Pre-IPO investing: How to Invest in Startup Companies
Key Takeaways
- Pre-IPO investments can help startups raise capital before conducting a public offering.
- Non-accredited retail investors rarely have opportunities to purchase pre-IPO shares, and when available, it is recommended that they do so cautiously.
- While pre-IPO investing can be lucrative, it is also very risky, can take some time to produce results, and lacks liquidity.
Initial public offerings of shares in a company can hold the potential for significant gains. However, what a lot of retail investors may not realize is that an initial public offering (IPO) usually isn’t the first time that shares have been offered for sale.
In many cases, long before companies have gone public, they have offered shares to institutional investors to raise startup capital. While these pre-initial public offerings can potentially be alternative investments outside of the traditional stock market, mainstream investors usually don’t have access to them. But with more opportunities available to invest in venture capital and private equity funds, here is what investors need to know about pre-IPO investing and how to potentially invest in startup companies.
What Are Pre-IPOs?
Offerings of shares in a company before it becomes listed on a public stock exchange are referred to as pre-IPO offerings. Generally, these are younger companies in need of startup capital to develop their business models, infrastructures, and product lines so that they can eventually go public.
The upside of these investments is the massive gains pre-IPO investors stand to realize when these companies make their initial public offerings. Valuations are usually deeply discounted in the pre-IPO phase, which means investors can sell those shares at a profit within months of the IPO.
Why Pre-IPO Companies Sell Stock
One of the reasons fledgling companies offer pre-IPO placements is, as stated above, the ability they provide to raise money before going public. Pre-IPO offerings can also help offset the risk that IPOs may be less successful than anticipated for a company. Further, the institutional investors who typically buy pre-IPOs do so with the understanding they will have a hand in helping the company’s management team with governance.
Pre-IPO Investing Benefits
The primary benefits of pre-IPO investing for investors are the potential for capital gain, as well as portfolio diversification. The broad range of additional opportunities that pre-IPO investments present is another potential benefit. Investors who have chosen well have experienced exceptional returns.
As an example, Singapore-based venture capitalist Ozi Amanat purchased a block of pre-IPO shares in the Chinese e-commerce, retail, internet and technology company Alibaba (NYSE: BABA) for $35 million before the company made its initial public offering in 2014. Those shares were valued at nearly $95 million after the company went public.
Pre-IPO Investing Risks
However, it should be noted that pre-IPO investments carry significant risks and should only be considered by investors with extreme risk tolerance. While post-IPO shares can be traded easily, pre-IPO shares are not SEC-registered and do not carry the same legal protections investors enjoy with public equity investments.
Liquidity is another concern of pre-IPO investments. In most cases, once you are in, you may have to stay in until the company issues public shares. While this problem can be mitigated somewhat by ensuring that the company is close to announcing its public listing, there are no guarantees the company will ever go public. There is a risk the company will fold, or never successfully complete an IPO. In that instance, pre-IPO investors have little to no recourse.
Because these companies are privately held, they do not fall under the purview of the Securities and Exchange Commission, which can also mean little or no transparency for investors. Further, pre-IPO shares are often sold with a lockup period agreement, preventing them from being resold immediately.
In other words, the risk factor is quite high with pre-IPOs.
Pre-IPO Due Diligence Questions
Before investing in a pre-IPO it is prudent to try to determine when the company plans to go public. What exactly is their plan for doing so? How detailed is their plan? What do they need to do to complete the plan?
The SEC also recommends asking the following questions before investing:
- Is the offering legally exempt from SEC regulation?
- What does the company produce and sell? Who are its customers? Can the existence of any facilities the company claims to have be confirmed?
- Who is running the company? What is their background? Have they successfully completed IPOs in the past? Do they have a criminal record?
- What investment bank is underwriting the offering?
- How was the offering brought to the investor’s attention? In some cases, advertising these offerings publicly can be illegal. What is the reputation of the offering’s promoter?
Who Can Invest in Pre-IPO Offerings?
Given the risks outlined above, it should come as little surprise that the primary investors in pre-IPO offerings are extremely well heeled. In fact, there was a time when only accredited investors and exceptionally well-funded organizations such as hedge funds, private equity firms and venture capitalists could take advantage of these opportunities.
This changed with the passing of the Jumpstart Our Business Startups (JOBS) Act of 2012. Companies are now allowed to raise equity through crowdfunding. The SEC also now allows companies to offer up to $50 million in shares without registering the offering.
This has created several different ways that retail investors can participate in pre-IPO offerings. In addition to participating in equity crowdfunding, non-accredited investors can purchase shares in companies that specialize in growth-stage business investments. There are also several pre-IPO platforms that offer these opportunities, though they may require investors to be accredited to participate.
Pre-IPO Investment Considerations
Early-stage investing, while offering the potential for great reward, should be approached cautiously. Pre-IPO investments can have long time horizons, so they should be considered long-term placements. Further, it is important to ensure a high degree of risk tolerance, as well as diversification needs.
Alternative investments such as these can be useful tools for portfolio diversification, which is generally agreed to be a smart investment strategy to pursue. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Portfolio Diversification and Alternative Investments
In addition to pre-IPO offerings, real estate, private equity, venture capital, digital assets, and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification.
As were pre-IPO investments, these assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. Yieldstreet opens a number of investment strategies that were formerly available only to institutional investors and the top one percent of earners to all investors.
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Summary
Pre-IPO investments offer a great deal of potential, but they also present a higher level of potential risk than does investing in established companies with solid fundamentals. After all, 90% of startups fail. It is important for investors to consider their risk tolerance and diversification needs before investing in securities of any type.
When it comes to pre-IPO investing, it is best to start gradually and keep the amount of the investment to less than 5% of the total percentage of a portfolio earmarked for alternative investments.
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