The Initial Public Offering (IPO) market has become increasingly popular over the years, following its share listing credibility and increased transparency. Today, more private start-ups with a valuation of over $1 billion have resorted to public listing through the IPO process. Primarily, most of these start-ups are moving to the public listing for easy trading and raising of new equity capital. While investing in stocks listed in major exchanges comes with plenty of benefits, investors can also gain massive returns by trading shares of a company before its initial public offering. This is popularly known as pre-IPO investing. This article explains what Pre-IPO investing is and how investors can trade shares in Pre-IPO companies.
What is Initial Public Offering (IPO)?
This refers to the issuance of shares of a private company to the public, including individual or retail traders and institutional investors. This allows private companies to raise sufficient capital from public investors before they can transition to full-fledged public companies. Typically, the private company preparing for an IPO will identify an underwriter for the process. The underwriter is usually an investment bank, which is also mandated to identify the stock exchange in which the shares of the private company will be listed.
Understanding Pre-IPO Trading
Pre-IPO trading refers to the sale or purchase of shares from a private company before the initiation of its IPO process. However, due to the risks and amounts of investments involved, Pre-IPO shares are not for everyone. Pre-IPO shares are issued in large blocks, and they are typically bought by hedge funds, private equity institutions, accredited investors, and a few other investors. The price of each Pre-IPO share may be discounted from the actual value of the shares. The purchase of these shares is said to take place without a prospectus. This means that it is impossible to know the actual price for which the shares will be issued, as well as no guarantee that the company will be listed publicly.
Benefits of Pre-IPO Market Trading
The Pre-IPO market presents investors with a unique trading opportunity that presents plenty of investment benefits. This section outlines some of the key advantages that come with buying shares from Pre-IPO companies.
Access of Shares from Fast-Growing Companies
The popularity of the Pre-IPO market is attributed to the looming growth of tech start-ups, which have the greatest potential for this category of stock market. Tech brands, such as Facebook and Amazon, are examples of small-cap companies that quickly moved into major stock exchanges. Through the Pre-IPO market, investors can access shares from such fast-growing companies.
The Benefit of High Returns
Over the last decade, the number of private companies deciding to make their initial public offerings has grown significantly. The increased demand for this market has seen it offer up to 10% annually based on historical data. Traders who make Pre-IPO investments, therefore, have been known to make tremendous returns. Notably, that Pre-IPO investors make higher returns than those who buy into the company after it has gone public.
Less Stock Volatility
Stocks listed on major exchanges are known to be extremely volatile. The volatility of the stock market is associated with such factors as political events, global financial crisis, or pandemics. However, unlike the typical stocks, Pre-IPO shares are not severely affected by these events, which is advantageous to both the company and the investors.
Generally, Pre-IPO shares are more profitable than the initial public offerings. This is especially because Pre-IPO stocks are issued at a discount. As a result, investors can gain a large profit margin generated by the difference in the price offered at the Pre-IPO stage and the rate issued by the company after a public listing.
How to Trade Pre-IPO Shares
When you decide to invest in the Pre-IPO shares, you will need to understand the trading process to be at an advantage. This section highlights a step by step guide on how to trade Pre-IPO shares.
Step 1: Decide on a Brokerage Account
There are two ways through which you can buy Pre-IPO shares. Firstly, you can liaise with a firm whose specialty is capital raisings and Pre-IPO shares. Secondly, you can consider a licensed stockbroker that deals in Pre-IPO shares. These two means should offer advice on the best way to go about Pre-IPO trading. The good thing using a brokerage account to trade such shares is that you will have full control of your trade in the comfort of your home or office.
Step 2: Monitor News
Once you have the account and the ideas on how you should trade Pre-IPO shares, you will have to keep track of the news for companies and start-ups that are planning to go public. You must exercise due diligence on the various Pre-IPO companies before investing your money in their stocks. At this point, you might also make enquiries from local accountants and bankers on companies that have the potential of moving to public listings.
Step 3: Pitch in Your Trading Interests
Basically, Pre-IPO trading is a mutual venture, where the involved private companies raise capital from investors as the traders buy into the ownership of the companies. Once you identify the ideal Pre-IPO company, you will need to pitch in your interest to invest in their shares. Consequently, you will be presented with several trading options as far as Pre-IPO shares are concerned. These options include the following;
Stock Tokenisation – This is the conversion of traditional shares of a company into cryptocurrencies. This is aimed at enhancing liquidity in the Pre-IPO markets and ensuring that the interested investors access Pre-IPO shares.
Angel Investing Pre-IPO – This refers to the funding of business start-ups before they are listed publicly, especially when most investors will not invest in such businesses. An example of angel investing Pre-IPO is Amazon, which was funded by friends to the CEO.
Secondary Market Trading – This is where existing employees and shareholders transfer shares to the interested investors at a cost.
Step 4: Money Transfer
Once you pitch in your interests in a Pre-IPO company, the next step will be to transfer money to the company in question. The company will provide its bank account through which the investor will transfer the money in a lump sum.
