Investing in startups before their Initial Public Offering (IPO) has generated some extraordinary returns for investors willing to add more risk to their portfolios. Hedge funds, private equity funds, and angel investors have been buying pre-IPO shares of promising companies for years, hoping to find the next Apple or Amazon before it goes public. With the recent introduction of pre-IPO trading platforms, retail investor interest has been steadily climbing with growth expected to continue as pre-IPO investing becomes more accessible. But has pre-IPO investing become overcrowded as startup valuations rise along with the use of crowdfunding platforms and secondary markets? Find out if pre-IPO investing is worth the risk and learn about the rewards potential investors can expect to reap below.
What is Pre-IPO Investing?
Pre-IPO investing, also known as angel or seed investing, is the act of privately acquiring shares in a company before it goes public. These investments are typically made when the company has yet to generate significant revenue (and sometimes even to generate any revenue at all). Typically, startups sell pre-IPO stock because their business model has yet to prove profitable. Often, when a company is unable to secure funding through more traditional means (i.e., venture capitalists or commercial banks), it will seek private investors to support its product roadmap in exchange for an equity stake in the business. A private investor with a significant financial stake in a company is much more likely to support the company's growth and success.
It’s important to note that Pre-IPO investing isn’t limited to ‘start-up’ companies. In many cases there are pre-ipo investment options in companies that have already achieved proof of concept, and possibly even profitability.
Who can purchase Pre-IPO shares?
For decades, pre-IPO investing was primarily reserved for institutional investors with large amounts of available capital. They were able to profit from highly lucrative positions in privately held companies before their Initial Public Offerings. In the past decade, private equity funds and hedge funds have been joined by a new group of investors - accredited individuals. The demand from individual investors has been steadily growing for several reasons:
The signing of the JOBS Act into US law in 2012, which made pre-IPO investing accessible to unaccredited investors.
The rise in crowdfunding platforms that provide investors with access to potentially high-growth startups.
The proliferation of secondary market platforms that aggregate individual pre-IPO shares in a single place - allowing retail investors to make investments through a managed portfolio.
The recent spike in interest in pre-IPO investing is unprecedented and although it's difficult to quantify, tracking of pre-IPO share sales shows that the number of purchases has nearly tripled since 2015.
Why invest in Pre-IPO companies?
Pre-IPO investment opportunities can offer the chance to get in on the next unicorn - companies that have valuations of $1 billion or more before going public - which can lead to rapid exponential returns.
Apple's first Angel investor, Mike Marrkula, made over an 800% return in three years on his initial investment in the company when it was listed in 1980. Ozi Amanat earned over a 50% return on his investment in Alibaba in less than six months when share prices soared by more than $30 after being publicly listed. Tom Alberg, along with several other early-stage Angel investors made well over 1,000,000% on their initial pre-IPO investments in Amazon.
Historically exposure to high returns from young growth companies has been attainable through small cap stocks, but that may be diminishing as well. Companies are now waiting longer to go public and reach larger valuations. In 1999, the average age of a newly public technology company reached a low of 4.5 years, which since has been creeping up. From 2017 through 2019, the median age of technology companies going public was more than 12 years old (Data according to research published by Prof. Jay Ritter in Initial Public Offerings: Updated Statistics.).
Currently on common pre-ipo marketplace Equityzen, 39 companies have a valuation in the mid-cap range, above 2 billion dollar. Compare that to Amazon’s IPO at 438 million in 1997.
Maybe pre-ipo investing has replaced the small cap premium? That’s a whole nother topic.
Pre-IPO returns vary greatly depending on company stage, sector, and potential exit valuation. The range spans from low single digits to triple digits or more. While returns like these are not typical for most pre-IPO investments, higher returns are more likely with the right strategy and timeline. As Jeff Bezos noted in his 2016 Letter to Shareholders, "Given a 10 percent chance of a 100 times payoff, you should take that bet every time. But you're still going to be wrong nine times out of ten."
That actual heuristic can be a bit hard to comprehend though. A look at the performance of realized returns from Equityzen provides a better, although incomplete look at the performance.
33% of the companies that have gone public after being available on EquityZen have had a negative IRR while 67% have had a positive. The highest having an annualized rate of return above 2,800%. The numbers presented are annualized, not total return, so some of the companies could have 100x’d over a period of a few years even though.
Investors seeking pre-IPO opportunities should always consider a company's total addressable market, its finances, and management team, and the quality of its existing investors before investing. While success can't be guaranteed, investors' chances of higher returns increase tremendously through careful analysis.
Potential Risks of Pre-IPO Investing
As with any early-stage investment, there is no guarantee that the company in question will succeed in getting an IPO or will survive long enough to generate returns. Due to the expensive and time-consuming nature of IPOs, delays are common and may limit a company's ability to go public. More than 90% of startups fail and the same percentage of pre-IPO companies don't get an IPO.
Risks can be magnified if a company doesn't have a viable business model or execution strategy. One of the challenges with vetting potential Pre-IPO candidates is a lack of transparency and access to financial data. While public companies are required to make certain financial disclosures, private companies are not. Even when data is available, it may be difficult to accurately interpret the information.
Even if a company performs well and has early success in its IPO, it is difficult for individual investors to predict long-term potential or how quickly returns will be realized. While large returns can be achieved within a few years, it’s often unclear whether a company will grow at a sufficient rate to make a long-term investment worthwhile.
Potential investors should also be aware of the lack of liquidity with pre-IPO shares. While IPO shares are often available on secondary market platforms once the company goes public, pre-IPO investments are typically not liquid until after an IPO. Although early investors may be able to sell shares before a company is listed by way of negotiation, there is no guarantee that any individual investor will have the opportunity or ability to do so.
The Bottom Line
Pre-IPO investment opportunities offer the chance to buy into well-established private companies before they go public. The success of these investments often depends on the investor's ability to interpret financial data, predict future IPO potential, and assess company valuation.
A Private Placement Memorandum is given to all potential investors to provide insight into company performance, value, and valuation. Because this is typically the only document available for analysis before an IPO, its contents should be carefully reviewed before making any investment.
While investors are not guaranteed returns, pre-IPO investing has historically outperformed the S&P 500 index, especially over the last decade. However, the risk of total loss should always be considered before any investment is made.
Personally, I like the idea of allocating a small percentage of a portfolio to Pre-IPO for a high net worth investors and believe there will be continued outperformance.