What is Pre-IPO Investing?

Investors Education
winding road through greenery for equityzen pre-ipo investing

Pre-initial public offering (pre-IPO) investing opens up opportunities beyond the traditional stock market to invest in companies before they go public and be part of a company's growth story earlier on.

As you explore the pre-IPO market, understanding the nuances of accreditation, the return potential of mid- to late-stage growth, and the balancing act of risk versus reward becomes paramount. This guide will equip you with the knowledge to make informed decisions in the private investment landscape.

Table of contents

  • Introduction to Pre-IPO Investments
    • Differences Between Pre- and Post-IPO
    • How Do Pre-IPO Stocks Work?
    • How Can You Buy and Sell Shares in Private Companies?
    • Who are Eligible Pre-IPO Investors?
    • How Does Equity in a Private Company Work?
  • Summarizing the Pros and Cons of Pre-IPO Investing
  • Managing Your Risk in Pre-IPO Investing Strategies
  • Example of Pre-IPO Investing: A Hypothetical Case Study
  • Key Takeaways
  • Related Resources
  • Get Started With EquityZen

 

Introduction to Pre-IPO Investments

A pre-IPO investment means buying shares in a private company before its initial public offering. These investments enable individuals to access exclusive, fast-growth startups alongside institutions and venture capitalists, typically via secondary investments.

Secondary investments occur when existing shareholders of a private company sell their shares to investors. In these secondary transactions, the shares are sourced from a selling shareholder, not the company, so the proceeds go to the shareholder rather than the company. This is the same type of transaction that enables you to buy public shares on a stock exchange.This contrasts with primary issuances, where a company issues new shares to employees (often as stock options) or investors to raise capital. Secondaries are named as such because they are a step removed from the primary issuance that initially created the securities.

The employees and investors who own primary shares may choose to sell them in the secondary market through EquityZen at a later date. The pre-IPO investments we’ll be discussing are via the private secondary market.

Through pre-IPO investing, you get the opportunity to invest earlier in a private company, supporting that company as it grows with the goal of your investment increasing in value. Pre-IPO investors aim to buy in at lower prices than are often available in the public markets to achieve a greater payoff if the company's value continues to grow over the coming years before it goes public. On EquityZen’s platform, for example, pre-IPO investors typically buy at a discount[1] to the last primary funding round the company raises.

In summary, think of pre-IPO investing as getting a head start in supporting tomorrow's leading companies before they go public. While investors and market enthusiasts talk about the excitement of a company going public, the real groundwork and growth often happen while companies are still private, offering a unique opportunity to pre-IPO investors. Especially as companies stay private for longer now than ever – a median of 11 years versus an average of 4 years in 2000 – pre-IPO investing allows investors to capitalize on growth that is less frequently achievable in the public markets.

 

Differences Between Pre- and Post-IPO Investing

The main differences between pre-IPO and post-IPO investing lie primarily in the stage of the company's life cycle at which you are investing, the accessibility of the shares and the perceived risk.

Pre-IPO investing is about buying shares in a company before it goes public, targeting mid- to late-stage companies that have typically raised at least a Series B round of financing, are rapidly growing, and may offer higher returns but with less liquidity and higher risk. Pre-IPO investing is also only typically available to accredited and institutional investors.

On the other hand, post-IPO investing begins when a company is publicly listed, offering quick and easy share trading, broad access for all investors, and potentially lower risk given the company's established status and public disclosure requirements, which appeal to investors seeking potentially less risky investments. Instacart, Birkenstock and ARM are examples of companies that went public in 2023.

 

How Do Pre-IPO Shares Work?

As an analogy, think of pre-IPO stocks or shares like backstage passes to promising startup companies before they hit the big stage. Via a pre-IPO investing platform, you gain exclusive early access to invest in and support the company behind the scenes. If the company files for an IPO down the line, as typically expected, your backstage pass (pre-IPO stock) converts into liquid public stock listed to trade openly.

In terms of pre-IPO stock prices, these shares are typically priced at a discount to the company’s last private funding round. This accounts for the illiquidity of the shares and the lack of publicly available information. You can liken buying pre-IPO shares to paying less for concert tickets before reviews are out.

Pre-IPO companies also typically impose "lock-up periods" where investors can't sell their shares right away after the company goes public. This prevents pre-IPO investors from immediately selling when the stock becomes liquid, one of the trade-offs between earlier access to potential growth and waiting to realize profits.

However, investing in a pre-IPO company allows you as an investor to get in earlier on what could be the next big success story in AI, tech or other promising industries. It's about seizing the opportunity to be part of a private company's growth, potentially reaping significant rewards as it expands, matures and goes public.

