3 Tips to Finding Small Companies With Huge Potential

For most things in life, more is better.

Vacation…

Happiness…

Square feet.

But for others, more can be worse.

One surprising example?

Money.

Hey, quit laughing! I’m serious…

In certain cases, it really is better to have less money.

One of those cases: start-ups.

As we learned from a fascinating new study, start-ups that raise less capital can provide bigger returns.

companies that raised $2-to-$3 million provided the highest return on capital for their investors.

Why is this? And what does it mean for your early-stage investment strategy?

Today we’re going to take a look.

Entrepreneurs often try to raise as much capital as they can.

Makes sense…

Capital means life. Capital means they can live to fight another day.

But as it turns out, more capital for the company doesn’t necessarily lead to better returns for the investors.

Let’s look at the numbers.

A company called Exitround just released the results of a study.

An online marketplace for buyers and sellers of small tech companies, Exitround was able to access some hard-to-find data.

In one part of their study, they looked at the relationship between how much money companies raise, and how much they sell (or “exit”) for.

They dug through data from more than 200 acquisitions going back to 2006.

For this particular study, they only looked at transactions that were less than $100 million. Why? Because historically, this is where 88% of tech M&A happens.

And lo and behold: the data revealed a “sweet spot” – a particular level of funding that provided the highest return-on-capital for investors:

The study found that companies that raised $2-to-$3 million provided the highest return on capital for their investors.

At that level of funding, early investors would make up to 10x their money.

To make money in early-stage investing – to be rewarded for the inherent risks – 10x returns are exactly what you should be shooting for on your winners.

So what happened when companies raised more than a few million dollars?

As it turned out, with more money, return-on-capital went in the wrong direction…

It went down.

Companies that raised $3-to-$5 million, for example, had an average acquisition price that was less than $18 million.

How about if they raised $5-to-$10 million?

Well, this group had higher acquisition prices – on average, about $30 million – but since investors like us paid higher prices to buy into these investments, our return-on-capital went down!

And as more and more money was raised – $10 million and up – the returns for investors just kept getting worse.

The data has spoken:

More capital doesn’t lead to better returns!

What About Going Even Smaller?

So if going bigger doesn’t help returns, how about going smaller?

Check this out:

The companies that raised between $1 million and $2 million did pretty well… and those that raised less than $1 million did even better.

Although acquisition prices for this group were smaller, they still provided a 3-to-7x return-on-capital.

Not quite 10x, but not too shabby.

So what’s going on here?

It doesn’t take much capital to start a company nowadays, or to give it an initial marketing push.

It doesn’t need expensive hardware, or pricey TV advertising.

For about $500,000, a start-up can hire a small team, build a prototype, and do some online advertising.

For another $2 million or so, a company can figure out what the market wants and start creating revenues.

Sure, a start-up could go on to raise a bunch more capital and try to go big – like Google or Facebook big.

But you can’t ignore the numbers…

Since most acquisitions take place for less than $100 million, investors like you should focus less on swinging for home runs…

And more on optimizing for return-on-capital.

To succeed with early-stage investing, focus your investments on companies that require only small amounts of capital.

Here are a few guidelines to keep in mind:

  1. If a company has already raised a couple million dollars, and is raising more now, you’re getting into the danger zone.
  2. If a company’s business plan reveals the need for millions of dollars for things like inventory or expensive hardware, that’s another red flag.
  3. If you have doubts about how much funding a company will need, or how it plans to use investors’ funds, email the founder and ask! All the funding platforms we feature on Crowdability let you email the management directly with questions.

 

Happy Investing!

Best Regards,

Matthew Milner
Founder, Crowdability.com
for The Daily Reckoning

Ed. Note: What if you could invest in a slew of tech startups, that largely fell within “magic number” range that Matthew describes above? The study he outlines fits nicely within an incredible investment opportunity that allows you to invest in a number of small tech-startups, with just the right amount of cash, before they even go public. To discover great investment strategies like this, sign up for the FREE Tomorrow in Review email edition, right here.

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