Four questions to ask to avoid getting burned by tech stocks

What can venture capitalists teach private investors about picking the best tech stocks? Matthew Partridge outlines four key questions to ask before you buy.

Venture capital (VC) now plays a huge role in the global economy, with around $150bn invested in companies in 2015. Nearly all of today's big-name tech firms relied on backing from VCs in their early stages. While few of us will ever have the chance to invest directly in a tech start-up, there are many small tech stocks on the London Stock Exchange and Aim. So what can venture capitalists teach private investors about picking the best prospects? Here are some key questions to ask before you buy.

How will the idea make money?

It's easy to be dazzled by a new technology. But the point of a business is to make money for its shareholders. So while customers might be interested in a product or service, will they pay enough to make the firm viable? As Eugene Kleiner, the late co-founder of the Kleiner Perkins Caufield & Byers VC firm, an early investor in Amazon, said: "Are the dogs willing to eat the dog food?" The firms that survived the bursting of the internet bubble in 2001 were those who had figured out how to monetise their ideas.

What business is the company in?

Many tech firms fail because they focus too much on the wrong part of their business, or don't even understand what business they are truly in. Apple's breakthrough came when it realised there was more money to be made dominating the market for music players, smartphones and tablets, than in being an also-ran in the personal computer market. And almost 90% of Google's revenue comes from its two advertising platforms: AdSense and AdWords.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Is the idea original?

One problem with tech investing is that many companies are just riding a bandwagon, rather than generating their own ideas companies are often brought to market simply to cash in on a particular trend, rather than because they have a strong business plan. The odds of success are even worse if the underlying market is small. As Kleiner put it: "Two companies fighting over a niche market are like two bald men fighting over a comb."

Is there a large upside?

Most VCs, such as Peter Thiel, the co-founder of PayPal, are big believers in Pareto's Law the idea that 80% of the results from a given endeavour come from 20% of the effort. In VC, a small number of very successful investments, known as "unicorns", pay for the majority of failures. A 2014 study by the technology firm Correlation Ventures suggests that, between 2004 and 2014, two-thirds of VC-backed firms either failed, or didn't make their investment back. So tech investors need to be more diversified than normal and focus on finding investments with high upsides to offset the inevitable failures.

I wish I knew what dual-class stock is, but I'm too embarrassed to ask

When we talk about shares we usually mean ordinary' shares (or common' in the US). These give the shareholder part-ownership of the company, the right to vote on various decisions, such as the election of board members and whether to accept a bid for the company, and a share of the dividends. However, some companies issue other classes of share that come with different terms and conditions these are known as "dual class" stocks.

Often, the dual-class structure is designed to give certain shareholders more power than others. In this case, a company may issue two classes of shares that have the same right to profits and dividends, but one class carries fewer than the other or even no voting rights at all. This has become common with US tech firms where the founders wants to list the business without surrendering control. However, there are several other types of share. One example is energy company Royal Dutch Shell, which has two classes, "A" and "B". While the former is subject to a Dutch withholding tax, the latter is not.

"Preference" shares are a cross between shares and bonds the owners get first call on any dividends paid, and are higher up the list of creditors than ordinary shareholders. However, preference shares are less secure than bonds and their dividend payment is often fixed, in which case they won't benefit from rising dividends. "Redeemable" shares can be bought back by the issuer, either on a certain date, or at the issuer's discretion. These are often used in employee-run firms such as John Lewis where managers wants to give staff a stake in a company, but don't want them to retain the shares if they leave.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri