How To Invest in Private Companies Before They Go Public

Investors Education
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Getting in early as an investor in a promising company has the potential to drive substantial returns. Pre-initial public offering (pre-IPO) investing, or buying shares in a company before it becomes publicly traded, offers just that opportunity. This guide aims to demystify the process of investing in promising companies before they go public.

Whether you're a seasoned investor or new to the game, understanding how to strategically invest in private companies before they hit the public market can significantly enhance your investment portfolio's potential.

Table of contents

  • Understanding the Private Secondary Market
    • Benefits and Risks of Pre-IPO Investing
  • Evaluating Pre-IPO Stocks as Investment Opportunities
    • Understanding Market Trends
    • Identifying High-Potential Pre-IPO Stocks
    • Evaluating the Investment
    • Taking a Deep Dive into the Company's Offerings
    • Notable Pre-IPO Industries To Watch in 2024
  • How To Decide if You Should Invest
    • Qualifications for Pre-IPO Investing
  • How To Invest in Pre-IPO Stocks
    • Specialized Investment Platforms
    • Alternate Investment Routes
  • What Happens When a Company Goes Public?
    • The IPO Process
    • Implications for Pre-IPO Investors
  • Key Takeaways
  • Related Resources
  • Get Started With EquityZen

 

Understanding the Private Secondary Market

The private secondary market is a niche but growing segment of the investment landscape, where shares of private companies are bought and sold before they are listed on a public exchange like NYSE or NASDAQ. The companies that trade here are usually in their mid-to-late stages of growth, often having raised at least a Series B round of financing and have shown a clear path to further growth.

While not without risk, investing in pre-IPO companies through the private secondary market offers a strategic entry point into high-growth potential startups and established companies before they go public, often at more attractive valuations than those found post-IPO.

Unlike investing in the public markets, where shares are readily available through stock exchanges, pre-IPO investments involve transactions in the private secondary market. Like public market investing, though, you are buying shares from existing shareholders, not directly 

from the company. Sellers can include employees who received shares as part of their compensation package or early investors looking to liquidate their holdings. 

The process contrasts with primary market investments, where funds typically go directly to the company for growth and development. Instead, the secondary market provides liquidity to early investors and employees, facilitating investment opportunities without directly impacting the company's capital. Accredited investors can purchase shares directly from existing shareholders or through pre-IPO investment platforms like EquityZen, which democratizes access to these opportunities, previously reserved primarily for institutional investors, by offering a curated selection of pre-IPO companies to individual investors.

The private secondary market is a critical mechanism for investors, founders and employees to achieve liquidity for their shares while offering new investors a chance to participate in a company's growth before an IPO.

 


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Benefits and Risks of Pre-IPO Investing

Navigating pre-IPO investing presents investors with a unique blend of opportunities and challenges. With the chance to be part of groundbreaking companies' journeys before they hit the broader market, this investment path offers both the excitement of earlier-stage involvement and the need for strategic consideration. 

Below, we explore the nuanced landscape of pre-IPO investments, laying out the potential benefits that attract investors to these opportunities alongside the risks that necessitate a thoughtful approach.

Advantages

  • Access to Innovators: Pre-IPO investments offer a unique opportunity to get in earlier and gain a stake in companies that could revolutionize markets, especially in fast-evolving sectors like technology and artificial intelligence. This earlier involvement not only allows investors to support innovation but also to reap significant rewards if these companies achieve strong growth.
  • Preferential Pricing: Investing in companies before they become public offers the opportunity to potentially buy shares at a lower price. This approach recognizes the risks of earlier-stage investment while anticipating significant future gains. It may allow investors to benefit from favorable pricing before the company's value escalates in the public market.
  • Strategic Growth Participation: Investors get more than just financial stakes; they become part of a company's growth, benefitting from its journey toward becoming a publicly traded entity.
  • Portfolio Diversification: Adding pre-IPO investments to your portfolio introduces a level of diversification that can reduce correlation and mitigate risk across different asset classes. The unique risk-reward profile of pre-IPO investments complements traditional stocks, bonds and mutual funds, potentially smoothing out volatility and enhancing overall returns.
  • Potential for Outsized Returns: Pre-IPO investing can yield outsized returns compared to traditional equity markets, especially if the company experiences rapid growth or becomes a market leader in its sector. The success stories of pre-IPO investors in companies like Facebook, Uber and Airbnb highlight the lucrative potential of these investments.

