May was a bumper month for small-caps with the cash taps finally flowing.

New investment in the sector ranged from the £13million raised by the The Smarter Web Company to the £135,000 brought in by Braveheart Investment Group.

Below, we’ve taken a look at what this all means for investors, and the hidden costs associated with tapping shareholders, debt firms and the providers of other forms of more exotic forms of financing.

Filling the tank

Every small-cap company runs on fuel. But it is not oil, electricity or software. It is cash. And in today’s UK public markets, that fuel is increasingly scarce, eye-wateringly expensive and often laced with long-term risk.

For decades, the London market has styled itself as a haven for growth companies. From junior oil explorers to cutting-edge biotech firms, AIM was created to fund ambition.

But over the past three years, a sharp shift in market sentiment, triggered in part by the geopolitical shock of Russia’s invasion of Ukraine, has left public small-caps cut off from the risk capital they need to survive.

The result has been a silent cull of businesses that can no longer afford to stay public. Record numbers have delisted, gone bust or quietly sought rescue in private hands, often at the expense of shareholders.

The problem is not always the quality of the business. It is the rising cost of capital and the brutal economics of life on market.

Over the past three years, a sharp shift in market sentiment has left public small-caps cut off from the risk capital they need to survive.

Why small-cap equity raises are getting more expensive

Raising capital on the market might appear straightforward. You issue shares, raise cash and carry on. But for many small-cap firms, that path is now lined with penalty clauses.

Take the practice of issuing equity at a discount. A 20 per cent markdown from market price might sound modest. But consider a company raising £5million at 80p per share when its fair market value is £1.00.

To raise the capital, it must issue 6.25 million shares, effectively selling a £6.25million slice of the business to bring in £5million. The effective cost of capital is not 20 per cent but 25 per cent.

And that is just the starting point.

In weaker markets, discounts balloon. Placings at 30, 50, even 70 per cent below the prevailing price have become increasingly common. These are not aggressive expansion plays. They are rescue raises, driven by cash burn and deteriorating investor confidence.

Behind them lurk even more corrosive practices. Dribble placements, where small tranches of equity are sold into the market via third-tier brokers, sap value incrementally.

Often arranged on unfavourable terms and leaked before official announcement, they can lead to spiralling share price declines. Investors call it ‘death by a thousand cuts’. It is an apt description.

Understanding the risks of convertible loan notes and exotic finance

When traditional equity becomes too expensive or impossible, companies often turn to more complex, so-called exotic financing structures.

On paper, these arrangements offer flexibility and reduced dilution. In practice, they are often a form of deferred compromise and the costs are both hidden and heavy.

Take the convertible loan note (CLN), a favourite among early-stage companies. Typically structured with a 10 to 12 per cent annual coupon, these notes accrue interest over time and convert into equity at a pre-agreed discount. That combination can be lethal.

Imagine a £5million CLN with a 12 per cent compound annual coupon. After three years, the note is worth nearly £7million. If it converts at a 20 per cent discount, the investor receives £8.75million worth of equity, not £5million.

The company faces a dilution impact far greater than it bargained for. What looked like smart bridge financing becomes an equity event on punishing terms.

Then there are death spiral convertibles, instruments that allow the lender to convert debt into equity at a discount to the prevailing market price.

The lower the share price goes, the more shares the lender receives. The act of conversion itself creates selling pressure, pushing the price further down. It is a self-reinforcing cycle. The spiral is not metaphorical.

Other instruments, like structured royalty deals or equity line facilities, carry their own risks. Royalty agreements, popular in the life sciences and resource sectors, exchange upfront cash for a percentage of future revenues.

Listing on AIM can easily consume £500,000 to £1 million per year 

But those royalties often bite hardest just as the company begins to scale. They become a tax on success, not failure.

Equity-linked loans and SEDAs (standby equity distribution agreements) are no better. While marketed as flexible drawdowns, they usually come with conversion triggers, penalties and mandatory draw clauses.

If a company’s cash balance dips below a threshold or it misses a milestone, the financier can force conversion or impose fees. Control shifts from the boardroom to the back office.

What unites these instruments is their asymmetry. The investor is hedged, discounted and collateralised. The issuer is exposed.

Why more small-cap firms are abandoning public markets

The deeper problem is not just structural. It is philosophical. More and more, founders and finance directors are questioning the utility of a public listing at all.

Costs are a major factor. Listing on AIM can easily consume £500,000 to £1 million per year. Nomad retainers, audit and legal fees, brokers, registrars, exchange fees and ESG reporting obligations all mount up. For companies with little or no revenue, this is not capital well spent. It is capital wasted.

Meanwhile, the scrutiny is relentless. Public shareholders, especially in small-caps, can be unforgiving. Liquidity is thin, sentiment volatile and price movements disconnected from fundamentals. The CEO’s job is no longer just to build a business. It is to manage the market.

Faced with that trade-off, many choose to delist. Others never list at all. The most innovative early-stage companies now bypass AIM entirely, opting for private capital that comes with fewer strings and no public reporting burden.

Venture capital and private equity, meanwhile, often refuse to invest in listed vehicles. Their support is conditional on delisting, a growing trend in the tech and biotech sectors. The UK’s public markets are no longer the default path for scaling a growth company. They are the route of last resort.

The consequences for small-cap investors and long-term growth

This leaves investors in a bind. The traditional promise of small-caps, innovation, growth, 10x returns, is still alive. But it is harder to access, more expensive to back and easier to lose.

Public market investors now face thin liquidity, high volatility and regular dilution. Placings are discounted. Exotic instruments skew outcomes. And even the best companies may be forced to leave the market just as the real value emerges.

Yet the attraction endures. For every five failures, there is one success story that justifies the risk. That keeps investors coming back, chasing the elusive ‘ten bagger’, hoping the next placing is the last.

A failing ecosystem for UK-listed growth companies

The UK small-cap market is not broken, but it is badly frayed. A system built to support innovation now punishes it with high costs, shallow liquidity and structural inefficiencies.

Until that changes, until capital becomes cheaper, structures become fairer and confidence returns, the story of small-caps will remain one of ambition held back by arithmetic. Of companies fighting to grow while paying dearly just to stand still.

And of investors, once again, learning the hard way that in small-caps, survival has a price. And that price is always paid in cash.

For all the breaking small- and mid-cap news go to www.proactiveinvestors.co.uk

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