How to Invest in Companies Before They Go Public
Companies used to do an initial public offering (IPO) when they were much younger, giving investors a much better chance of higher returns. Today, that's where pre-IPO investing comes in.
First Arm, then Instacart and Klaviyo. More companies are starting to list publicly this fall, ending a historically quiet IPO market. Yet, by the time many of these companies go public at 10 or 15 years old, it’s worth asking how much growth is left for public market investors to capture. With venture-backed technology companies staying private longer than ever, how do investors go about accessing growth equity investments? The answer is pre-IPO investing.
Wondering how to get started? This guide will provide an overview of the pre-IPO market and a framework for investors to evaluate potential investment opportunities.
Given the cost of going public (which can be substantial in terms of time and resources), the short-termism of the public markets (which can cause public companies to focus on quarterly earnings rather than long-term growth) and the abundance of capital available in the private markets, technology companies have fewer reasons to go public than they did a decade ago.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
In 1999, U.S. technology companies typically went public after four years.
Today, the median age at which technology companies list publicly is 12 years. As a result, venture-backed technology companies are reaching valuations of $1 billion and even more than $50 billion, before they go public. This means more value being created pre-IPO and less potential upside for public market investors.
With an estimated $3.8 trillion of market capitalization locked up in private unicorn companies, the private secondary market is unlocking that value for investors who had previously been shut out due to high investment minimums and exclusivity.
First of all, what is the private secondary market?
The private secondary market is one in which existing shareholders sell their shares to investors while a company is still private. Typically, these transactions are available to accredited investors. Secondary transactions differ from primary transactions in that the proceeds of a secondary sale go to the selling shareholder instead of the company.
Private secondary marketplaces act as intermediaries between shareholders seeking liquidity and investors who want exposure to late-stage technology companies before they ultimately go public or get acquired. Once an investment is made, investors hold these shares typically via a fund, until there is an exit event. A holding period of two to seven years is not unusual. If the company goes public, investors receive shares they can sell after the IPO lockup period. If the company gets acquired for cash, investors receive cash.
Private secondary investments are typically made in later-stage firms. They tend to exceed $500 million in valuation, generate significant revenue, demonstrate market traction and are backed by top-tier venture capitalists. These companies aim to prove their business models have staying power, with many generating hundreds of millions of dollars of revenue and employing thousands of workers. Twenty years ago, such firms would already be publicly traded.
Late-stage private companies are different from early-stage companies, which tend to have high market, product and execution risk. While early-stage companies can create outsized rewards for the earliest of investors, they are risky. Therefore, on a risk-adjusted basis, late-stage companies tend to provide a growth-equity-style return.
For this reason, many investors consider late-stage private company investments as part of their growth equity allocation. Recent studies have shown that late-stage investing can drive strong returns. In fact, according to one study by Manhattan Venture Partners, investing at the price of a company’s Series E, F or G has generated a mean annualized return of 75%-plus six months post-IPO.
Meanwhile, investors who invested after the IPO, measured as the closing price on the first day of trading, achieved a mean return of -1.4% over the same period. If you’re long-term minded, investing before the IPO may be meaningfully more rewarding than investing on the day of the IPO.
Evaluating pre-IPO investment opportunities
Unlike public companies, there are fewer disclosure requirements for private firms, which can mean greater risk. So how do you evaluate a pre-IPO investment opportunity? Here are some important things to think about.
Business overview. What does the startup do, and how does it generate revenue? What makes this company great?
Market. What is the size of the market that the target company is seeking to capitalize on? What is its go-to-market strategy? Who are its competitors and how does it differentiate itself?
Team. What gives the company’s leadership an edge?
Investment terms and pricing. What are the terms, and what is the price you’ll pay for shares? In the private markets, while primary market pricing is set by the institutional investors who lead a financing event, secondary transactions are typically priced relative to the company’s most recent round of primary funding. The price can also be influenced by factors of supply and demand, as well as the share class of the shares you are purchasing. You can learn more about other factors that impact secondary pricing on the EquityZen blog.
