What is the Role of Broker-Dealers in Pre-IPO Investments?

Investors Education
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Pre-initial public offering (pre-IPO) investing is gaining popularity as it presents a unique chance for investors to be part of a company's growth from an earlier stage with the potential for substantial returns, while not without risk. Central to this process are broker-dealers whose expertise and services are indispensable in bridging the gap between private companies and interested investors.

In this guide, we’ll cover the role that broker-dealers, such as EquityZen, play in making pre-IPO investments more accessible and how they help manage risks associated with these investments.

 

Understanding Broker-Dealers

Broker-dealers are key figures in the financial markets, serving dual roles that facilitate the buying and selling of securities. As brokers, firms like EquityZen act on behalf of their clients, executing orders to buy or sell, ensuring their clients' interests are always prioritized. When operating as dealers, they trade securities from their accounts, directly engaging in the market. 

Broker-dealers include many firms, ranging from large entities linked to well-known banks and investment companies to smaller, independent firms offering niche services. They are generally split into two categories: full-service and independent.

Full-service broker-dealers typically offer a broad range of financial products and services, leveraging their larger parent organizations' resources and brand recognition. They can provide clients access to diverse investment options and comprehensive wealth management, financial planning and other advisory services. Independent broker-dealers tend to be more specialized and focused on specific areas or market segments, like the pre-IPO market. They offer more customized and tailored solutions to their clients, and their specialized focus allows them to develop deep expertise in their areas of concentration. For example, by focusing on pre-IPO investments, EquityZen has become a leader in that market, helping clients complete over 41,000 transactions in over 450+ late stage private companies1 over the past decade.

The broker-dealer structure allows for active and ever-evolving markets characterized by regular transactions, dynamic prices and the continuous entry of new participants. This dynamism is the lifeblood of the financial markets, fostering a competitive and innovative environment where various investment strategies, products and preferences can thrive, all suited to different investors’ needs. Broker-dealers help ensure that financial markets continue to function smoothly, efficiently and in the best interests of all market participants.

 

The Function of Broker-Dealers in Pre-IPO Stock Transactions

Broker-dealers act as intermediaries that link sellers of pre-IPO shares with accredited or institutional investors looking for earlier-stage investment opportunities. Platforms like EquityZen specialize in these transactions, providing a marketplace where early startup shareholders can find liquidity for their shares before the company goes public or has an M&A event, by selling to accredited investors interested in pre-IPO investment access.

Broker-dealers handle everything from the initial listing of pre-IPO shares to the final settlement of transactions. They ensure that all parties meet the necessary criteria for buying and selling and that the shares are correctly listed, priced and transferred. One of their key responsibilities is to conduct thorough due diligence, verifying the shares' legitimacy and the investors' accreditation while also adhering to the regulatory framework that governs pre-IPO transactions.

Broker-dealers provide essential liquidity in a market where pre-IPO shares are inherently illiquid. This has become more important as companies continue to stay private longer than ever. By offering access to secondary markets, pre-IPO sellers can convert their shares into cash and buyers can invest in investment opportunities previously only available to large institutional investors. This mutual benefit enhances financial flexibility and security for sellers while offering buyers the potential for lucrative returns in fast-growth companies.

Broker-dealers also provide valuable expertise in raising company capital through services like underwriting and marketing for companies aiming to go public. This assistance is key for firms tackling the complexities of public offerings, making broker-dealers essential allies in the IPO process.

 

Benefits to Sellers

Pre-IPO shares are not traded on public stock exchanges, making them difficult to sell before the company goes public. The wait for an IPO can be lengthy and uncertain for early investors and employees who receive shares as compensation. This situation can be challenging because these shares are illiquid and cannot be easily converted into cash.

Even following an IPO, challenges remain for shareholders. Lockup restrictions often prevent shareholders from selling their shares for a period typically from 90 to 180 days. This period is intended to prevent a sudden sell-off that could negatively impact the stock price and is usually detailed in the company’s prospectus, but this prolonged waiting time can be difficult for shareholders who need liquidity sooner.

This illiquidity can make early investors' capital inaccessible for an extended period, sometimes several years, without guaranteeing a profitable return and inhibiting their ability to make new investments. The ability to achieve liquidity is crucial — it enables these early investors to access their funds when needed rather than waiting for the company to go public. The early access to capital that the private secondary market provides solves for this, providing peace of mind and financial planning options to both individuals who have contributed to a company's early growth stages and early stage investors.

Broker-dealers mitigate this issue with platforms and services that offer liquidity and security for pre-IPO shareholders, including:

  • Pre-IPO Liquidity Solutions: Broker-dealers act as an avenue for sellers to liquidate part of their holdings before a company’s IPO, enabling stakeholders to convert their shares into cash or other liquid assets, sidestepping the traditional market's limitations.

