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.
- A pre-IPO method of placement happens when private investors buy shares of a firm before the IPOIPOInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes. 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 shareIssue The ShareShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. to the private investors at a discounted price than the price it is going to 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 by pre IPO investment.
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 ESOPSESOPSEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). , 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 to sell 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 settlementDate Of SettlementThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade., 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.
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:
- 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 investorAngel InvestorIndividuals who invest in new firms and start-ups are known as angel investors. In exchange, they demand equity or debt. It's more of an informal investing approach in which the company doesn't have to go through a lot of compliances., but this involves a lot of money, and only HNIs can afford so.
- Try to invest in a different hedge fundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques., 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 managementFund ManagementFund management is the process of a company taking a person's, company's, or another fund management company's financial assets (generally high net worth individuals) and investing them in companies that use those funds as an operational investment, financial investment, or any other investment in order to grow the fund. 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 investedCapital InvestedInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash 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, a 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 dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company..
#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.
- 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 the 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.
- Investments are primarily made without the availability of a prospectus. Also, due to the absence of a stockbroker or any underwriterUnderwriterThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there. makes the investment riskier for a long term perspective.
- When we are committing to a pre-initial public offering, there is no assurance that it will lead to an IPO or what the future share price will be. 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 span of time.
- It is not prevalent among most investors because only wholesale investors or HNI clients can afford them. Even these are common among private equity firmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations' private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP. or professional investors. Thus to get such exposure, we need to get connected to the right set of people.
- Pre-IPO is a sale of a chunk of shares to private investors or wholesale investors at a discount from the IPO price. It is done basically to accumulate funding for the initial public offering.
- 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 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.
This article has been a guide to What is Pre IPO & its Definition. Here we discuss how to invest in pre-IPO along with examples, risks, advantages, and disadvantages. You can learn more about from the following articles –