Pre-IPO investing offers a unique opportunity to invest in startups before they go public. This guide dives into the nuances of pre-IPO investments, outlining their significant risks and potential rewards.
Key Takeaways
- Pre-IPO investing can get you shares in growing companies at bargain prices. The earlier you invest, the greater the potential gains.
- It’s not always easy. Pre-IPO shares are often available only to accredited investors and may not be available at all.
- Pre-IPO investing is possible. Shares may be available from employees who have received stock as part of their compensation or from early investors. Several platforms facilitate these transactions.
- Pre-IPO investing is risky. There is no assurance that there will ever be an IPO or that your shares will be salable, among other risks.
📚 In this post:
What Is Pre-IPO Stock Investing?
Pre-IPO stocks are shares that a private company sells to investors before the company goes public (before its IPO). Most companies who sell pre-IPO stock use a process called pre-IPO placement. These shares are often bought by institutional investors like hedge funds and private equity firms, along with a few retail investors.
Why Do Companies Sell Pre-IPO Stock?
There are two key reasons why many private companies offer pre-IPO shares to investors before they go public.
Raising Funds
Pre-IPO placements allow a company to raise funds before it goes public. Once a company goes public, its share price can be affected by a wide range of factors. The IPO may not meet expectations. If investors don’t buy the shares, the company might not be able to raise the funds it needs.
Pre-IPO shares, on the other hand, are not subject to market-related volatilities. The company can sell large blocks of shares at a fixed price and raise a predictable amount of money.
Getting Guidance from Investors
Large investment firms, hedge funds, and other institutional investors who have unmatched resources, expertise, and decades of experience are the ones that buy most pre-IPO shares. They can guide the company’s management, help them make the right decisions, and smoothen the process of transitioning from a private company into a publicly-traded company.
The advice and insights offered by these investors can be invaluable, particularly for startups.
Can Retail Investors Purchase Pre-IPO Shares?
Pre-IPO investing is not easy and has a high entry barrier. A vast majority of pre-IPO shares – which are usually offered in large blocks – are purchased by deep-pocketed institutional investors. Individual investors can participate, but there are significant restrictions in most cases.
Accreditation Requirements
Many countries require individuals to meet specific criteria before being allowed to purchase pre-IPO shares. These criteria usually address the following two questions:
- What is the minimal net-worth and/or income level of investors allowed to participate?
- What proof do investors need to provide to show that they meet these criteria?
In the US, SEC rules restrict many private offerings to “accredited investors“, who must have significant income and net worth and demonstrated experience with investment markets.
📋 The SEC has recently revised the criteria for “accredited investors”. The criteria are still restrictive but they have been significantly relaxed, meaning more investors will be able to invest in these stocks. Check the SEC’s revised accredited investor criteria.
Lock-in Periods
Pre-IPO shares have a lock-in period, during which you are not allowed to sell or trade them. This is usually designed to prevent pre-IPO investors from dumping their shares immediately after an IPO.
📚 See all the ways you can get in on pre-IPO investing: How to Buy Pre-IPO Stocks?
What Are the Advantages of Pre-IPO Investing?
Pre-IPO investing has advantages that are difficult to duplicate in any other investment market. Let’s look at some of them.
The Opportunity to Get Exponential Returns
This is the biggest reason why many seasoned investors choose to invest pre-IPO. If you pick the right company at the right time, you can get enormous returns on your investment.
😃 One of the most commonly cited pre-IPO success stories is that of the Alibaba Group, the Chinese conglomerate which went public in 2014. Before going public, Alibaba offered pre-IPO shares (at less than $60 per share) to investment firms and high net worth investors.
💵 Among the investors who bought Alibaba’s pre-IPO shares was Ozi Amanat – a Singapore-based venture capitalist. He bought a block of shares worth $35 million. A few months later, Alibaba went public in the largest global IPO to date, and its share price reached $90 on the very first day. It allowed Ozi Amanat and other investors to earn a 50% return on their investment in a span of just a few months.
Pre-IPO Stocks Are Available at a Discounted Price
When you invest in pre-IPO stock, you don’t know how the company will actually perform once it goes public. To offset this risk, private companies usually offer pre-IPO stocks at a discounted price.
👉 For example:
If a company sets its IPO price at $20 per share, it might offer pre-IPO shares at $10 per share. That lets you buy in at a lower price that’s likely to yield profit even if the IPO is not highly successful.
📉 Let’s assume that the company’s share price declines from $20 per share to $15 per share, due to a political crisis or a pandemic. Investors who bought the company’s shares at $20 apiece will suffer losses. It might take them several weeks or even months to recover their losses. You will be less affected by the dip in the share price since you only paid $10 per share.
📈 If the company performs well and if its share price increases significantly, you stand to earn substantially higher returns on your investment than someone who invested in the company’s IPO. It can help you build enormous wealth over a period of time as well as allow you to earn passive income through dividends.
A Chance to Build Long-Term Wealth
One of the biggest benefits of pre-IPO investing is that you are investing in a company that is on its way up.
If the company performs well, you can benefit enormously from its growth in the long term. It is not uncommon for million-dollar startups to turn into billion-dollar public companies, especially in the tech industry. So, your investment in a company at the pre-IPO stage could pay off massive returns in the future and help you build long-term wealth.