 

How Can You Buy and Sell Shares in Private Companies?

Unlike public company shares, you won't find pre-IPO shares on standard exchanges like the New York Stock Exchange (NYSE) or Nasdaq. Instead, private market platforms like EquityZen enable you to access exclusive pre-IPO shares via the private secondary market.

Each private company chooses who can trade their pre-IPO stocks via shareholder agreements and approval processes. Experienced pre-IPO marketplaces like ours have relationships with many of these private companies, making the transaction process more streamlined.

 


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Who are Eligible Pre-IPO Investors?

Pre-IPO investing is now more accessible for individual investors thanks to secondary marketplaces and new regulations opening up access to private deals. However, you typically must be an accredited investor to invest in growth-stage private companies.

Investing in the next big company before its stock is publicly available is exciting. Yet, pre-IPO investing is a path laden with regulatory safeguards. Accredited investors must meet the SEC's criteria, typically involving meeting income or net worth thresholds. This accredited investor status is crucial for pre-IPO investing, as it denotes individuals or entities with the financial resilience and sophistication to understand and bear the risk of loss associated with these investments.

More details about applicable regulations and legal considerations

In addition to being an accredited investor, navigating the pre-IPO investment landscape means understanding and adhering to a framework of rules designed by the SEC to protect investors and the integrity of the markets.

Here are some of the regulatory cornerstones pre-IPO investors should be aware of:

  • Rule 506 of Regulation D: Perhaps the most widely utilized exemption, Rule 506 allows companies to raise unlimited capital from accredited investors without requiring a registered offering. It's pivotal for most pre-IPO transactions, ensuring a streamlined path for companies seeking funding and investors looking to participate in these opportunities.
  • Rule 144: This rule provides a safe harbor for selling securities in the public market, applicable to restricted or controlled securities after a specific holding period. Understanding Rule 144 is vital for accredited investors as it dictates when and how their shares can be sold, which is crucial for liquidity planning.
  • Rule 701: Exclusively relevant for startups and private companies, Rule 701 exempts certain securities offerings under compensatory arrangements, such as employee equity plans. As investors, knowing the ins and outs of this rule helps understand the equity structure of the company you're investing in.

Adhering to these regulations allows accredited investors to participate in the potentially lucrative pre-IPO market, armed with the knowledge and legal protections these rules provide. As always, though, individuals should consult with financial and legal advisors to navigate the legal requirements of pre-IPO investing with confidence.

Requirements to Be an Accredited Investor

Accredited investors can purchase private company (pre-IPO) shares through private placements before an IPO. The SEC has set financial criteria to qualify as an accredited individual investor. You typically need an annual income exceeding $200K individually or $300K jointly in two of the last three years and a reasonable expectation of the same income in the current year, or a net worth above $1 million, excluding your primary home.

Institutional investors, like venture capital and private equity funds, also can participate in pre-IPO deals. As professional investment firms, they have the financial analysts, industry expertise, due diligence resources, and experience to thoroughly assess the risks and growth prospects of private companies they may invest in.

Individual accredited investors may not have comparable resources for digging into pre-IPO opportunities, even if they meet the wealth requirements.

 

How Does Equity in a Private Company Work?

When you invest in a private company, you buy a stake in that business — also known as equity ownership. The founders and employees also typically own equity, usually via stock options or share grants.

In the secondary market, investors buy shares from existing shareholders who are seeking liquidity before an IPO or exit. Many of these shareholders are employees or early investors who have held their shares for several years and may be looking for cash to pay a downpayment on a home, fund education or finance other life needs. With companies today staying private longer than ever, this liquidity need has become more apparent, lending to a more active private secondary market.

If the company you invest in pre-IPO performs well and increases in value, your equity becomes more valuable. You can capture returns through an exit event, like an acquisition or when the company eventually goes public in an IPO. However, if the company fails, the equity can lose value or become worthless. So, while investing in private companies offers growth potential, it also comes with a higher risk level than public stocks.

 

Summarizing the Pros and Cons of Pre-IPO Investing

In terms of potential benefits, pre-IPO investing offers the following:

  • Access to Potential Growth: Pre-IPO investing allows you to buy into a company before it's offered to the public, often at a lower valuation. This early entry can lead to substantial gains if the company grows significantly.
  • Exclusive Opportunities: This type of investing gives you access to innovative startups and companies that could be the next big thing, allowing you to be part of potentially revolutionary ideas from the ground up.
  • Diversification: Adding pre-IPO investments to your portfolio can offer diversification, spreading out potential risk and opportunity across various sectors and stages of growth.[2]

That said, investors should be aware of the risks associated with private companies:

  • Liquidity Risk: Investments in pre-IPO companies are often illiquid. You should be ready to hold onto your shares for up to seven years before you can sell them, usually not until after the company goes public or is acquired.
  • Risk of Failure: Many startups and younger companies fail, making pre-IPO investments riskier than public market investing. The high potential reward comes with the potential for total loss.
  • Limited Information: Private companies are not obligated to disclose as much information as public companies, making it challenging for investors to fully assess the risk and value of the investment. This lack of transparency can lead to difficulties in making informed investment.

