In the golden days of tech investing, retail investors had access to “ground floor” opportunities when companies like Ebay, Oracle, Apple, Microsoft, Amazon, Salesforce, and Google went public.
These startups, which once held just a spark of potential, are now among the globe’s top tech companies—with some reaching mind-boggling market valuations above the $1 trillion mark.
But ever since the 2000 dot-com bust, companies have been staying private longer (of 10-12 years on average) and gaining more of their value before they IPO.
This shift benefits the institutional investors with exclusive access to pre-IPO deals, but leaves average retail investors out in the cold.
However, with Title III of the JOBS Act kicking in on May 16th, 2016, investing became a whole lot more inclusive. Regulation Crowdfunding made it possible for just about anyone, not just the big-money accredited investors, to get in on private market deals.
This opened up a world where the regular investors could have a shot at investing in companies before they go public, and access the potential of early growth companies.
But to truly capitalize on these pre-IPO offerings, you’ll need more than just money.
Pre-IPO investing is high risk and high reward. On the one hand, you could make outsized returns. But you could also end up losing your entire investment altogether.
In this article, we’ll explore the benefits, drawbacks and investment process for pre-IPO deals.
- Pre-IPO Shares: Shares of privately held companies, which may or may not go public in the future.
- Pre-IPO Buyers: These are typically institutional investors like private equity funds, venture capital funds, hedge funds, as well as individual accredited investors who can purchase shares in primary capital raising rounds or through a secondary marketplace.
- Pre-IPO Benefits and Risks: Benefits include gaining early access to high-growth startups, potentially experiencing significant returns, and diversifying their investment portfolios. However, it’s important to consider potential risks, including higher fees, limited transparency, and the possibility of financial loss.
What is Pre-IPO?
Pre-IPO, as the name suggests, refers to a period before a company’s initial public offering (IPO), if that ever happens.
Steps involved in going public, from pre-IPO to post IPO.
What is a Pre-IPO company?
To put it in simpler terms, it’s the phase when a company is still private, meaning its shares are not publicly traded on stock exchanges like the New York Stock Exchange or NASDAQ.
In some cases, private companies – or promoters of private companies raising capital – will market themselves as pre-IPO, when in fact, they either have no intentions of going public or are still several years away from reaching a public offering. For the purposes of this article, we will consider a pre-IPO company to be a company that is raising a round of capital prior to going public, within the next 6-24 months. Keep in mind, even if a company intends to go public, there is no guarantee they will be able to do so.
The buyers are usually big players like private equity firms, hedge funds, or other institutional investors who are willing to buy a substantial stake in the company.
But here’s the catch. Often times, the IPO underwriter will require something called a “lock-up period” – a period of time after a company has gone public when major shareholders are prohibited from selling their shares. During the IPO lock-up company insiders and early investors cannot sell their shares, helping to ensure an orderly IPO and not flood the market with additional shares for sale.
If you are one of the investors who invested prior to this provision, you may not be able to sell your shares for 90-180 days following the IPO.
If you are considering investing in a company that has recently conducted an initial public offering, you should determine whether the company insiders have a lockup and when it expires. This is important information because a company’s stock price may drop in anticipation that locked up shares will be sold into the market when the lockup ends.
To properly assess the potential of a pre-IPO company, it’s worth understanding the role that IPO underwriting plays in the IPO process.
What is IPO Underwriting?
Underwriting an IPO involves a series of complex tasks undertaken by investment banks or commercial banks. The underwriters first propose the valuation and type of security to be issued, then create an agreement with the company detailing the IPO process and commissions. This commission is typically between 3%-7% of the gross spread, which is the difference between the sale price of the public issue by the underwriter and the purchase price of the public issue by the underwriter. Generally, attorneys for both sides, the underwriter and the issuer, will work together on preparation of the Underwriting Agreement and its provisions, as well as the offering documentation and its contents, including offering limitations and risk disclosure.
The underwriters then prepare numerous regulatory documents for the SEC before embarking on marketing roadshows to drum up investor interest. They must also decide on the IPO pricing strategy (fixed pricing or a book building approach). Following the public subscription period, the underwriters finalize the IPO price and share allocation. If the offering is a ‘firm-commitment’ issuance, the underwriter is responsible for buying/absorbing any shares that were not placed with investors. Beyond the base commission, underwriters can also earn additional revenue from reselling these ‘unplaced’ shares to the public, thereby compensating them for the risks involved in the process. However, if the secondary market price for the shares declines after trading in the shares begins, the firm may take a loss on that portion, which is why they try to place them all at the IPO.
