The evolution of small company finance

So it piqued our interest when a little-known, London-based financing group called Darwin Strategic kept popping up as a major new investor in Aim penny stocks.

During the past three months, Darwin has committed to a combined £33.6m in new financing deals with five Aim companies. And in 2012, it agreed to invest a total of over £100m in close to a dozen companies that otherwise might have struggled to raise money.

Notably, all Darwin's deals are structured as complicated, multi-year drawdown agreements called 'equity finance facilities', or EFFs - and if the financial crisis has taught us anything, it's that we should pay especially close attention to unusual financial arrangements.

Given their regular use (see table) it's surprisingly hard to find information on how these products work, although the team behind Darwin were very open when we asked them. So what exactly are they?

EFFs essentially work like a line of credit, repayable in shares instead of cash. Darwin and other EFF providers agree to supply a listed company with an amount of cash they can draw down in small tranches at their discretion over a period of a few years. So, rather than trying to raise, say, £5m or £10m from hard-to-tap capital markets all in one go, companies can drip-feed themselves money from an EFF. They don't have to repay the line of credit using shares priced at a large discount, either - instead, whenever they draw down, the company issues new shares at or near the prevailing market price. They also don't have to use the facility if they don't need it - usually no fees are attached.

The catch is that Darwin typically short-sells shares of the listed company in the open market just before a draw down occurs. It then gives the short-selling proceeds to the listed company in return for shares, and then closes out its short position with the new shares issued by the company. The end result is often something what Darwin’s chief executive, Anand Sambasivan, calls "risk neutral", whereby Darwin has limited or no exposure to shares in the listed company despite just giving them hundreds of thousands of pounds in exchange for an equivalent amount in shares.

Darwin profits by taking a percentage cut of the transaction, plus whatever it can make from the spread between the short-selling price and the issued price of the new shares. In addition, Darwin is usually issued warrants when signing the EFF, so if the listed company’s share price were to rise afterwards, then it could make money on those, too.

We've got no problem with this - and Darwin are justifiably proud to have developed a vehicle that allows them to provide much-needed financing to small companies in a mutually beneficial way. But the companies using them should take greater care not to position them as strategic investments by a large and well-respected investor - in this case Henderson Global Investors, Darwin's majority shareholder.

Mr Sambasivan told the Investors Chronicle that Darwin’s facilities are designed to be "net neutral" and that they are "never net short". Sometimes, however, he says they go "net long" or get an institutional investor, such as Henderson, to take up a portion of the shares in a long position.

One Aim executive, who wished to remain anonymous, claims to have received and declined several EFF offers lately - albeit from parties other than Darwin. He described them as "a necessary evil" but said he was "very concerned about the lack of disclosure to shareholders".

Darwin's chief executive nevertheless argues his equity finance facilities allow companies to raise money at better prices than if they had to raise it all in one go. "Companies are no longer held hostage when they want to raise money," Mr Sambasivan says, pointing out that EFFs bring "a sort of institutional flavour back to the Aim market" at a time when institutional investors have largely abandoned the natural resource sector.

As for creating pressure on share prices: "We look at it very carefully. We have someone, an ex-market maker for the Aim market, who really knows what he's doing with this and he's able to do it with absolutely minimal impact to the share price." Nevertheless, we'd still suggest that investors don't take such fundraisings as a vote of confidence in the prospects of any companies using them.