Pre IPO (Definition, Example) | Risks in Pre IPO Investment

What is Pre IPO?

Pre IPO can be defined as a method used by companies to procure capital by selling a large amount of shares/stocks before it has actually been publicly traded in some exchanges to private investors, hedge funds, HNIs, etc. and also it has no prospectus available when the sale takes place.

Explanations

A pre-IPO method of placement happens when shares of a firm are bought by private investors before the IPO goes live in the market. These private investors are generally private equity firms, HNIs, AIFs, SSFs, hedge funds, etc. who are in a position to purchase a big stake in the company.
When there is a steady demand in the market for an upcoming release of IPO, the company generally first issues a pre IPO. The company firsts issue the share to the private investors at a discounted price than the price it is going to quote during IPO.
This 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 by pre IPO investment.

Examples

Uber, the well-known app-based taxi service company had issued pre IPO placement before the launch of its IPO in May 2019. 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.

Who sells Pre IPO Shares?

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 span of time as compared to the earlier company life cycles. Quite frequently, start-ups and privately-held companies face the liquidity crunch because of the absence of the market enabling them for selling shares and/or 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 as a backup for unforeseen circumstances during IPO issues or unexpected trading volume with the IPO.

Process of Selling Shares in Pre IPO

Usually, private investors pitch in for their interest to buy pre-IPO shares
The issuing company provides the bank account for the transfer of the sum to take place.
The buyer or private investor provides it’s DEMAT account details.
On a particular date of settlement, the issuing company transfers the shares to the DEMAT account of the private investor whereas the private investor transfers the purchase amount to the bank account details of the issuing company.

How to Invest in Pre IPO?

Pre-IPO operates more in an unorganized when compared to the IPO process. One can invest in such shares by:

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Transferring shares from existing shareholders or employees who are already holding it. Prior to this one needs to undergo a thorough analysis of whether these shares are further tradable.
By becoming an angel investor but this 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.

Risk Involved in Pre IPO Investment

#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 by 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 capital 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 as there 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 liquidity crunch may tend to 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

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

Advantages

It is investing can sometimes be considered a more profitable investment than 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 subscribers to the shares of a company even before it has reached the public.
The share obtained are bought at a discounted rate which immediately triggers profit-making in the mode of difference in the amount of share bought at the Pre IPO stage and to the price that the company will quote during IPO
It helps in avoiding 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.

Disadvantages

Investments are primarily done without the availability of a prospectus. Also due to the absence of stockbroker or any underwriter makes the investment more risky for a long term perspective.
When we are committing to pre-initial public offering there is no assurance that it will lead to an IPO or what the future share price will be. This 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 span of time.
This 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 an exposure of these we need to get connected to the right set of people

Conclusion

Pre-IPO is a sale of a chunk of shares to private investors or wholesale investors at a discount from the IPO price. This is done basically to accumulate funding for the initial public offering.
The company uses the capital as a hedge to mitigate the risk that 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 any kind of prospectus or any kind of guarantee that the pre IPO placement will lead to an IPO. Thus the discounted price is treated as the compensation which the buyer gets for bearing this risk or uncertainty.