Risks

  • Lack of Liquidity: Shares bought in the private market are generally less liquid than public shares. Selling these shares can be challenging until the company goes public or another buyer in the private market is found. EquityZen's Express Deals can help pre-IPO investors achieve liquidity if they meet certain criteria. However, investors should expect to hold these investments until the company has an IPO or other exit event, which can take 5 to 7 years.
  • Higher Risk: Investing in companies before they go public carries a higher risk, including the potential for the company to fail or not grow as anticipated. Therefore, investors should only allocate capital to pre-IPO investments that fit within their portfolio's riskier bucket.
  • Limited Information: Private companies are not required to disclose as much information as publicly traded ones, making it harder to make informed investment decisions. Secondary market investors typically invest based on publicly available information. Platforms like EquityZen create research reports and analyze the capitalization tables of pre-IPO companies to help investors make better-informed decisions in this opaque market.

     

Evaluating Pre-IPO Stocks as Investment Opportunities

The narrative of pre-IPO investors reaping significant returns upon a company's IPO is compelling, drawing many to consider these investments. However, the landscape contains both opportunity and risk, so investors must understand the market to make smart investment decisions. Here are tips for evaluating pre-IPO shares to get you started:

  • Understand Market Trends: Accessing industry reports from sources like McKinsey or Gartner and staying updated with financial news from outlets like Bloomberg and The Wall Street Journal can provide insights into market trends and potential growth sectors. You can also stay up-to-date with expert advice, such as EquityZen's blog, government data and industry events, to inform your pre-IPO investment strategy.
  • Identify High-Potential Pre-IPO Stocks: Look for companies with disruptive potential, scalable business models, strong management teams, and solid financial health. Innovative solutions, unique technologies, and a track record of revenue growth and effective cash flow management indicate a company's potential for significant impact and success.
  • Evaluate the Investment: Assess the company's valuation, growth potential and regulatory environment to gauge its market positioning and growth potential. Compare the company's value with that of its industry counterparts and consider the market size, product development pipeline and any regulatory impacts on its growth prospects.
  • Take a Deep Dive Into the Company's Offerings: Understand the demand for its product or service by evaluating its market size and growth potential. Assessing the competitive landscape helps identify the company's unique value proposition and potential for market leadership.

Notable Pre-IPO Industries To Watch in 2024

In 2024, several sectors have emerged as frontrunners in the race for growth, driven by technological innovation, evolving business and consumer needs and a shifting global economic landscape. Here's a brief overview of the fastest-growing sectors and notable stocks within each that are catching the eyes of investors:

Healthcare

The healthcare industry continues to show remarkable resilience and growth, mainly due to technological advancements such as telehealth and the ongoing development of innovative treatments. This sector's critical role in society makes it a solid choice for investors seeking both stability and growth potential. 

Agriculture

Agriculture is undergoing a revolution with the introduction of sustainable practices and technological advancements to enhance food security. As the global population rises, the demand for efficient and sustainable agricultural solutions is set to increase. The sector's push toward precision farming and biotechnology underscores its growth trajectory. Additionally, agriculture is resilient as a continuously growing population means ongoing demand for food access.

Green Energy

Green stocks encapsulate a broad range of companies, from those harnessing renewable energy to innovators in energy storage and electric vehicles. The sector is riding a wave of historic investment, with S&P Global Commodity Insights projecting investments in clean energy technology to approach nearly $800 billion in 2024. This represents a significant uptick of 10% to 20% from 2023, highlighting the sector's robust growth trajectory.

