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AIM - the opportunities for IT and software companies

Friday, October 31, 2008

Delphine Currie, Partner at SJ Berwin

Software and computer services companies make up only 7.8% of the AIM market by volume(1), yet there are still many opportunities for growth within this sector. Over the last few years, such companies have seen some of the greatest levels of growth, 59.5% in the case of software companies on AIM since their IPOs(2). Even in an economic downturn, the prospects for such companies are far from bleak. The FT recently reported that IT departments spend up to 80% of their budgets on operations and that this spending cannot easily be cut if the underlying business is to remain competitive(3). This was backed up by a recent survey from Datamonitor, which revealed that 57% of industry respondents in the healthcare sector actually planned to expand their IT expenditure in 2009(4).

Against this backdrop, logic would seem to dictate that the IT and software sector is one of the few where it should still be possible to raise equity financing on AIM and other public markets to fund growth. Indeed, given the current unavailability of debt financing, the equity markets may be the only option and, whilst it would be a brave manager that would be willing to launch an IPO amidst the current volatility, now is the time to start the preparatory work. Experience has shown that proper preparation and planning can drastically reduce the IPO timetable, resulting in significant costs savings and reducing the demands on management time.

From a legal perspective, one of the most important things for any IT or software company to check is that it owns the intellectual property on which its business depends. For companies that are reliant on IP generated by third parties, this means ensuring that all the necessary licences are in place and that their terms are sufficiently robust to give investors comfort that the licence cannot be revoked for a spurious reason. If necessary, renegotiate any licences whose terms are disadvantageous.

Companies that generate their own IP should check that adequate service agreements are in place with any employee who is involved in the production of software, know-how or bespoke hardware. In the absence of specific contractual wording, IP rights vest in the person who created the product. Therefore, it is vital that service agreements properly specify that any IP created in the course of employment belongs to the company and not the employee. Restrictive covenants and confidentiality provisions should also be checked to ensure that an employee cannot easily go and work for a competitor and share valuable trade secrets.

Another problematic area involving employees is option arrangements. It is perhaps a legacy of the dot.com era that employees in IT and software companies expect to receive options; an IT company that came to the market a couple of years ago had no less than fifteen separate option arrangements in place! Whilst AIM does not restrict the number of shares under option, some other public markets (for example, the Official List) do and, generally speaking, investors will be put off by companies which have been too generous with options because of the dilutive effect that this may have in the future.

The terms of all option arrangements will need to be clearly explained to the market in the documentation issued at the time of the IPO, so the company should ensure that everything is properly documented. The company should also ensure that its employees understand the constraints of share ownership in a public context; for example, employees in possession of inside information will find their ability to exercise options and sell the resulting shares severely restricted. Such issues should be addressed at an early stage to ensure that employees do not feel aggrieved post-IPO.

From a practical perspective, directors often underestimate both the amount of management time which an IPO takes and, even with AIM’s “lighter touch” approach to regulation, the increased time demands post-IPO. Unless properly managed, these extra obligations can distract attention away from the normal running of the business. This is particularly the case during the preparation for listing, as the competing requirements of due diligence (legal, financial and possibly technical), document production, verification and meetings with potential investors inevitably pull the management team in different directions. If these tasks are not carried out properly and in a timely manner, the IPO will, at best, be delayed and, at worst, may never happen. There is also the possibility of personal liability for the directors if the public documentation is inaccurate or misleading because it has not been prepared with proper care and attention.

One way of avoiding these issues is to ensure that the management team is adequate both in terms of its size and experience. This will also help the investment case as investors tend to look at the experience of the management team when deciding whether or not to invest. In IT and software companies, the creative and entrepreneurial people who started the company and designed the products on which its business depends are not always the best suited to run a public listed company. Therefore, before embarking on an IPO process, it is worth considering whether the management team needs to be strengthened by, for example, employing a new MD or FD with appropriate experience.

It is also important to consider how the team will be organised both pre- and post-IPO. Pre-IPO, it can be useful to set up a team with the specific task of dealing with the flotation, leaving the rest of the management team to focus on the day-to-day running of the business. It may be worth considering hiring short-term help over this period; there are a number of consultants available with many years of public company experience who are happy to be parachuted into a pre-IPO situation to guide the company through the process. Post-IPO, it needs to be decided who will deal with the additional tasks such as ensuring compliance with the market rules, drafting and approving announcements and investor relations. Many of these tasks can be outsourced but there needs to be someone at the company who ultimately takes responsibility for these matters.

The key message is that early preparation is vital and it is never too early to start, particularly for a company in a sector that looks as if it may continue to see growth and buck current market trends.

Notes:
(1) As quoted in August 2008 statistics on the AIM website of the London Stock Exchange, www.londonstockexchange.com downloaded on 22 October 2008.
(2) Table 1, Technology Companies by sector as reported in Technology Companies on AIM 2007 13.06.2007 downloaded from Growth Company Investor on 22 October 2008.
(3) Financial Times Special Report on Digital Business Wednesday 22 October 2008, What do buyers really want? by Stephen Pritchard
(4) Figures for August 2008 as reported in “IT budget crunch” on www.growthcompany.co.uk downloaded on 17 October 2008.

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Delphine Currie is a partner in the Corporate Finance department of law firm SJ Berwin LLP. She deals with all aspects of corporate finance work, including mergers and acquisitions, takeovers, joint ventures, IPOs on the Official List and AIM market of the London Stock Exchange and both public and private equity fundraisings.