will begin to taking investment positions.

AIM-listed companies that fail to approach this sort of valuation will not be attractive to new professional investors once the VCTs have moved into a realisation phase.

Fortunately, reaching this magic £50m figure and resolving the problems that beset many small stocks – unpopular paper that trades only occasionally and in small quantities – relies more on judgement than luck. One company that successfully made the transition is Huveaux plc. Currently capitalised at around £60m, this media and publishing group has grown quickly through making quality acquisitions (including the purchase of an excellent business called Parliamentary Communications Limited), and strong organic growth.

As a consequence of rapid growth, and meeting or exceeding independent forecasts, Huveaux’s strong management, led by chairman John van Kuffeler, has the support of the mainstream institutional funds. Not only that, but the placings undertaken have occurred at increasingly higher prices – a great way of reducing dilution for van Kuffeler’s management team.

Huveaux’s experience provides a valuable insight into how growing companies seeking to ‘cross the chasm’ can enhance their appeal to institutional fund managers.

As well as having to produce strong organic growth, it’s likely that at least one groundbreaking acquisition will be necessary to achieve a £50m market capitalisation. But it is widely acknowledged that acquisitions can, unless made wisely, fail to deliver all the value on which they were predicated.

Doing deals gets the juices flowing for every budding entrepreneur, but as a result many ignore the downsides to a potential acquisition.

Making an acquisition is time consuming and can, unless carefully managed, lead to a loss of focus on the day-to-day running of the business. It’s useful for smaller listed companies that haven’t made an acquisition before to know what to expect from the process. Corporate finance specialists can explain the pitfalls and how best to avoid them, as well as identify the good deals and avoid the bad.

Good quality acquisitions will be necessary to cross the chasm but are not always easy to get right. However, with your help, companies are more likely to choose the right deal and pay the appropriate price in the first place. And consequently their longer-term chances of success are much improved.

Companies need to provide a consistent financial performance and be aware of the importance of hitting turnover, earnings and dividend growth targets. Hitting financial and other performance targets is a vital part of keeping existing investors happy and will also prove a selling point for the larger institutional investors.

Investors judge the ability to meet financial targets as a good indicator that the management team is in control of its destiny and knows how to set expectations.

A swing between profit and loss could be regarded as a demonstration of a company not in control of its destiny – these companies are generally seen as weaker long-term investment prospects.

Professional investors will not support companies that are in regular danger of running out of cash. Although it is easier said than done, it’s important they try and maintain a strong balance sheet. When companies are fundraising it is part of your job to help them present an enticing, well-researched and memorable investment ‘story’.

To move from the imposed £16m gross asset limit to the promised land of a market capitalisation of over £50m is the terrain of only the favoured few who, like Huveaux, get the City’s full support.

Luke Ahern is director of broking at Corporate Synergy Plc.