Managing Your Risk in Pre-IPO Investing Strategies

Navigating the waters of pre-IPO investing requires a strategic approach to mitigate risks. Here are ways to help safeguard your investment and increase your chances for success:

  • Diversify Your Investments: Don't put all your eggs in one basket. Spread your investments across different sectors and stages of companies, either through multiple investments or investing in a diversified fund offering.
  • Thorough Due Diligence: Ensure you understand the business model, the market and the management team. Leverage professional networks and resources available.
  • Understand Your Time Horizon and Liquidity Needs: Recognize that you may need to hold these investments for an extended period and that exiting the investment might take more time and effort than in the public markets.
  • Stay Informed: Keep up with news and updates about the company and its industry. Changes that significantly impact your investment can happen quickly.

 

Example of Pre-IPO Investing: A Hypothetical Case Study

To help illustrate pre-IPO investing, we’ll use a case study of a hypothetical company called “Innovatech.” Imagine this is a late stage tech startup specializing in renewable energy solutions. They've developed a groundbreaking solar panel that's cheaper and more efficient than current market options. As an accredited investor, you learn about an investment offering in Innovatech via a secondary marketplace like EquityZen. You invest in the company, attracted by the innovative technology and the team's expertise.

As Innovatech grows, it secures more patents, expands its customer base, and increases revenue. After several years, Innovatech announces its IPO. The public offering is successful, and the stock price surges. Your investment has multiplied in value, and you now have the option to sell some or all of your shares, reaping the rewards of supporting an innovative company before it is IPO.

This hypothetical scenario illustrates the potential high rewards of pre-IPO investing, along with its speculative and long-term nature. Each investment opportunity is unique and requires careful consideration and due diligence. It’s important to note that pre-IPO investing also comes with risks. For example, not all pre-IPO investments will succeed and not all pre-IPO investors will benefit from an exit event. In some cases pre-IPO investing can result in a loss of the full investment amount.

 

Key Takeaways

If you’re interested in pre-IPO investing, here are the important takeaways from this guide:

  1. Pre-IPO vs. IPO: Investing in a company before it goes public can offer lower valuations and therefore the potential for higher returns but comes with greater risk and less liquidity than investing post-IPO.
  2. Accreditation is Key: Only accredited investors, defined by specific financial or professional criteria, can participate in pre-IPO investing. Understanding whether you qualify is the first step in this investment journey.
  3. Legal and Regulatory Landscape: Pre-IPO investing is governed by a series of regulations like Rule 506 of Regulation D, Rule 144 and Rule 701. Understanding these can help navigate the complexities of private investments.
  4. Equity Ownership Comes with Risks and Rewards: Investing in private companies means buying a stake in their future. While there's a potential for significant returns if the company succeeds, there's also a risk of total loss if it fails.
  5. Risk Management is Crucial: Diversifying investments, conducting thorough due diligence, understanding liquidity needs and staying informed are all critical strategies for managing the inherent risks of pre-IPO investments.
  6. Access and Trends: The landscape of pre-IPO investing is evolving, with more access paths opening up for individual accredited investors through secondary marketplaces and regulatory changes.

 


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Related Resources

If you’re interested in learning more about pre-IPO investing, feel free to browse our blog, look at the company shares we have available, or check out the related resources below:

  1. The Value of Private Company Investments in Your Portfolio
  2. Getting Started with Private Market Investing: Part I - Investments page + Indicating interest
  3. Getting Started with Private Market Investing: Part II - EquityZen’s Investment Products
  4. Getting Started with Private Market Investing: Part III - The Offering Document
  5. Getting Started with Private Market Investing: Part IV - The "Standard" Investment Process

Get Started With EquityZen

As you consider the vast potential of investing in the private markets, remember that pre-IPO investing is a strategic move toward diversifying and enhancing your portfolio's growth potential. EquityZen makes unique pre-IPO investment opportunities more accessible than ever with some of the lowest investment minimums available. It's not just about access; it's about making informed, strategic choices with the backing of a robust platform and a community of fellow investors.

Sign up with EquityZen today and take a step towards potentially being part of tomorrow's success stories.


[1] EquityZen data, as of 1.17.24

[2] Diversification does not assure a profit or protect against market loss.

 

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