Why Do Companies Pre-IPO?
Companies pursue pre-IPO placements to secure funding, gain strategic advice from institutional investors, and mitigate IPO-related risks while maintaining control over their business. Let’s explore each reason more in-depth.
Annual IPOs, 2000-2021
Raising Funds for Growth
With pre-IPO placements, the company may avoid some of the risks and uncertainties associated with an IPO, such as the share price being affected by market volatilities or failing to meet expectations. By selling large blocks of shares at a fixed price during a pre-IPO, the company is more assured of raising a predictable amount of money.
Getting Guidance from Investors
Usually, large investment firms, hedge funds, and other institutional investors, who boast years of experience and vast resources, are the ones that purchase most pre-IPO shares. Their inputs and insights can be invaluable, particularly for startups, as they navigate the complex process of transitioning from a private company to a publicly-traded entity.
Maintaining Control Over the Business
Often, traditional institutional fundraising routes like venture capital (VC) or private equity (PE) firms can result in founders relinquishing more equity and control over their business than they’d prefer.
There’s also the risk with VCs and PE firms that their mandates, which primarily focus on returning capital to their funds, may not align with the company’s long-term interests, potentially pressuring them into decisions that may not be in the business’s best interest. Crowdfunding portals like Equifund can provide an alternative route for raising funds without ceding too much control. More on that below.
Creating a Customer/Shareholder Flywheel
An innovative concept that has been gaining popularity is the idea of turning customers, vendors, and suppliers into investors, creating what’s called a Customer/Shareholder Flywheel. The rationale here is that these stakeholders are more likely to be aligned with the company’s mission and values, leading to better customer and shareholder value creation.
Companies partnering with crowdfunding platforms like Equifund, for instance, can access a friendlier source of capital, while simultaneously growing their business with the help of a community of people who understand and are invested in their success.
Who Can Buy Pre-IPO Shares?
Pre-IPO shares are typically difficult to come by and end up in the hands of a select few types of investors. At the forefront are institutional investors such as private equity funds, family offices, venture capital funds, and hedge funds who are able to make large investments in private companies.
Publicly traded corporations might also purchase pre-IPO shares to secure an early stake in innovative companies that are on the verge of disrupting their industry. One example of this is Microsoft investing $10 billion in OpenAI, aiming to tap into their groundbreaking AI technology ahead of competitors like Google.
The last category consists of individual investors. More specifically, those who qualify as accredited investors as per the SEC’s financial suitability requirements. Such investors are individuals who maintain an annual income of $200,000+ individually or $300,000+ jointly for the past two years and expect to keep up this income level in the current year, or have a new worth of at least $1 Million excluding any equity in their primary residence.
These investors can get a piece of the pre-IPO pie in various ways. They might be part of a friends and family investment round during the nascent stages of a startup, or they might participate in crowdfunding offerings like those listed on Equifund.
The Pros and Cons of Pre-IPO Investing
The primary benefit of buying pre-IPO shares is investing in a valuable company before it goes public—ideally at a lower price than its IPO valuation. Let’s break this down further.
While there’s no guarantee that startups will increase in value if they go public – virtually any investment, especially startups, has the potential to lose some or all of its value – you at least have the opportunity to get in early.
Potential for Market-Beating Returns
While this is far from guaranteed, highly anticipated IPOs are sometimes able to provide massive single-day gains for pre-IPO investors. For example, Visa’s 2008 IPO saw its shares surge 28% on the first day of trading. The inverse can be true as well, and values can drop from the IPO price, so due diligence on the offering and the ability to withstand a potential loss are key.
In some cases, the buyers in a pre-IPO placement may get a discount from the price stated in the prospectus for the IPO.
For example, if a company sets its IPO price at $40 per share, it might offer pre-IPO shares at $20 per share. That lets you buy in at a lower price that may yield profit even if the IPO is not highly successful.
The Downsides of Pre-IPO Investing
As with any investment strategy, pre-IPO investing is not without its drawbacks. Just remember that for every Facebook, there are countless startups that don’t ever make it to IPO or that fail post-IPO.
When we talk about investing in a pre-IPO company, we’re banking on a future event: the company actually going public. However, there’s no guarantee this will happen. Various factors can influence the company’s decision to hold off on an IPO or cancel it altogether, whether it’s market volatility, financial instability, or regulatory issues.
The second risk associated with pre-IPO stocks revolves around liquidity, or rather, the lack thereof. Unlike publicly traded stocks that can be bought and sold on a public stock exchange, pre-IPO shares – by definition – are privately owned companies. For this reason, shares can be difficult to trade while the companies are privately owned (although shares may be available on secondary marketplaces).
