“Getting in on the ground floor” is the dream of just about every investor who has heard of the fortunes amassed by early investors in Apple and Amazon. Because of that, the average retail investor shows a keen interest in Initial Public Offerings (IPOs).
However, one step ahead of them are those who invest in pre-IPOs. Often, companies issuing pre-IPO stock never make it to the IPO stage, and those investors who bought pre-IPO shares of those companies don’t realize the return they had hoped for.
Still, there can be pronounced financial benefits, such as exponential returns on their investment, that pre-IPO investors can realize. This article will touch on those benefits, how investors can access a pre-IPO, and what to keep in mind when investing in a pre-IPO to avoid potential pitfalls.
Let’s start at the beginning and define the pre-IPO.
What are Pre-IPOs?
When a privately owned company takes the big step to become a publicly owned company (also known as “going public”), there is an initial public offering (IPO) of stock available to institutional and retail investors.
However, even before going public, many companies offer large blocks of shares of their stock to institutions and individuals through what is known as a pre-IPO. This is one method private companies employ to raise capital to grow their business and eventually trade publicly.
What is Pre-IPO Investing?
Pre-IPO investing is an activity that a select few can participate in. Financial institutions and investors identified by a company to have ample liquidity to purchase shares before their IPO can be fortunate enough to be offered pre-IPO shares as an investment vehicle. Shares can be bought by individuals who have met strict criteria concerning their experience and net worth (accredited investors) and institutions or hedge funds.
Why Invest in Pre-IPOs?
Most investors participate in a pre-IPO for three primary reasons:
- They can buy shares at a price that is usually substantially lower than the IPO price per share on the first day the stock is offered to other investors.
- There is the potential for exponential returns if shares are bought in the right company with the right product or service at the right time.
- It’s an opportunity for the investor to build long-term wealth.
Like any investment, there is the potential for financial gain, as well as the risk of losing some or all of the capital invested. Let’s look at both.
Advantage of Investing in Pre-IPOs
The advantage of investing in pre-IPOs is getting in front of the crowd of other investors before a promising company launches an IPO and goes public, and entering at a very advantageous price per share.
One of the most commonly cited examples of successful pre-IPO investing is venture capitalist Ozi Amanat, who profited over $17 million in one day after investing in Alibaba’s pre-IPO. He purchased his shares at $60 each and watched as the stock closed near $90 per share on the first day of public trading, earning him a 50% return on his investment—Alibaba’s all-time high stock closing price: $317 in October of 2020.
Amanat’s significant advantage was buying the stock at the discounted price of $60 per share. He had the foresight to invest in a company with tremendous potential, and he was rewarded for spending $35 million for his pre-IPO shares.
Associated Risks in Investing in Pre-IPOs
Like any investment in the capital markets, the most significant risk associated with pre-IPO investing is the lack of a guarantee that the stock will perform as well as expected.
Another risk investors face in pre-IPO investing is the possibility that the company they’re investing in may never go public. Many IPOs have been stopped in mid-stream or have been canceled for a variety of reasons.
And, there’s always the risk for investors of not having enough information to make a qualified decision on whether or not to participate in the pre-IPO. Though publicly traded companies must, by law, disclose financial information to shareholders, private companies do not share those requirements.
How to Invest in Pre-IPO Stocks
It’s one thing to understand a pre-IPO; it’s quite another to know how to have the opportunity to participate. There are three primary ways to get involved with a pre-IPO investment opportunity.
- Use a broker. Brokers and financial advisors can sometimes open doors for you to gain entry into a pre-IPO trade. They may know of companies in the early stages of growth-seeking buyers of their pre-IPO stock.
- Buy directly from the company. Angel investors and venture capitalists often provide funding for early-stage financing by purchasing pre-IPO stock offered directly by the company issuing the stock. Though these companies may never reach the stage where they go public, the potential for substantial gains is often there.
- Buy shares indirectly. This can be accomplished through publicly held venture capital firms with pre-IPOs in their portfolio or through private equity exchange-traded mutual funds that purchase a wide variety of pre-IPO shares.
Tips to Keep In Mind When Investing in Pre-IPOs
- Do your research. Though it’s more difficult to gather empirical data on private companies, you can still explore the market demand for the company’s product or service, how realistic their projected rate of growth is, who their competitors are and what their market shares are, the price of the pre-IPO shares and the consensus on what the IPO price will be set at.
- Be patient. It can take months, sometimes years, for a company that has sold pre-IPO stock to finally go public. If you see the potential in a company and are confident that the loss in the time value of money will be worth it, invest and exercise patience.
- Be realistic. Investors in pre-IPOs and IPOs often expect the company they’ve invested in to be the next Apple or Microsoft. It may be, but there are very few trillion-dollar companies and rags-to-riches stories out there.
- Scrutinize legal documentation. Pre-IPOs are complex and challenging for the average investor to fully understand. It may very well mean investing some of your time and money reviewing documents with an attorney who understands pre-IPOs and the legalities involved. Their knowledge and advice might make the difference between moving forward with your investment or not.
- Learn the guidelines. Talk with your broker or investment advisor and do your homework on what makes a pre-IPO worthy of consideration and the investment of your capital. Don’t just rely on luck to be successful as a pre-IPO investor; know the rules and increase your chances for success.
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