Risks. What could go wrong, and how is the company taking steps to mitigate those risks? These risks will be unique to your target company and could include things like economic risk, competition risk, financial risk and operational risk.
Outcomes. What type of returns could this investment generate? Use the information you gathered above to estimate a base, bull and bear case for your investment.
Highlights. What makes this a compelling investment opportunity? Each investment will have its own unique highlights, for example:
- Has your target company achieved “product market fit” meaning, has its product gained traction with its target customer?
- Is the company profitable? Does it have a strong balance sheet?
- Have top-tier venture capital investors invested in the company?
- Do you have the opportunity to purchase shares at a compelling valuation?
- Is the company quickly gaining market share in a large and growing market? Does it have room to grow?
Investment decision. If you've gotten this far, you're ready to make an investment decision. Nice work!
So where do you go to invest in late-stage companies before they go public? Due to the relative recency of the private markets, one additional decision to make is to select the right partner to help you execute the pre-IPO trade. EquityZen, the platform I founded, is one of the leaders in the market and has helped investors make over 47,000 investments in over 450 companies. We provide in-depth analysis on private companies, informed by 10 years of trading in the private secondary market. Another option is Nasdaq Private Market.
There is so much more to learn about the exciting innovations happening within private companies. As companies stay private longer and the private market grows, pre-IPO secondary investments will become increasingly important to drive meaningful returns and a well-balanced portfolio.
related content
To continue reading this article
please register for free
This is different from signing in to your print subscription
Why am I seeing this? Find out more here
Atish Davda is the co-founder and CEO of EquityZen, a leading marketplace for private company stock. He has been responsible for running the firm, designing and managing the leadership team and product development since its inception a decade ago. Prior to EquityZen, Mr. Davda was Vice President Product at Ampush, a data-driven advertising technology company, where he launched the firm’s New York office. Mr. Davda began his career as a Research Analyst at AQR Capital Management, a pioneer in rigorous quantitative investing, where he worked on a small team responsible for portfolio management of their $4 billion Global Stock Selection strategy.
-
Peloton Stock Is Turbulent After CEO Split, Job Cuts
Peloton stock is on a roller-coaster ride after announcing a leadership change and restructuring plan. Here's what you need to know.
By Joey Solitro Published
-
11 Tips for Talking to Your Aging Parents About Their Finances and Future Care
Such a sensitive subject requires a careful approach.
By Kiplinger Advisor Collective Published
-
Risk in Retirement: What’s the Right Level for You?
Your situation and retirement goals call for an investment approach that takes into account your risk tolerance, risk comfort and capacity for risk.
By Scott Noble, CPA/PFS Published
-
The Earlier You Take Advantage of Your 401(k), the Better
The power of compound interest can turn modest contributions into big savings for retirement.
By Rich Guerrini Published
-
How Non-Traded REITs Could Give Your Roth IRA a Boost
In addition to increasing the diversity of your portfolio, adding a non-traded REIT within your Roth IRA allows the resulting dividends to grow tax-free.
By Edward E. Fernandez Published
-
Tips to Help Single Women Struggling to Save for Retirement
The gender wage gap and taking time away from the workplace for caregiving duties make saving for retirement a bigger challenge for many women.
By Kristi Martin Rodriguez Published
-
A Letter of Wishes: No Legal Power But Powerful Nonetheless
A letter of wishes lets you explain, in plain language, your intent behind your estate documents, potentially heading off any misunderstandings or disputes.
By Steve Lockshin Published
-
If Cars With Touchscreens Are Unsafe at Any Speed, Why Do We Have Them?
Studies show how distracting car touchscreens can be, yet many automakers still use them, perhaps because they’re cheaper to upgrade than physical components.
By H. Dennis Beaver, Esq. Published
-
How to Assess the Impact of Your Charitable Giving
Here are five simple ways to 'do this, not that' when trying to find out from a nonprofit what kind of impact your donations are having.
By Catherine Crystal Foster Published
-
How a Two-Year Installment Sale Strategy Can Save on Taxes
When selling property or another substantially appreciated asset, you could spread the taxes over two years to save big bucks. Following the rules is critical, though.
By Derek A. Miser, Investment Adviser Published