Step 5: Settlement
On the agreed settlement date, the investor and Pre-IPO company will exchange money and shares, respectively. You can then provide your dematerialised (DEMAT) account through which the transferred shares will be held.
Sites Where Pre-IPO Shares Can Be Traded
Today, investors can trade Pre-IPO shares through any of the existing multiple brokerage websites. This section highlights some of the best Pre-IPO trading sites in the industry.
Sharespost has been in the trading industry for over 10 years now, having started in 2009. Since its inception as a broker for private securities investments, Sharespost has generated over $38 million from traders. The broker matches sellers of private company shares with interested buyers. Sharespost is also popular for providing tools and information to the investors to make the trading process easy and safe.
Forge Global was started in 2014 as a brokerage platform for investors looking for top Pre-IPO shares. The electronic trading platform features an insights tool that notifies investors of the latest news on Pre-IPO companies, and gauges market sentiment. Forge Global is regulated by the Financial Industry Regulatory Industry of the United States. Recently, Forge Global announced a merger deal with Sharespost, where the two will be joining to form one of the largest private securities brokers worldwide.
EquityZen is another global leader in the brokerage of Pre-IPO shares. The platform links investors with private company shareholders for Pre-IPO trading. Started in 2013, the company has brought together over 70000 investors with an equity value of over $4 billion. Examples of companies that have traded on EquityZen include Airbnb, Rivian, Quibi, and SpaceX.
Nasdaq Private Market was founded in 2004 as a liquidity solutions provider to private companies. Since its inception, NPM has facilitated transaction volumes of over $19 billion, making it one of the premier Pre-IPO investment platforms globally.
Templum provides regulation solutions for secondary trading and raising capital in the private markets. Founded in 2017, Templum has also acquired the renowned Liquid M Capital, a dealer that facilitates stock tokenisation. Today, Templum is said to have raised up to over $3 trillion worth of equity.
Risks Associated with Pre-IPO Trading
While investing in Pre-IPO companies come with substantial gains, these shares can also be quite risky. Some of the risks associated with Pre-IPO shares include the following;
Less Liquidity – Although stock tokenisation has been adopted as a way of enhancing the liquidity of Pre-IPO shares, most of these stocks are generally less liquid. There is no guarantee that the Pre-IPO company you invest in will be acquired or listed in a stock exchange. As a result of failure to augur well in the market, potential investors might not be interested in the company. This means that the current investor or shareholders might struggle to sell their shares in the foreseeable future, without having to lower their value below the current market prices.
Capital Loss – If the company you invest is not acquired or listed in a stock exchange, you are likely to lose your capital investment in its entirety. Unfortunately, these listings and acquisitions are not guaranteed. Also, Pre-IPO companies are subject to bankruptcy due to a lack of future funding or operational failure. This might lead to partial or total capital loss.
Lack of Dividends – Stock investors earn returns through annual dividend yields. Unfortunately, for Pre-IPO companies, investors might have to see the year end without expecting dividend returns. This is because most Pre-IPO shareholders opt to have the company’s returns reinvested in the same company. Such a company, therefore, might find it challenging to distribute annual dividends to some shareholders and leaving out others.
The Dilution Risk – Stock dilution is a scenario where your share percentage (ownership) in a company declines as a result of the issuance of new equity. Pre-IPO investors are highly exposed to this risk, following the size and nature of private companies. For example, a private company might need more funding in the future. In efforts to acquire more funds, these companies might be forced to issue new subscribed, which affects the ownership percentage of the other shareholders.
Metrics to Use When Investing in Pre-IPO Shares
When choosing a Pre-IPO company to buy shares from, investors must undertake due diligence on that company. This section identifies some of the metrics that can help you assess the short-term and long-term value of a company in its positioning for IPO.
The outstanding value of the company’s shares is measured by what is commonly known as market capitalisation. However, investors can use a more precise metric known as equity value. This metric reflects the value of the company to its owners and shareholders. Equity value takes into account both common and preferred stocks.
This is a measure of the total value of a company. When investors want to compare Pre-IPO companies with varying capital structures, then enterprise value is the metric to consider.
Enterprise Value to Sales Ratio
This metric establishes how much a company incurs to acquire its sales. The enterprise value to sales ratio compares the company’s total value to its yearly sales. A lower measure of this metric implies that the prospects of the company’s future sales might not be attractive for investors, and the vice versa is also true.
This metric measures the value of a company beyond its forecasting period. The terminal value is the ideal means for investors to predict the future cash flow of a company after the projection period lapses.
Most investors perceive the initial public offering (IPO) of a company as the only way to invest in a fast-growing company. Contrary to this opinion, traders can buy shares in a private company before it is publicly listed in a stock exchange through the IPO process. This is popularly known as Pre-IPO trading, which is coupled with plenty of benefits to investors, including high returns, less stock volatility, and discounted stock prices. However, you must exercise due diligence when trading Pre-IPO shares, as this can expose your investment to substantial risks.