Pre IPO

Pre IPO can be defined as a method companies use to procure capital by selling many shares/stocks before it has been publicly traded in some exchanges to private investors, hedge funds, HNIs, etc. Also, it has no prospectus available when the sale takes place. However, it is important to know that there are significant risks with such investments.

Pre IPO investing has its share of risks such as illiquidity, difficulty in choosing the right companies, and losing the whole capital invested. Nevertheless, entering into the investors list of a company before the Initial Public Offering (IPO) can also give investors tremendous returns if entered at the right time.

A pre-IPO placement method happens when private investors buy shares of a firm before the IPO goes live in the market. These private investors are generally private equity firms, HNIs, AIFs, SSFs, hedge funds, etc., who can purchase a big stake in the company.

When there is a steady demand in the market for an upcoming IPO, the company generally first issues a pre IPO. The company first issues the share to the private investors at a discounted price than the price it will quote during IPO.

It is mainly done to mitigate the risk of any possible outcome during the IPO launch and focus on the expected trading volume. Any risk that arises based on the above two factors can be covered up to some extent, with the capital raised through pre IPO investors.

The company uses the capital as a hedge to mitigate the risk of the initial public offering failing as what it was hoped for. The buyer utilizes it as profit earned from the discounted share versus the actual share price during the IPO though there is no fixed assurance that the market will pay the expected price per share.

The purchase is made without the availability of a prospectus or any guarantee that the pre IPO placement will lead to an IPO. Thus, the discounted price is treated as the buyer's compensation for bearing this risk or uncertainty.

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Let us understand the concept of pre IPO investing with the help of a couple of examples.

Example #1

Mark has been investing in the stock and bond market for over two decades. With the wealth he has been able to accumulate, his portfolio had shifted to a more conservative approach comprising of real estate, bonds, and blue chip stocks.

To take a wee bit of risk and invest in a company before more investors jump onto the bandwagon, he decided to invest in a food delivery company before its IPO.

In a couple of years, the IPO was announced and was a massive success. As a result, Mark made significant profits and exited the stock.

Example #2

Uber, the well-known app-based taxi service company, had issued pre-IPO placement before the launch of its IPO in May 2019. However, the shares were very limited and were available to only key individuals from the board of directors and also for private investors to raise significant amounts of capital before the actual launch of the IPO.

For pre IPO investors who want to diversify their portfolios or even take a risky call on their investing scheme, this option could be considered. However, it is important to purchase such shares from a source that is reasonable and secure. Let us understand who sells these shares through the discussion below

• An increase in dealings in Pre IPO means that founders of the company, employees holding ESOPS, and private investors are gaining liquidity in a shorter period than the earlier company life cycles. Quite frequently, start-ups and privately-held companies face a liquidity crunch because of the absence of the market, enabling them to sell shares and transfer obligations that may obstruct the sale.
• Thus pre IPO investments are an answer to the above problem. Private investors who look for fruitful companies make their profit based on the discounted issue of shares by the issuing company. Companies also use this capital raised to back up unforeseen circumstances during IPO issues or unexpected trading volume with the IPO.

The process of Pre IPO investing has four major steps. Let us discuss them to understand the concept in detail.

1. Usually, private investors pitch in for their interest to buy pre-IPO shares.
2. The issuing company provides the bank account for the transfer of the sum.
3. The buyer or private investor provides its DEMAT account details.
4. On a particular date of settlement, the issuing company transfers the shares to the DEMAT account of the private investor. In contrast, the private investor transfers the purchase amount to the bank account details of the issuing company.

A pre IPO investor may fins that this market is slightly more unorganized than that of the IPO market. However, as mentioned before, it is important to choose the right sources. Let us understand how to buy these shares through the discussion below.

• Transferring shares from existing shareholders or employees who are already holding them. Before this, one needs to analyze whether these shares are further tradable thoroughly.
• Becoming an angel investor involves a lot of money, and only HNIs can afford so.
• Try to invest in a different hedge fund, which has some exposure to the pre IPO based on its portfolio.
• A retail investor can find access to this with the help of some advisory firms or fund management companies.

Pre IPO investing is not free of risk alike any investment. As a result, it is vital to understand the risks involved in such investing options. Let us understand the risks through the discussion below.

#1 - Capital Loss

Investing in companies where the IPO has not been tried and tested can, at times, lead to total capital washout. Here the expected return is also coupled with the risk of a complete or partial wash out of the sum invested in such unlisted companies. The company may go bankrupt in the future due to operational failure or absence of future funding and lead to a loss to the invested by pre IPO.

#2 - Lack of Liquidity

When we invest in an unlisted company, the chances of selling the share in the future are grim. There may be a lack of buyers interested if the company fails to generate a positive pulse in the market. Thus on account of the difficulty in selling or trading the shares, a liquidity crunch may arise.

#3 - Scarcity of Dividends

Few companies may fail to pay dividends out of Pre IPO placements because majority shareholders will opt for the money generated to be reinvested in the company itself. Thus companies raising capital by Pre IPO will find it difficult to give returns in the form of dividends.

#4 - Dilution

Suppose the company plans to accumulate new funds later through additional funding by issuing newly subscribed shares. In that case, the value of holding previously held by pre-IPO investors who fail to subscribe to this new additive capital will eventually fall.

Let us understand the advantages from the perspective of a pre IPO investor through the points below.

• Investing can sometimes be considered a more profitable investment than an IPO.
• A great product/service can be funded by it and the one investing it, providing seed capital to this amazing investment. One becomes the early subscriber to the shares of a company even before it has reached the public.
• The share obtained is bought at a discounted rate, which immediately triggers profit-making in the mode of difference in the share bought at the pre- IPO stage and to the price that the company will quote during the IPO.
• It helps avoid the trading stampede in the market where the share prices go aggressively high or low and offer an opportunity to get the trading or investment done before others do.

Despite the advantages mentioned above, it is crucial to understand the other side of the spectrum to be able to understand the concept in depth or invest in these stocks. Let us discuss the disadvantages through the explanation below.

• Investments are primarily made without the availability of a prospectus. Also, the absence of a stockbroker or any underwriter makes the investment riskier from a long-term perspective.
• When we commit to a pre-initial public offering, there is no assurance that it will lead to an IPO or the future share price. It is basically because the time consumed between a share being pre IPO and attaining an IPO level can vary around 2-3 years, which further means the amount invested gets stuck up for this period.
• It is not prevalent among most investors because only wholesale investors or HNI clients can afford them. Even these are common among private equity firms or professional investors. Thus to get such exposure, we need to connect to the right set of people.

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This article has been a guide to what is Pre-IPO. Here we explain how to buy them, process, examples, risks, advantages, and disadvantages in detail. You can learn more about from the following articles –

• RHP
• Private Placement in Investment Banking
• Box IPO Valuation
• Publicly Traded Companies