What is it that strikes fear into the hearts of people who “could have” earned a ton of money? Losing out on pre-IPO investment opportunities is a bitter pill to swallow. You can, of course, reduce the chances of missing out if you know how to invest in startups before they IPO.
Consider, for instance, WhatsApp.
Sequoia Capital and Jim Goetz first invested $8 million in 2009. They then invested more money through two more funding rounds in 2011 and 2013. On the whole, their early investment was $60 million.
In 2014, Facebook acquired WhatsApp for $19 billion. It was, at that time, the largest acquisition of a private company backed by venture capital.
For Sequoia Capital and Jim Goetz, their $60 million investment turned into a $3 billion payday.
What about those who missed out?
All they could do was shrug their head and look for the next WhatsApp.
Investing in pre-IPO startups comes with risks. Then again, that is the nature of investments. If things go well, the potential return of buying a stake in a company before IPO could be remarkable.
Table of Contents
What Is an IPO?
An Initial Public Offering (IPO) is the process of selling shares in a new stock issuance.
7 reasons why private corporations would offer shares to the public are:
Capital Raising. Companies can use the funds to meet their financial needs. Usually, it is to expand their business. But there are cases in which it was to reduce their debt burden.
Acquisitions. Funds raised from the public make acquiring smaller companies possible. It is an excellent strategy to boost growth.
Liquidity and Marketability. Shares getting traded on the stock exchange become liquid. In turn, it increases the investability of companies, thereby attracting more investors.
Exit Route for Investors. Going public is a means for early investors to take advantage of a higher valuation. Selling some or all their shares is also a way to liquidate their stake.
Increase Trust. The strict regulations imposed by the SEC reduce the likelihood of fraudulent activities. Getting listed, in effect, increases stakeholders’ confidence in the company.
Enhance Brand Awareness. Getting listed attracts the attention of investors, analysts, and even public consumers. The publicity, in effect, enhances brand image.
Attract Top Talents. Listed companies have the option of offering an Employee Stock Ownership Plan (ESOP). By doing this, they increase the chances of hiring talented employees.
What Is Pre-IPO Investing?
In a nutshell, pre-IPO investing refers to the act of buying a stake in a company before it goes public.
Jumpstart Our Business Startups Act
In the past, startups only had limited options for raising capital. Other than taking out bank loans, they can turn to investors. But pre-IPO investing was exclusive to only a select group, such as:
Accredited investors
Hedge funds
Private equity firms
Unfortunately, individual investors, retail investors, and unaccredited investors have no access.
On April 5, 2012, Barack Obama signed the Jumpstart Our Business Startups (JOBS) Act.
At the Rose Garden on the same day, he talked about the bill’s bipartisan nature. While it brought many benefits to private companies, it also gave the public more opportunities. The JOBS Act, in essence, allowed more Americans to take part in pre-IPO investing.
Benefits of the JOBS Act
Startups can now tap into non-accredited investors, not only institutional investors.
Retail investors can now invest in startups because of changes in how companies can raise funds. The JOBS Act, for example, allows for more options in crowdfunding. It also increased the limit of securities that startups can offer.
Startups can source up to $1 million through equity crowdfunding.
Under the JOBS Act, the expanded Reg A (or Reg A+) allowed companies to offer up to $50 million in stock each year. And they can do this without meeting standard SEC registration requirements.
The number of shareholders a company can have has increased to 2,000. In the past, they needed to go through SEC registration after reaching 500. This change, in effect, lets the companies raise capital while staying private for a longer time.
In 2016, the titles adopted by the SEC from the JOBS Act went into effect. Non-accredited investors, thus, can invest in startups before IPO for as little as $100.
How Private Companies Can Sell Pre-IPO Shares and Stock Options
Startups can sell pre-IPO stocks using any of these three methods:
Venture Capital Firms and Angel Investors. These investors are on the constant lookout for the next big thing. Yet, finding the right startups is difficult due to too many new businesses. That is why they use startup investing platforms such as Allianse.
Pre-IPO Placements. Startups can raise funds before IPO by offering large blocks of stocks. Usually, the buyers are institutional investors like private equity firms and hedge funds. Because of the risks involved, the share price offered will be lower than the IPO price.
Employee Stock Options. Unlike the previous two, offering stock options – a type of equity compensation – does not raise capital. Instead, it is a means to recruit talented people by providing them with a stake in the company. Or, it may also be a tool to incentivize employees to work harder in helping the company grow.
Why Should You Start Investing in Pre-IPO Companies?
Investing is one way you can put your money to work and build wealth. Among the many types of investments, one that can give huge gains is to invest in pre-IPO shares.
