Is Pre-IPO Investing Worth the Risk? What to Consider Before Getting Started

Investing in companies before they go public, also known as pre-IPO investing, has garnered considerable interest, especially in recent years. The allure is undeniable: the potential to get in early on the next big thing, potentially reaping significant rewards when the company goes public. However, like with all investments, pre-IPO investing comes with risks. So is it worth it? Here we’ll weigh the potential risks and rewards to determine if it’s a worthwhile strategy for the average investor.

What is Pre-IPO Investing?

Pre-IPO investing involves purchasing shares of a private company before its initial public offering (IPO). These shares are typically offered at a lower price compared to the expected IPO price, presenting an opportunity for substantial gains. Investors might access these shares through venture capital firms, private equity funds, or specialized pre-IPO investment platforms like EquityZen.

While there are risks to pre-IPO investing, it’s important to distinguish between pre-IPO and early stage investing since they have different risk profiles. Early stage investing is typically investing at the seed or Series A stage, when a company is in its infancy and just starting to grow. Many companies at this stage are still developing product-market fit, building out their business model and gaining initial market traction. While investing at this stage can have great upside potential because these companies can have so much growth ahead of them, there is also more risk. Starting a business from zero is hard, leading to the statistic that 90% of startups fail. So while there is high reward potential, early stage investing comes with a high degree of risk.

Pre-IPO investing is different from early stage investing. This stage of private market investing focuses on companies that are typically one to four years away from an exit and more established. These later stage companies have typically raised at least $50 million in capital from top-tier VCs, have valuations north of $500 million and have established business models. Examples of pre-IPO companies that have since gone public include Lyft, Pinterest, Docusign, Spotify, and Instacart, among others. These businesses are growing rapidly, but have made it past the early stages of their lifecycle. As they prepare for an IPO they are typically scaling their organization and putting key hires in place to help the company transition to its next phase. Given the size and scale of these businesses, they typically pose less risk than early stage companies. While there is still risk, which we’ll discuss further below, they should not be considered in the same category. This is a key distinction when it comes to evaluating the risk of pre-IPO investing. 

The Appeal of Pre-IPO Investing

1. High Potential Returns: The most compelling reason for pre-IPO investing is the potential for outsized returns. Recent research has shown that investing in late stage companies before an IPO can result in strong returns, while mitigating some of the risk that comes with investing in early stage companies. You can consider this the pre-IPO sweet spot.
2. Exclusive Access: Investing pre-IPO allows investors to access opportunities usually reserved for institutional investors or ultra-wealthy individuals. The growth of pre-IPO investment platforms has been key to democratizing access to these investments to accredited investors, allowing a broader group of investors to participate in pre-IPO growth.
3. Portfolio Diversification: For sophisticated investors, adding pre-IPO shares can diversify an investment portfolio, reducing dependency on public markets and traditional asset classes. Furthermore, as companies stay private longer, growth equity returns have moved to the private markets. More investors are investing in the private markets to tap this return profile that is less often available in the public companies given shifting market dynamics. 

Interested in browsing the private company investment opportunities available on EquityZen's marketplace?

The Risks Involved

• Lack of Liquidity: Pre-IPO shares are not as easily tradable as those in public markets. Investors should expect to wait several years before a company goes public or is acquired, during which their capital is typically locked up. EquityZen’s Express Deals aim to mitigate this concern by allowing investors to offer their shares to another investor on EquityZen’s platform before an IPO or exit. While this can enhance the potential for pre-IPO liquidity, it is not guaranteed that investors interested in selling will find a buyer willing to purchase their shares.
• Higher Uncertainty: Startups and private companies often operate in highly competitive environments. On top of this, private companies are not required to disclose information about their financials, growth and performance publicly, which can pose a due diligence hurdle for private market investors. Even with thorough due diligence, the success of these companies can be unpredictable. Working with an experienced broker in the pre-IPO market can help mitigate this risk and arm investors with the information needed to make prudent decisions¹.
• Valuation Risks: Determining the fair value of a pre-IPO company is challenging. Overvaluation at the time of investment can result in disappointing returns, even if the company performs well post-IPO. EquityZen looks at a wide range of data points when pricing the investment opportunities on our platform to help mitigate this risk. Our pricing is informed by the bids, asks and actual trades of over 450 late stage private companies over the past 11 years. Understanding the potential upside and downside of an investment based on its implied valuation is crucial.
• Regulatory and Market Risks: Changes in regulatory landscapes or market conditions can significantly impact the trajectory of a private company. For instance, shifts in data privacy laws, technology standards, or economic downturns can adversely affect their prospects².

Mitigating the Risks

1. Thorough Due Diligence: Investors should rigorously analyze the company’s business model, market potential, financial health, and management team. Consulting with financial advisors and leveraging expert insights can be invaluable. 
2. Investing Through Reputable Platforms: Choosing established and reputable investment platforms or funds that specialize in pre-IPO investments can provide additional layers of vetting and risk management.
3. Diversification: Allocating only a small portion of one’s portfolio to pre-IPO investments can mitigate risk. Investors should think about their pre-IPO allocation in the context of their broader alternative investment exposure. In addition, diversifying across multiple companies and sectors can also reduce the impact of any single investment’s poor performance, especially for first-time investors³. 
4. Long-term Perspective: Pre-IPO investments should be approached with a long-term mindset. Patience is essential, as the path to liquidity can be lengthy and unpredictable. This illiquidity premium, however, is part of why return potential can be greater too. 
   
   

So, Is Pre-IPO Investing Worth the Risk?

Pre-IPO investing is not for everyone. It requires a tolerance for risk, the ability to conduct or access thorough due diligence, and the patience to wait for potential returns. However, for investors who can navigate these considerations and determine the right percentage of their portfolio to allocate to pre-IPO companies, the rewards can be substantial. 

Ultimately, like any investment strategy, pre-IPO investing demands a careful assessment of one’s financial goals, risk tolerance, and the specific opportunities available. By balancing the potential for high returns with the inherent risks, investors can make more informed decisions about whether pre-IPO investing is the right choice for their portfolios.

Interested in browsing the private company investment opportunities available on EquityZen's marketplace?

Disclaimers

1. A lack of publicly available and verifiable information can materially impact the accuracy of information provided, including without limitation, estimates relating to the valuation and capitalization of companies subject to investment.
2. 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.
3.  Diversification does not assure a profit or protect against market loss.