Pre-IPO: What It Is and How to Invest in It
I. Introduction to Pre-IPO
What Is Pre-IPO and Why Invest?
Pre-IPO investments involve acquiring shares of a private company before its initial public offering (IPO). This type of participation is usually closed, conducted through venture capital funds, angel investors, or specialized online platforms. Investors receive a stake in the business prior to its listing on the stock exchange, allowing them to invest at a price typically significantly lower than the market price post-IPO.
The primary motivation is the potential for substantial growth in investments upon a successful listing. However, this could take several years, and selling assets before the IPO can be challenging due to limited liquidity. Investors must understand that such investments are suitable only for those willing to accept the long-term commitment and associated constraints.
II. Valuation Techniques and Key Risks
Valuation Methods at the Pre-IPO Stage
1. Discounted Cash Flow (DCF). Discounting future free cash flows helps derive a "theoretical" company value. The accuracy of this method depends on the quality of input assumptions, such as revenue forecasts, margins, and capital expenditure levels.
2. Comparable Multiples. Comparing with publicly traded companies in similar industries using multiples like P/E, EV/EBITDA, and Price/Sales helps adjust the valuation based on market conditions. This method is simpler but less precise when there is incomplete information about the private entity.
3. Comparable Recent Transactions. This method looks at the prices at which investors entered earlier and later funding rounds. Such comparative analysis reflects the actual demand for shares and market sentiment surrounding the company.
Primary Risks of Pre-IPO Investments
– Liquidity. Shares remain illiquid until the IPO or the emergence of a secondary market, preventing investors from quickly closing their positions. This restricts portfolio flexibility and increases the required investment horizon.
– Dilution. With subsequent investment rounds, dilution of ownership can occur: when a company attracts new investors, the total number of shares increases, decreasing the share of initial participants.
– Lock-up Period. Following the IPO, there is often a prohibition on selling shares by insiders and early investors (usually 6–12 months). Violation of this rule can lead to asset blockage and legal complications.
– Regulatory and Legal Risks. Non-compliance with local and international regulations, incomplete documentation, and errors in contracts can result in sanctions, fines, and legal disputes.
III. Mechanisms for Accessing Pre-IPO Investments
Venture Funds and Angel Investors
Venture funds aggregate capital from institutional investors and allocate it to high-risk startups at various stages. Participating through a VC fund offers the advantage of collective selection and management but requires a significant minimum investment and payment of management fees.
Angel investors are individuals investing their own capital in the early stages of project development. They often contribute not just financially but also through mentorship, accelerating growth and increasing the chances of a successful IPO.
Specialized Online Platforms
Platforms like EquityZen and Forge Global provide access to shares of companies such as Uber, Airbnb, and SpaceX. These platforms connect holders of private shares with potential buyers, creating a market for secondary transactions prior to the IPO.
CartaX serves employees of startups and early investors by facilitating internal trading of company shares during the pre-IPO phase.
Crowdfunding platforms (SeedInvest, Republic) allow retail investors to enter well-selected startups with a minimum investment threshold of a few thousand dollars.
Criteria for Selecting Access Channels
– Platform Reputation: It is crucial to examine the history of transactions, price dynamics, and participant reviews. A reliable platform demonstrates transparency and efficiency in order execution.
– Minimum Investment Size and Investor Legal Status: Some platforms require proof of accredited investor status or residency in specific jurisdictions.
– Fees and Charges Structure: Fees can range from 5–10% per transaction, while annual portfolio management fees can diminish overall returns.
IV. Secondary Market and Liquidity
What Is the Secondary Pre-IPO Market?
The secondary Pre-IPO market comprises closed platforms where holders of private shares can sell them to other investors before the IPO. Prices are determined based on bid-ask orders, and the market resembles an exchange, albeit with lower transparency and higher volatility.
Limitations and Fees
– The spread between buying and selling prices often exceeds 20–30%, reflecting heightened risk and low liquidity. – Platform fees can amount to up to 10% of the transaction value. – Lock-up periods may entirely restrict the sale of certain shares within specified timeframes, even if a buyer is found.
Exit Options
– Tender Offer: The company repurchases shares from investors at a predetermined price, allowing an exit under agreed conditions. – Trading on specialized platforms after the secondary market opens. – Selling post-IPO on public exchanges without lock-up restrictions.
V. Legal Aspects and Due Diligence
Financial Audit
A financial audit is conducted by professional auditing firms that verify the accuracy of financial statements, debt structure, and cash flow projections. Audit results enable investors to assess the financial health of the company and identify potential hidden liabilities.
Legal Audit
A legal audit entails verifying intellectual property rights, contracts with key counterparties, technology protection mechanisms, and the level of potential litigation risks. This step helps to uncover latent legal issues and assess the quality of corporate governance.
Corporate Structure and Term Sheet
A Term Sheet is a preliminary agreement outlining the essential investment terms: company valuation, investor stake, liquidation preference, anti-dilution mechanisms, and lock-up periods. A detailed analysis of the Term Sheet helps protect investor interests and mitigate risks.
VI. Comparison with Other Instruments
| Instrument | Accessibility | Liquidity | Return Potential | Key Risks |
|---|---|---|---|---|
| Pre-IPO | Private Market | Low–Medium | High | Liquidity, Valuation, Lock-up |
| IPO | Public Market | Medium–High | Medium | Volatility, Post-IPO Drawdown |
| Venture Capital | Early Stages | Low | Very High | High Risk of Failure |
| Equity Crowdfunding | Retail Investors | Low | Medium–High | Startup Management, Regulation |
VII. Strategies and Real Cases
Pre-IPO Diversification Strategies
1. Allocate funds across various sectors: IT, biotechnology, fintech, and consumer services. This reduces sectoral and macroeconomic risks.
2. Invest in companies at different financing stages: from early rounds to those preparing for an IPO, balancing high returns with relative reliability.
3. Combine direct Pre-IPO investments with participation in venture funds, where experienced managers select projects and manage the portfolio.
Successful Cases
– Airbnb: Early investors Sequoia Capital and Greylock achieved over tenfold returns upon the 2020 IPO. Their decision to enter the company at the Series B stage became one of the most profitable.
– SpaceX: Despite the lack of a formal IPO, the secondary market allowed employees and angel investors to realize multiple profits before the public offering, demonstrating the importance of liquidity even without an official listing.
– Robinhood: Investors on the EquityZen platform managed to exit at prices significantly exceeding early round valuations, thanks to high activity in the secondary market before the IPO.
Common Mistakes and Lessons Learned
– Overvaluation in late rounds often leads to disappointment for investors when market conditions change and the IPO occurs at a lower price.
– Ignoring lock-up conditions results in investors being unable to sell shares on time, losing opportunities to secure profits.
– Shallow due diligence leaves investors vulnerable to hidden legal and financial issues that may arise post-IPO, affecting stock value.
Conclusion
Key Takeaways
Investing in Pre-IPO presents a unique opportunity to engage with high-tech and rapidly growing companies at the early stages of their development. High return potential comes with significant liquidity, valuation, and legal risks. Success hinges on thorough valuation assessments, deep due diligence, portfolio diversification, and the careful selection of access channels.
Adhering to these principles can help mitigate risks and enhance the likelihood of achieving stable returns through long-term investments prior to public offerings.
