Is Pre-IPO Investing Worth the Risk of Getting Burned?
Returns for investors who get in before companies go public can be white-hot. But you'd better be savvy and have nerves of steel. What to consider first.
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 chance 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 with 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.
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While there are risks to pre-IPO investing, it’s important to distinguish between pre-IPO and early-stage investing, because 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 more established companies that are typically one to four years away from an exit. 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 they have made it past the early stages of their life cycle. 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
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.
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.
Portfolio diversification. For sophisticated investors, adding pre-IPO shares an 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.
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.
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 decisions.
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.
Regulatory and market risks. Changes in regulatory landscapes or market conditions can significantly affect the trajectory of a private company. For instance, shifts in data privacy laws, technology standards or economic downturns can adversely affect their prospects.
Mitigating the risks
Thorough due diligence. Investors should rigorously analyze the company’s business model, market potential, financial health and management team. Consulting with financial advisers and leveraging expert insights can be invaluable.
Investing through reputable platforms. Choosing established and reputable investment platforms, such as the one I work with, EquityZen, or funds that specialize in pre-IPO investments can provide additional layers of vetting and risk management.
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 investors.
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.
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