Benefits to Buyers

For accredited investors, pre-IPO investments carry the potential for lucrative returns, as investors can buy into companies at an earlier stage of growth, typically at lower valuations than they might be when the company goes public, though these opportunities also come with risks. 

Broker-dealers open the door to pre-IPO investment opportunities for buyers, among other benefits, including:

  • Comprehensive Vetting: Broker-dealers establish structured transaction integrity and secure investment environment. This includes ensuring sound due diligence of investment opportunities including checking on financial health, assessing the viability of a given company’s business model and evaluating their growth prospects.
  • Suitability of Pre-IPO Investments: Broker-dealers may act as advisors to ensure pre-IPO investments align with each investor’s financial goals and risk tolerance. By conducting thorough evaluations and leveraging in-depth market analysis, they recommend opportunities that fit well within the investor's portfolio, with the goal of driving returns and alignment with long-term financial objectives. Typically, pre-IPO investments are only suitable for investors with at least a 5 to 7 year investment horizon and the willingness to take investment risk. 
  • Transaction Security: They employ advanced security protocols, including encrypting financial transfers and adhering to strict financial compliance standards. This layered approach safeguards the transfer of funds and shares and protects both investor and shareholder information from unauthorized access.
  • Insightful Analysis: With dedicated research departments, broker-dealers offer in-depth insights on market trends, financial fundamentals and offering details for specific securities, aiding in more informed investment decisions. They also provide clear and transparent communication about the investment process, helping investors understand the nuances of each opportunity.
  • Investor Education: Broker-dealers often offer a wealth of resources, from seminars and webinars to comprehensive online tools and content, to educate investors on financial concepts, investment strategies and market dynamics.

 


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Challenges and Considerations

Beyond illiquidity and other challenges we’ve covered, investors who want to invest in pre-IPO shares have additional risks to consider that broker-dealers can provide support for. Here are some to be aware of:

  • Regulatory Risks: Pre-IPO companies operate under a different set of disclosure and regulatory standards than publicly traded entities, making achieving full transparency in investments challenging. Broker-dealers conduct due diligence and adhere to securities laws, registering with the Securities and Exchange Commission (SEC) and following Financial Industry Regulatory Authority (FINRA) guidelines.
  • Accreditation and Lock-up Periods: There are many regulatory complexities to be aware of, including requirements around investor accreditation and handling lock-up periods post-IPO. Broker-dealers ensure compliance with regulatory standards by verifying investors' accreditation status and understanding lock-up period implications. Their guidance helps investors successfully maneuver through these pre-IPO investment stipulations.
  • IPO Uncertainty: The IPO process is unpredictable, with no guarantee that an IPO will happen or achieve high returns. Market volatilities, regulatory changes or company financial health shifts can affect the IPO's success. Broker-dealers advise on strategic investment timing and sales, factoring in market conditions and the regulatory landscape to help investors enter the market confidently.

The Importance of Broker-Dealers in the Evolving IPO Landscape

Companies have increasingly been choosing to stay private longer, driven by the availability of private funding, allowing companies to grow and scale without the need to go public for capital. As a result, the average age of companies at their IPO has extended from a few years in the early 2000s to 10 years today2, heightening interest in pre-IPO shares for earlier access to high-growth potential investments.

As investors seek early access to potentially high-growth companies before they become publicly traded, broker-dealers have become more important. They facilitate access to pre-IPO investment opportunities, connecting institutional investors, venture capitalists, early employees and high-net-worth individuals all looking to trade in the private secondary market.

Moreover, by offering investments backed by reputable institutional investors and venture capitalists, broker-dealers may help bolster a company's market perception amongst retail investors, making it more attractive to potential IPO investors. This enhanced market perception can lead to a more successful IPO, benefiting the company and its early investors.

 

Start Pre-IPO Investing With EquityZen

The importance of broker-dealers in the pre-IPO investment sector cannot be overstated. They offer essential guidance and services that demystify the process for buyers and sellers, ensuring a clear, efficient experience. Broker-dealers also ensure that each transaction meets the highest compliance standards and aligns with their client’s investment horizon and risk appetite.

EquityZen’s user-friendly platform gives you tools and deep market insights to guide you in buying or selling pre-IPO shares through our funds. You’ll get access to some of the most competitive investment minimums and exclusive opportunities to be part of the success of groundbreaking companies.

It's never been easier to take a strategic step toward diversifying and enhancing your investment portfolio. Learn more about becoming an investor to get started!

Sources

  1. EquityZen data as of April 2024
  2.  https://site.warrington.ufl.edu/ritter/files/IPOs-Age.pdf 

 


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