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Why you should be wary of tech shares chasing handouts

Investors find tech stocks attractive, and it’s not hard to see why. A compelling online proposition can offer rapid growth for a song, and often shareholders are only too happy to tip more cash in when these companies raise capital – which is usually at a discount to recent (often elevated) share prices.

There’s a darker side to this however, as outlined by companies such as Ltd (ASX: RNT) and Newzulu Ltd (ASX: NWZ), which are in trading halts pending announcements about capital raisings later today.

When a company can’t use the cash it raises to generate more cash, it’s a one-way ticket downhill for its share price – and its shareholders. Newzulu Ltd is tapping the well for the umpteenth time, with the only semi-benefit being that it’s usually venture capitalists taking the risk, rather than ordinary shareholders.

However, shareholders will still feel the sting of a share float that has ballooned out to 725 million shares – diluting their holdings, despite the company’s market cap of just $17m. is a more attractive proposition, having exceeded all the milestones the company set for itself during its Initial Public Offering (IPO) prospectus. However, shareholders must still evaluate the likelihood of future growth eventually resulting in a positive cash flow to the business. Shareholders who bought in at 30, 40 and 50 cents per share recently will potentially be stung by today’s capital raising, which could be conducted at a discount to the last traded price of 17.5 cents.

Even several months ago, a capital raising appeared likely as cash outflows far outstripped revenues and the company had a small cash balance. It’s a similar story over at 1-Page Ltd (ASX: 1PG), whose share price has been crashing recently after the company announced an accelerating cash burn, on the back of still insignificant revenues. Future capital raisings could hurt the company’s long term prospects, as lower share values will require a proportionately greater number of shares be issued to raise the same amount of funds.

There are scores of examples of tech stocks raising funds to stop-gap a cash haemorrhage, with iWebGate Ltd (ASX: IWG) another recent example. Freelancer Ltd (ASX: FLN) managed to do it successfully last year, raising capital to expand its operating cash-flow positive business.

I’m not saying that these businesses can’t go on to be successful, but investors are taking a big risk by buying small, unprofitable growth companies with a limited cash balance. It’s not hard to find yourself down 50% on your investment before your company announces a capital raising and increases the number of shares on issue at a discount to the last traded price.

These types of businesses are only suitable for investors with a high risk tolerance, and then only for a small part of your portfolio. It’s best to pro-actively keep an eye on the company, check if it’s hitting its targets and making progress towards positive cash flow – and ruthlessly cutting it if it keeps falling short.

There is one positive though – small companies are pretty dependent on goodwill among media and shareholders to attract support for their fundraising activities. So if you’re not sure about something to do with a company – try sending them an email or giving them a call. You might be surprised at the quality of the response.

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Motley Fool contributor Sean O'Neill owns shares of Newzulu Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.