Pre-IPO Investing Risks
Like any other investment, pre-IPO stock also comes with risks, which you need to consider before making an investment decision.
The Risk of Low Returns
The biggest risk associated with pre-IPO investing is that there is no guarantee that the stock will perform well. If the IPO fails and if there is no demand for the company’s stock, you might not get the returns you expect to get.
⚠️ If the company you invested in performs terribly, its stock might lose value rapidly. You might end up losing most or all of your investment.
The Company Might Not Go Public
When you invest in a company pre-IPO, you do so expecting that the company will go public in the near future. You do not actually know that it will go public. IPOs can be postponed, halted, or canceled at the last minute for a number of reasons.
👉 For example:
Back in November 2020, Ant Group – an affiliate of the Alibaba Group – was expected to make its stock market debut. Valued at $34.5 billion, it was the biggest and the most anticipated initial public offering in the recent past. The IPO was canceled at the last minute due to some regulatory issues.
Lack of Adequate Financial Information
One of the problems with pre-IPO investing is that you might not be able to get all the data you need to make an informed decision. Publicly traded companies are required by law to disclose their financial information to the public. Private companies have no such requirements.
This creates an information asymmetry, wherein the people who are selling the shares (the company management) know all about the company and its financial situation whereas the people who are buying the shares (the investors) do not have access to this information. This is something you should keep in mind while investing in pre-IPO stock.
Things to Keep in Mind While Investing in Pre-IPO Stocks
Do Your Research Before Investing
Do your research and find out as much as possible about the company you are about to invest in. Is there a genuine demand for the product or service the company offers? Is their projected rate of growth realistic and achievable? Are the shares reasonably priced? These are things you need to find out before you make a decision.
Be Aware of the Risks Involved
Understand the risks involved in pre-IPO investments. Not all pre-IPO investments succeed. Some make big money. Others never go public at all. Be careful about what you invest in and how much you invest.
Read the PPM Carefully
Private companies which intend to go public provide a Private Placement Memorandum (PPM) to their investors. It is a document that contains the information you need to decide whether the company is worth investing in or not.
A PPM usually contains information about the company, its management, the products and services it offers, the customer base it caters to, its performance in the past, its financial resources, and potential risk factors that investors should consider.
Make sure you read the PPM carefully before deciding to invest in pre-IPO stock. You can also request your investment advisor or stockbroker to take a look at the PPM and ask them for their opinion.
Start Small
Do not make a large investment straight away – especially if this is the first time you are investing in pre-IPO stocks. It is advisable to start small and increase your investments gradually over a period of time. As they say – dip your toe in, don’t dive.
Be Patient
Pre-IPO investing is not a get-rich-quick scheme. It can take several months – or in some cases, even years – for a company in the pre-IPO stage to go public. Moreover, even after the company goes public, its share price might not increase right away. So, it’s paramount for you to be patient and focus on long-term wealth generation rather than expecting quick returns on your investment.
Be Realistic in Your Expectations
Not every company you invest in will turn into a Google or Amazon. Do not be swayed by stories of people who invested a few thousand in Apple or Amazon when they were fledgling startups and then made millions. It does not happen every day!
Instead of looking for the next big thing to invest in, look for companies that have the potential to perform well over a period of time. Aim for good returns on your investments, not a single grand slam.
Should You Consider Pre-IPO Investing?
Investing in pre-IPO stock can be a strategic way to build wealth in the long term. If you manage to invest in the right company at the right time, you can get tremendous returns on your investment. There are risks in pre-IPO investing – as is the case with any other investment – but the upsides can be tremendous. If you have the resources and a suitable risk profile, it is an investment opportunity you should not miss out on.
Want to learn more about pre-IPO investing? Check out our guide on how to invest in pre-IPO stocks.
The Motley Fool Stock Advisor has outperformed the S&P 500 3 to 1 over the last 20 years. Join more than 1 million members for just $99/year (that’s $1.90/week), and don’t miss out on their stock picks. Sign Up Now →
FAQ
What is a pre-IPO company?
A pre-IPO company is a private company that is raising capital in the lead up to its planned listing on a public exchange.
What are pre-IPO stock options?
Many companies offer stock or the option to buy stock to employees as part of their compensation. If employees receive stock or exercise the option to buy stock they become owners of those shares. Some companies allow employees to sell these shares through pre-IPO marketplaces. These sales must be approved by the issuing company.
What are the risks in pre-IPO investing?
– The risk of low returns
– The possibility of the company not going public
– The lack of adequate financial information
What do you get by investing pre-IPO?
– The opportunity to get exponential returns
– Stocks in a company at a discounted price
– A chance to build long-term wealth
Should I buy pre-IPO stock?
If you have the resources and a suitable risk profile and you are confident in the Company’s future, it is a significant investment opportunity. There are also significant risks.
Can individual investors purchase pre-IPO stock?
Yes, but with significant restrictions. In most cases, you will have to be an accredited investor with a high net worth. See all the ways you can purchase pre-IPO stock here.
If you liked this article and would like to read more articles like this, you can subscribe to our newsletter to get the latest updates.