Pre-IPO investing often involves dealing with a complex web of regulations and company rules. For instance, only accredited investors typically have the opportunity to invest in pre-IPO shares. Additionally, companies often impose lockup periods that prohibit shareholders from selling their stocks immediately after the IPO. This means that your investment could be tied up for six months or longer, regardless of what happens to the stock price post-IPO.
Potential for Total Loss
There’s always the chance that the company you invest in may not perform as expected after its IPO. This could result in your investment losing value, or in the worst-case scenario, becoming worthless.
Lack of Financial Transparency
Public companies are obligated by law to disclose a wealth of financial data, but private companies face no such mandates. This could leave you, as an investor, with limited insight into the company’s financial health, making it challenging to make informed investment decisions.
Example of a Pre-IPO Company
Back in 1997, Amazon’s (AMZN) pre-IPO investors experienced a remarkable exit. The stock’s target price had been set at $18 by underwriters prior to the IPO, but soared as high as $30 on the first day of trading—likely netting double or even triple digit returns for early investors.
However, not all pre-IPO investors end up becoming rich—even after a successful exit. Uber employees who bought pre-IPO stock options had to wait four years for their options to “vest”. By the time they were finally able to sell their shares, Uber’s stock was worth 44% less than its IPO valuation.
How Do I Buy Pre-IPO Stocks?
Retail investors typically simply don’t have access to the pre-IPO opportunities that institutions do. In most cases, they’re better off simply investing in public companies. But there are several ways that an investor might get a slice of the pre-IPO action.
Contact Financial Service Providers
Banks, accounting firms, stockbrokers, investment advisers, or specialized pre-IPO brokers may have insight into which tech startups are currently raising funds.
Attend Business Events
You can discover high-potential tech businesses by attending startup pitch events, and visiting incubators or accelerators (e.g. Y Combinator).
Use a Secondary Marketplace
Secondary marketplaces like EquityZen connect accredited investors with high-growth, VC-backed startups, allowing them to own stakes in private companies at past valuations.
This is the most likely way for average retail investors to get “true” Pre-IPO shares (that are on the brink of going public). But the problem with secondaries is that there’s no underwriting on the shares you purchase.
In other words, investors have no idea if they’re buying shares at a “good price” and are simply speculating that they can sell them at a higher price later on.
The only other way for you to fix this problem is to acquire shares directly from the issuer in a primary marketplace.
Use a Primary Marketplace
When investors buy shares on a secondary market, with no real underwriting, they are probably overpaying for these shares in the hopes there is still upside.
Primary marketplaces, like Equifund, allow retail investors to buy shares directly from private companies (i.e. “issuers”).
Become an Angel Investor or Join an Angel Syndicate
As an angel investor, you invest your personal capital into tech startups in exchange for equity. But to qualify as an angel investor, you do need to meet accredited investor standards.
Angel syndicates, on the other hand, allow groups of angel investors to pool together their money and invest as one entity—giving them access to better deal flow.
Invest in Pre-IPO Stock Indirectly
There are two main ways for retail investors to indirectly invest in pre-IPO stocks. Firstly, by investing in public companies that own shares in private companies.
Alternatively, you can invest in a special purpose acquisition company (SPAC). SPACs are publicly traded shell companies that acquire or merge with private companies to bring them public. Companies like Lucid and WeWork opted to go public via SPACs.
Best Practices for Investing in Pre-IPO Companies
To invest like pre-IPO insiders (particularly investment banks), you have to think like one. Generally speaking, investment banking consists of seven parts:
Various services and processes related to banking.
1. Raising Capital
While banks raise capital by borrowing money from other individuals and corporations, your primary source of capital, as a retail investor, will be from the active income you generate from your day job, or your personal savings.
2. Asset Allocation
Once you have the capital, now you have to have a plan for what to do with it.
This includes coming up with an Investment Policy Statement, which describes your investment objectives and portfolio construction methodology. One popular way to think about structuring a portfolio of public and private companies is the Tiger 21 Member Allocation.
Tiger 21 Member Allocation portfolio
Generally speaking, Pre-IPO companies would likely fall under the Private Equity portion of this allocation model. Also, generally speaking, Pre-IPO companies tend to be larger – and later stage – than what would traditionally be considered a “startup.”
In terms of diversification and risk management, depending on the stage of the corporate lifecycle you invest, you might have different risk/reward assumptions that would impact your decisions regarding how much capital to allocate to this type of strategy.