Renewable Energy

Renewable energy, particularly solar and wind, is expected to dominate clean energy investments. Renewable energy is experiencing unprecedented growth, propelled by substantial investments, competitive costs and the urgent need for clean energy solutions. Governments worldwide are setting ambitious renewable energy targets, further boosting the sector's prospects. 



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Qualifications for Pre-IPO Investing

Individuals need to qualify as an accredited investor to participate in pre-IPO investments. The SEC sets forth specific criteria to determine who is accredited to protect individuals from taking on financial risks they cannot afford. Here are the primary qualifications:

  • Income Requirements: An individual whose annual income has exceeded $200,000 (or $300,000 together with a spouse) for the last two years and who expects to earn the same or higher income in the current year.
  • Net Worth Requirements: An individual or a couple with a net worth exceeding $1 million at the time of the investment, not including the value of their primary residence.
  • Professional Credentials: Certain professional certifications, designations or credentials may also qualify an individual as an accredited investor. These can include holders of certain professional licenses, such as the FINRA Series 7, Series 65 and Series 82 licenses, among others.

EquityZen's platform makes it easy to verify your investor qualifications. After signing up, you will quickly know your eligibility as an accredited investor. 

 

How to Invest in Pre-IPO Stocks

For investors keen on accessing the growth potential of companies before they list on public exchanges, there are several avenues to explore, each with its unique set of considerations.

Specialized Investment Platforms

The rise of specialized investment platforms like EquityZen has significantly lowered the barriers to entry for investors interested in the pre-IPO market. These platforms serve as critical connectors, linking private companies with a broader audience of potential investors. Here's an overview of the value they provide and operational insights:

  • Accessibility: They offer unprecedented access to pre-IPO investment opportunities traditionally reserved for institutional investors or individuals with a high net worth. By aggregating these opportunities, these platforms allow a broader base of accredited investors to participate in the growth potential of private companies with lower investment minimums.
  • Exclusive Access: Many pre-IPO investment opportunities are exclusive, neither available through public markets nor widely advertised. Specialized investment platforms and networks provide access to these deals, offering a gateway to investments that might otherwise be hard to source.
  • Due Diligence and Transparency: One significant advantage of using specialized platforms is their level of due diligence and transparency about each investment opportunity. For example, EquityZen offers detailed analyses of the company's financial health, market position and future growth prospects based on publicly available information, along with analysis of the capitalization table to help investors make informed decisions.
  • Investment Management: Beyond facilitating the purchase of pre-IPO shares, specialized platforms often manage the investment until an exit event. This includes handling all the paperwork, ensuring compliance with regulatory requirements and providing updates on the company's progress and market conditions. 

While these platforms open the door to potentially promising investment opportunities, investors need to be aware of the fees involved, the platform's selection criteria for listing companies and the liquidity terms of their investment.

Alternate Investment Routes

Beyond specialized platforms, there are additional avenues for accessing pre-IPO opportunities, each requiring different capital levels, risk tolerance and involvement in the private market ecosystem.

  • Direct Investments in Private Companies: This involves personally investing in primary funding rounds, requiring in-depth market knowledge, a strong private market network and a willingness to conduct extensive due diligence individually.
  • Venture Capital Funds: Offers a way to invest in a diversified portfolio of pre-IPO companies through a managed fund, albeit with management fees and less personal control over individual investment choices.

What Happens When a Company Goes Public?

The transition from private to public entities is a significant milestone for a company and its investors. When a company decides to go public, it embarks on an initial public offering, which can significantly impact pre-IPO investors in several ways. Understanding this process and its implications is crucial for anyone considering or holding pre-IPO investments.