Advantages
How do pre-IPO investments help increase your wealth? Here are the main reasons.
Buy Pre-IPO Shares at Lower Prices. Expecting higher returns on pre-IPOs is reasonable but comes with risks. Also, the sale of private company stocks is not as widely known as IPOs. These are only two factors why the share prices are lower than the IPO prices.
Opportunity to Invest in a Startup/Pre-IPO Company. Institutional investors can fund startups before, during, and even after IPO. But for many other would-be investors, pre-IPO was off-limits. The JOBS Act opened up the possibility for more people to own a stake in a private startup.
Diversify Investment Portfolio. Seasoned investors understand the importance of keeping a balanced portfolio. Pre-IPO investments offer the advantage of not being subject to second-to-second fluctuating valuations in the stock market. It also helps that pre-IPO shares do not correlate much to traditional assets.
Disadvantages
Before investing in pre-IPO startup companies, it is best to consider all the risks involved.
Lower Liquidity. Each time you invest, your liquidity decreases. If there is a need for liquidity, you cannot sell pre-IPO shares.
Less Regulatory Scrutiny. Unlike IPOs, there are fewer SEC regulations and requirements for pre-IPOs. Because of that, it is difficult to assess the financial position and risk profile of pre-IPO companies.
Exit Not Guaranteed. There are instances where a startup does not follow through, not going public. Such is one of the risks of investing in a startup pre-IPO. Should this occur, the upside of the investment is severely limited.
How Do You Invest in Pre-IPO Companies?
If you are thinking of buying pre-IPO shares from a promising startup, there are a few options.
1. Consult with Stockbrokers and Advisory Firms
Consult with brokers and financial advisors who specialize in pre-IPO shares. Some of them may have stocks you can buy. Others may represent startups offering pre-IPO investment opportunities.
2. Buy Stock Indirectly
New investors may have trouble with meeting minimum investment requirements and other conditions. In this case, the option is to buy from:
Publicly-held Venture Capital Firms
Private Equity Exchange-traded Funds
3. Buy Stock Direct from a Pre-IPO Startup
Another option is to do what venture capitalists and angel investors do, invest in the startup yourself. While this method is viable, finding a promising company to invest in will be challenging.
Some of the ways to find startups are:
Seek Referrals. Ask banks, financial institutions, and accounting firms for recommendations. Some of them may be aware of startups planning to offer pre-IPO shares.
Attend Startup Pitch Events. Such activities are an excellent way to network with promising startups. It also allows you to connect with and learn from seasoned investors and industry leaders.
Follow Financial News. Be on the lookout for news reports on upcoming companies. If some of them have plans to raise capital, you can contact them directly.
Use Crowdfunding Platforms. Angel investing is widespread, and there are many platforms and Angel communities. You may consider registering and finding startup investing opportunities.
Register with Startup Investing Platforms. While it offers some of the functionalities of crowdfunding sites, these platforms take investing to a whole new level. For instance, as a member of Allianse, you can get connected with highly-vetted startups that fit your preferences.
What Is Your Risk Tolerance?
As a general rule, you invest money that you can afford. With that said, here are some industry facts that you should think about before investing in pre-IPO shares.
Startup Genome, a leading innovation policy advisory and research company, paints a grim picture for startups. As published in the 2019 Global Startup Ecosystem Report, they claimed only 1 in 12 startups succeeded. At this rate, it is evident that pre-IPO investing is high risk.
Pre-IPOs are riskier than IPOs. Even so, value creation shifted from the public market to the private. One main reason is that investing in startups before an IPO can make the most gains. One estimate, for instance, shows that investors could lose up to 95% of the gains by investing in IPO instead of pre-IPO.
The higher the risks, the higher the rewards. Such is the nature of investing in IPOs and more so in pre-IPOs. In the end, the decision to invest in startups before an IPO comes down to your risk tolerance.
Not Missing Out on Opportunities Comes with Risks
Building wealth is the goal of all investors. And for decades, one of the main focuses of many has been to invest early by buying IPO shares. But that has changed in the last decade. Investors realized they could make the most gains by owning pre-IPO shares.
Once decided, there are a few ways one could take an ownership stake in startups:
Consult with brokers and financial advisors
Invest through publicly-held venture capital firms and private equity exchange-traded funds
Connect with startups planning to offer pre-IPO shares
Regardless of which route you take, using a startup investing platform is advantageous. Allianse, for instance, not only matches you with the most promising startups. They also have industry experts who could offer advice. While there is never a guarantee of success, you could lower the risks.