The concept of early-stage funding is simple. Investors with an appetite for risk agree to buy shares in a business at a pre-arranged price before it goes to AIM or the Official List (often within a period of six to 12 months) when, in theory, the value of the company will be higher.

It can enable your company to receive an injection of funds that improves its internal structure, expands its sales and profits, and generally makes it a more attractive prospect for investment.

A popular variant of straight equity pre-float funding is to issue a convertible loan, which tends to be interest bearing. This can later be turned into shares at an agreed price or according to a pre-determined formula.

In a sense, pre-IPO funding is the island between venture capital and the public markets. When entrepreneur Charles Cohen floated mobile phone gambling operator Probability on AIM in August last year with a £3.7 million placing at 76p a share, it wasn’t the first time several of its investors, including property magnate Vincent Tchenguiz, had put money into the company.

Finance director Ravi Ruparel recalls that Tchenguiz and others previously contributed to a funding round of £1.2 million a year at a fraction of the float price, with an entitlement to bonus shares if the eventual float did not achieve this price.

That bout of funding followed a £725,000 round. Before that, Probability had taken a loan from Finance South East, an arm of the not-for-profit South East England Development Agency.

Getting in early

Pre-float or ‘seed’ funding is a familiar feature on the investment scene. RAB Capital, the aggressive and so far highly successful investment group steered by the formidable Philip Richards, was an early-stage backer of TMO Renewables.

The company claims to have the technology to produce ethanol from non-agricultural materials and recently raised £15 million in advance of a planned AIM flotation. RAB states that the company’s Special Situations Fund usually makes from four to six times its money on pre-float investments.

Geoff Sankey of Yorkshire Fund Managers helps manage the London-focused Capital Fund, one of nine regional investment funds under the auspices of the Department of Trade and Industry (now called the Department for Business, Enterprise and Regulatory Reform) to back small and medium-sized private companies with growth prospects.

He says the fund ‘quadrupled its money’ on 2004’s AIM float of in-store TV group Avanti Screenmedia, and ‘didn’t do too badly’ out of last year’s AIM launch of advertising and marketing concern Ekay. The fund, which must sell on flotation, has ‘no target returns’, he explains. ‘But we do look for the prospect of fast growth.’

Ruari McGirr, chief executive of St Helen’s Capital, observes that it’s becoming harder for companies to raise between £2 million and £5 million, adding that professional pre-float backers often expect hefty margins.

While some investors may be content to target 30 per cent returns on pre-float deals, ‘private equity funds want returns of many times that’, he comments. ‘These people don’t make money by being nice guys.’

The process of due diligence for an investor in a pre-float deal can be rigorous. McGirr says that ‘most entrepreneurs are relatively sensible’ and accept the need to answer detailed questions about themselves and, for example, provide warranties that they are not harbouring any secrets or acting as fronts for other undeclared people or interests.

Gaining confidence from pre-float backers is far from a foregone conclusion, however impressive you believe your venture to be. Sankey at Yorkshire Fund Managers says the Capital Fund has seen ‘well over’ 2,000 backing opportunities in five years.

Evidently, trying to stand out from the crowd isn’t easy. ‘We’ve met a quarter of them and we’ve invested in 54,’ he recalls. Unlike many pre-float investors, the Capital Fund, which puts up to £500,000 in any one deal (‘more if it is part of a wider private fundraising’) always remains a minority investor and does not seek an active role, though ‘we normally put in a non-executive director’.

For a company planning to go public, pre-float funding is not without its complexities and potential pitfalls, from timing and pricing to the identities of those putting up the cash. You must give appropriate consideration to the amount of control you’ll be divesting by releasing equity at such an early stage, and the pressures that come from having investors with a specific exit in mind.

Ideally, the pre-float backer will come in at an appreciable length of time before the float and make a real contribution to making going public possible. Assuming that you have a view to the long term, you definitely want to avoid a backer who remains in the shadows and sells shares directly after an IPO.

That may not do a company’s reputation – or later fundraising ambitions – any good at all. When the African-oriented Lonrho Group floated uranium play Brinkley Mining last year with a £150 million funding at 50p, pre-float investors were in at a much lower price and hastened to cash in. Its shares continue to languish at 24.5p.

From time to time, corporate financiers, especially at the smaller company end of the market, voice suspicions of a murky underworld of pre-float punters who add nothing, but simply come in for a handsome short-term profit. ‘For some, it is a purely mathematical formula,’ laments one small company specialist.

“Lock-in” agreements, which force pre-float investors to hold their shares for a minimum period of a year or two, are one way of mitigating this risk. The terms of such an arrangement will depend on how strong a position you are in to negotiate. McGirr suggests it would, for example, be unreasonable to lock-in an investor who had agreed in advance to support a second and probably more highly priced round of pre-float funding.

Seeing it through
At Probability, Ruparel argues the successive rounds of seed financing before taking the big leap onto AIM were ‘critical’ to getting the company off the ground. With an innovative business model, Probability was an untried concept company, which sought to provide a gambling service via mobile phones. It needed to develop with the help of private cash infusions.

Tchenguiz and other pre-float backers took part in every funding round and one or two are showing profits of £2 million apiece, says Ruparel. In Probability’s case, the pre-float investors were locked in, although those backing the public float in August 2006 were not. The lock-in ended a few weeks ago.

Because their average buying price was well below the float price, the pre-float backers were comfortably insulated from the 27 per cent fall in Probability’s share price since flotation. The company has no quarrel with that as ups and downs are to be expected for any company.

Ruparel says: ‘The route to market is a journey. It’s all about creating your company’s strategic story and taking people with you – and you have to give them profits along the way.’

The mining and resources sector provides many examples of pre-float funding as new issues come thick and fast in this area. RAB and others provided seed capital at 10p a share for Solomon Gold, a company seeking to exploit gold prospects at Guadalcanal in the South Pacific. Having floated last year at 50p, Solomon’s shares have since fallen to 15.5p.

Entrepreneur David Bramhill raised £1.5 million seed capital from friends at 4p a share, and another £1.5 million at 7p, before floating US-focused Nighthawk Energy on AIM in March at 25p, and has since seen the shares rise to nearly 50p.

Diamond hopeful Xceldiam raised £9.4 million on AIM at 45p two years ago after earlier seed funding at 2p and 11p had raised £1.4 million, leaving the backers particularly well placed.

You might not like the idea of ceding some of your business to the market at a bargain basement price, but the investment can give you that additional muscle to go into the Square Mile and be taken seriously.

As one world-weary broker puts it: ‘These investors grease the wheels of commerce – and they need greasing back.’

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