Now that you have a plan, you need to go find opportunities to put your money into. You can either look for opportunities in the public stock market, or you can look in the private capital markets – for example, on alternative investment platforms like Equifund.
Once you originate an opportunity, now you need to perform due diligence.
While small balance investors participating in a private round of financing likely will not be able to directly negotiate the terms of the deal, what you can do is understand its underlying risks.
This includes analyzing the demand for a given product or service, the realism of its growth projections, and whether its shares are reasonably priced. Some of this information can be found in the company’s Private Placement Memorandum (PPM), or other offering documents.
It’s also crucial to understand each company’s cap table, which details the company’s value, who owns its shares, and how much they paid for their shares.
Assuming the opportunity meets your criteria, now it’s time to write a check. It’s generally recommended that small-balance investors don’t invest a large sum in pre-IPO stocks. Rather, start small and gradually increase your check sizes if your net worth grows over time.
6. Asset Location
Once that asset is acquired, it has to be held inside some sort of account (or “vehicle”).
You may have a variety of bank accounts, brokerage accounts, retirement accounts (e.g. self-directed IRA LLCs), and other accounts from which money can be invested.
Depending on a variety of factors (e.g. whether it’s taxable, tax-advantaged, or tax-deferred), it might make more sense to hold certain assets in certain accounts.
7. Asset Management & Trading
Last but not least, the asset has to be managed in an effort to produce positive returns, all while managing risk. These are all the decisions you’ll have to make AFTER you’ve purchased the asset.
As you can see, Pre-IPO investing isn’t a fast track to wealth. It can take months or even years for a pre-IPO company to go public. Even then, its share price may not outperform expectations. So it’s crucial to stay patient and invest for long-term growth.
Should You Invest in Pre-IPO Stock?
Investing in pre-IPO stock may potentially be part of a strategic approach to building generational wealth. However, these types of investments are generally considered to be high risk and speculative in nature. Please do not invest any money you cannot afford to lose or otherwise need access to in the short term.
While most pre-IPO opportunities are locked up and only accessible by “Insiders” like institutional investors, the average retail investor can still acquire private company shares from primary and secondary marketplaces.
Frequently Asked Questions About Pre-IPO?
What happens when a company goes public?
When a company goes public, it means they offer shares of their stock to the general public through an IPO. Going public allows the company’s shares to be traded on public stock exchanges.
At this stage, equity shareholders, regardless of their share classes, are usually converted into a single class of common stock, which is tradable on the public markets. Going public provides liquidity to existing shareholders, allows the company to raise capital for growth, and enables the public to invest in the company’s shares.
Is pre-IPO investing legal?
Yes, pre-IPO investing is legal. It refers to investing in companies before they go public and offer their shares to the general public through an initial public offering (IPO). Pre-IPO investing typically involves private market transactions with accredited investors or through specific investment platforms.
How do I value pre-IPO stocks?
Valuing pre-IPO stocks can be challenging since these companies are not yet publicly traded. Investors often assess factors such as the company’s financial performance, growth potential, industry trends, competitive landscape, and the expertise and track record of its management team.
Valuation methods commonly used in the private market include discounted cash flow analysis, comparable company analysis, and the assessment of recent funding rounds.
What is the best way to invest in pre-IPO stocks?
There are only two ways to purchase pre-IPO stocks; directly from the company raising capital (i.e., the primary market) or from an existing shareholder of the company (i.e., the secondary market).
Generally speaking, these types of investments are restricted to accredited investors only. However, companies raising capital using Regulation Crowdfunding (Reg CF) and Regulation A+ can accept funds from both accredited and non-accredited investors.
What kind of returns should I expect from pre-IPO investments?
Returns from pre-IPO investments can vary significantly depending on the individual company and market conditions. Venture capitalists often consider a 3-5x return over 5 years as successful for their entire investment portfolio.
A 10x return in 5 years would be considered incredible, and anything above that would be legendary. However, it’s important to note that pre-IPO investments are generally considered high risk and speculative in nature. Please do not invest funds you cannot afford to lose or otherwise need immediate access to.
How much should I invest in pre-IPO deals?
Determining the appropriate investment amount for pre-IPO deals is a personal decision and depends on various factors such as your financial situation, risk tolerance, and investment goals.
Broadly speaking, you can either invest small amounts across a large number of opportunities or invest larger amounts in select deals where you feel confident about the company’s potential. Whatever the case may be, it’s crucial to invest only what you can afford to lose and avoid investing funds you may need in the near future.
Remember, investing in pre-IPO stocks involves risks, and there is no guarantee of a secondary market or immediate liquidity for your investments.