Pre IPO Investing: Here’s How It Works

I…P…O… — those three letters have the power to make dreams come true, make business owners rich, and give investors a substantial return. When a company has a successful IPO, the actual people who make money are not the investors buying the initial stock offering but those who were able to get placed in a company before the IPO was offered in the first place. Usually, these types of deals are reserved for high-level institutional investors or accredited private investors. That being said, there are more and more ways for your average person to get exposure to companies in their nascent pre-IPO stage. Keep reading to learn more.

IPO and pre-IPO

IPO stands for initial public offering. This is when a company makes a stock offering on a public market, enabling retail investors to buy shares. Usually, these shares are listed on a popular exchange like the NASDAQ, NYSE, Hang Seng, or FTSE. An IPO is pretty easy to explain, but what about a company’s pre-IPO status? Here are the stages a company might go through before its IPO.

• Nascent
  • Startup/Venture Capital (VC) stage
  • First-round funding (Series A)
• Mid-level
  • Second-round funding (Series B)
  • Third-round funding (Series C)
• Considering IPO
  • Pre-IPO transformation stage
  • IPO transaction stage

Nascent company, startup/VC stage

A private company that is at its nascent stage will accept investment from just about anyone. This means that whether you are an accredited investor or the founder’s mother with no accreditation, you can invest in a company at this stage and take an equity stake. In fact, if you invest in the beginning stage, you can make incredible returns should the investment eventually go IPO.

Example: Titus Tech goes IPO and takes VC money

You might remember an article we did on pre-money vs. post-money valuations. This article covered how fundraising works when companies raise money through “series” rounds. Here is what might happen if Titus Tech goes IPO, and what happens to the pre-IPO stocks.

In this scenario, Titus Tech raises funds from pre-IPO investors, most likely from a venture capital firm. However, it’s possible that Titus Tech got off the ground by raising money from family and friends, which means they were able to make an even better return than the investors in Series A were able to muster. Thus there are two ways you can invest in a company pre-IPO at the nascent stage.

Invest directly in equity at the beginning with someone you know

If you have a connection with someone who is starting a company, then you have the opportunity to get in at the very beginning.

Invest in funds that invest money in startups at the nascent stage

Invest in the investor of seed capital, which is, more often than not, VC funds.

Invest via crowdfunding platforms

Online crowdfunding platforms are a fairly new concept, but they can allow investors to get in early on a company in return for an equity piece. This differs from crowdfunding platforms that focus on providing rewards in return for investment, rather than equity.

The Mid-level stage

When a company has raised its seed money and at least one series of investments, it will likely be considered at the mid-level stage. When investing in an IPO at the mid-level stage, there is much less risk as the company has a more proven track record. But the returns are not as great.

Example: Titus Tech has a series B fundraising round

Let’s see what the returns would be for an investor who got into Titus Tech at the middle level.

As a company’s profile grows, it becomes more and more difficult for private investors to get in. Effectively, the only real way to get access is through the following methods:

“Private” equity pre-IPO placements

Obtaining a private equity placement will give an investor an opportunity to get in on a pre-IPO company that is at the mid-level stage. This is usually difficult to do and is generally only accessible for high-net-worth or accredited private investors. That being said, if you know the right people, you might be able to get in on a company at this stage that is headed toward an IPO.

Invest in the investors (VC, PE, hedge funds)

The easiest and most accessible way to access a company at the mid-level stage, before IPO, is to invest in the private equity and VC investment firms that give companies money in their Series B and C stages. Several VC and PE firms are publicly traded, and investors can access them on the retail market. And they can have exposure to someone else who has the opportunity to purchase pre-IPO stock.

Invest through a secondary marketplace

Over the last few decades, with the invention of the internet, secondary marketplaces have popped up to offer investors the opportunity to invest before a company goes IPO. EquityZen, Forge, and MicroVentures are examples of platforms that offer equity investment opportunities. Typically these platforms resell shares that were obtained during the nascent stage of the company. However, these are not available for everyone, and in most cases, only accredited investors are able to access these privately held shares on the secondary market.

Considering IPO stage

When a company is considering an IPO, it will go through two phases: pre-IPO and IPO transaction. At this stage of investing, the company aims to go IPO very soon as they are putting all the infrastructure in place.

Pre-IPO transformation stage

The pre-IPO phase is when a company starts to change many aspects of the governing structure and overall management of the company. This includes hiring the top people in accounting, human resources, and tech to make sure that the company is governed properly. This type of investment has much less risk than earlier stages, so the return will not be as large. As a rule of thumb in investment is: the higher the risk, the higher the return.

Example: Titus Tech investment during the pre-IPO transformation stage

IPO transaction phase

The IPO transaction phase effectively means that the company is DEFINITELY going IPO as opposed to the pre-IPO phase, in which the company is gearing up to go public but has not set the proper wheels in motion.

Example: Titus Tech gets a capital injection during the IPO transaction phase

You can see the return on a pre-IPO phase and IPO transaction phase are significantly lower than if an investor were to invest at an earlier stage of the company. However, the risk in these stages is much lower. In short, the earlier you are able to get into a company, the better the return will be, but the greater the risk will be.

Usually, in this later stage, an investment bank that handles a company’s IPO will give the option to invest at this stage to its investment banking clients. The only way to get in at these stages is to have unearthly connections that give you a private placement opportunity. Or technically, you could invest in an investment bank or fund that deals with these types of opportunities. Institutional investors are usually the only ones that have access to pre-IPO stock at this stage of a company.

Downsides of Pre-IPO investing

The upsides to pre-IPO investing are fairly obvious — get in at a nascent or early stage of a company and make money when the company has an IPO. But what about the downsides? Here are some to consider.

Lock-up period

Before the company goes public, the potential returns are just on paper until they can be realized with an IPO. Therefore, there could be a long or undefined lock-up period before you can realize a gain. Remember, the earlier the stage of the company, the more arduous the road to IPO, and thus the lock-up period is much longer.

More often than not, only accredited investors can invest

Saying “accredited investors” is a fancy way of saying “people with a substantial amount of wealth.” You have to have a net worth of at least $1 million, not including your primary residence, or your annual income must exceed $200,000 or $300,000 jointly. This obviously locks many people out of the market. To invest early in a company, they would need to get in at the riskier VC or crowdfunding stage.

The company can fail

Publicly traded companies on the stock market can fail, and so can a company that is pre-IPO. In fact, the risk is considerably greater for a pre-IPO company, particularly if you get in at the nascent stage. When a company goes IPO, then different rules and regulations will kick in to force a company to operate with complete transparency. Pre-IPO companies are private companies and will not be bound by the same rules.

FAQ

How do I find pre-IPO investments?

The easiest way to do it is to know someone who either has access to a private company or is starting it themselves. Investing via crowdfunding platforms, a secondary marketplace, or investing in the investors are methods to get exposure to pre-IPO companies.

How risky is pre-IPO investing?

The earlier the pre-IPO shares are acquired, the riskier it is. Remember, the earlier you get in on a company, the more you can make and the more you can lose.

What are the risks of pre-IPO investing?

There are various risks, such as a long holding period or the company never going public. However, the greatest risk is that the company fails, and all money is lost. The pre-IPO stage revolves around private companies obtaining private investments and is not as well-regulated as an IPO.