The IPO Process

  1. Filing and Regulatory Review: The company begins by filing a registration statement, typically an S-1, with the SEC in the United States, detailing its financials, business model and plans for the funds raised. This document is scrutinized during review, during which regulators may request additional information or clarifications.
  2. Pricing and Roadshow: Concurrently, the company and its underwriters set a price range for the shares and conduct a roadshow to generate interest among institutional investors. The final pricing, determined just before the IPO, reflects demand and market conditions, potentially affecting the return for pre-IPO investments.
  3. Going Public: On the IPO day, shares are sold to the public, and the company's stock begins trading on a stock exchange. This is the first time the broader public can buy shares, marking a critical liquidity event for the company and early investors and an important access point for the broader investor market.

Implications for Pre-IPO Investors

  • Lock-up Periods: Pre-IPO investors are typically subject to a lock-up period, usually from 90 to 180 days post-IPO, during which they cannot sell their shares. This period is intended to prevent the market from being flooded with shares, stabilizing the stock price. The end of the lock-up period can lead to volatility as significant portions of stock may become available for sale.
  • Valuation and Returns: The success of the IPO, reflected in the company's market capitalization and stock performance, directly impacts the value of pre-IPO investments. A well-received IPO can yield substantial returns for early investors, whereas a lackluster market reception can diminish expected gains.
  • Market Reception and Performance: Post-IPO performance is influenced by broader market conditions, investor sentiment and the company's subsequent financial results and growth prospects. Pre-IPO investors need to monitor these factors to decide the optimal time to sell their shares, balancing the desire for immediate returns with the potential for long-term growth.
  • Tax Implications: The transition from private to public holdings and the eventual sale of shares have tax consequences. The nature and timing of these tax liabilities can affect the overall returns from pre-IPO investments, necessitating careful planning and consultation with tax professionals.
  • Dilution Risk: Subsequent funding rounds or the issuance of new shares during the IPO can dilute the ownership percentage of pre-IPO investors, affecting their share of future profits and control over the company. Understanding the IPO terms and any potential dilution is crucial for pre-IPO investors.

Key Takeaways

  • Navigating the Pre-IPO Secondary Market: Begin by familiarizing yourself with the private secondary market, where shares of private companies are traded before they list on public exchanges. This market offers unique access to companies poised for growth, often at more attractive valuations than their eventual public offering prices.
  • Analyzing Pre-IPO Investment Opportunities: Assessing pre-IPO companies requires carefully examining their market trends, financial health, growth potential and the competitive landscape. This step is crucial to identifying businesses with strong prospects for success and alignment with your investment criteria.
  • Deciding to Invest: Consider your financial goals, risk tolerance and the qualifications necessary to engage in pre-IPO investing, such as being an accredited investor. This evaluation will help determine if pre-IPO investing fits within your broader investment strategy.
  • Methods for Buying Pre-IPO Stocks: Explore the various avenues for purchasing pre-IPO shares, including direct investments in private companies, venture capital funds or specialized investment platforms like EquityZen. Each method has its own set of considerations, such as the required level of capital, risk tolerance and degree of involvement in the startup ecosystem.
  • Understanding the IPO Process: Learn how the shift from private to public entities impacts investors. Factors such as lock-up periods, potential for valuation changes and the broader impact on your investment are pivotal considerations.

Get Started Investing in Private Companies with EquityZen

Investing in private companies can offer unique opportunities for discerning investors. EquityZen makes these opportunities available to more investors by offering some of the lowest investment minimums available. Our platform simplifies the investment process, making the world of pre-IPO investing more accessible than ever and enabling more investors to participate in the growth of future market leaders.

Sign up with EquityZen and start your journey toward investing in the companies of tomorrow today.

 


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Disclaimer: Not all pre-IPO companies will go public or be acquired, and not all IPOs or acquisitions are or will become successful investments. There are inherent risks in pre-IPO investments, including the risk of loss of the entire investment, illiquidity, and fluctuations in value and returns. Investors must be able to afford the loss of their entire investment. This should not be construed as investment advice.

 

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