Pre-IPO Investing – Importance of Investing in Pre-IPO Companies

---

A key factor in the growth of a company is capital. Many of us have business ideas, but we do not have money to convert the idea into a business. Even when we do have enough to start a business, we would find it difficult to raise growth capital. Many small and medium enterprises the world over have remained small because of a lack of capital. 

 

Over the last few years, thanks to excess liquidity in world economies, money is now chasing business ideas. India has become the favourite destination for private equity firms. More graduates in India, especially engineering graduates, are looking at joining a start-up company or starting a company of their own rather than an established one.  

Private equity funds are not only providing capital to these companies but also providing strategic guidance. Many companies go through multiple rounds of funding or even mergers and acquisitions before they reach the stock market.

When some of these companies reached the stock market, investors who subscribed to the IPO and made money on its listing are now yearning for more. There were some IPOs that did not do well, nonetheless the search for investing even before the companies reach the market is increasing.

Enthused by short term gains and news of investors making bumper profits on their listing, there is increasing interest in going one step back, that is investing in these companies at a pre-IPO stage.

While the idea is good, it is not without risk. We are only looking at the success stories. Less than one company in ten ever reaches the IPO stage, despite the funding. 

Despite the low success rate, private equity funds are making money because they invest in numerous companies. The few companies that reach the IPO stage generate enough money to take care of the losses in the others and still leave enough on the table. 

Let’s have a closer look at pre-IPO funding.

What is pre-IPO funding and how does it work

• As the name suggesting pre-IPO funding involves funding a company before it approaches the primary market to get listed. 
• This can be just a few years before the IPO or many years. 
• Even if an investor invests after being told that the company is planning to get listed in a short time, there is no guarantee and such decisions have many variables including market condition, investor appetite and the company’s financials. 

For an individual investor, especially a retail investor, direct investing in a company at a pre-IPO level is difficult. This is mainly because companies look for the big-ticket and limited number of investors to fund them. They are ideally on the lookout for investors who understand their business and can add value if possible. Private equity firms or business houses that can add value or help their business grow are normally preferred. 

Should one invest in pre-IPOs

Unless one has excess money, investing in pre-IPOs is risky. 

• As these companies are not listed, there is little public information that can help in monitoring them. 
• Further, these are not transparent companies and are not obliged to part with financial information as the listed ones are. 
• They are not bound by the laws that listed companies are in terms of disclosing information. 
• No research reports are available on them. 
• More often than not, chances are that these companies may not make it to the IPO level. 
• Furthermore, one does not know the value of their investment, unlike a listed company where the share price is available. 
• Also, the investor cannot exit his position if he needs the money or is not happy with the company’s performance. 

How do you invest in pre-IPO companies?

In case an individual managed to invest in a pre-IPO company, the one way he can make money is when the stock is listed. He will need to check whether his investment is in the lock-in period. If it is, he will have to wait for the lock-in period to be over before he can offload his shares. 

However, there are avenues open for retail investors now. Some asset management companies (AMCs) have announced funds that will invest in companies requiring pre-IPO funding. This is a safer route for retail investors, as the fund manager and his team of analysts will be in a better position to understand the business and monitor the business. 

Investing in pre-IPO is not for the fainthearted. Unlike an investment in an IPO or the secondary market, where the exit is easy, pre-IPO investments do not have an exit route unless they are listed. 

Investment is like buying a partnership stake in a business. To do so, one needs to understand the business closely. Further, most companies in the pre-IPO stage that need investments are generally the new-age ones. These companies mostly work on a cash-burn model, that is, they are not profitable and need a steady and heavy dose of funds inflow till they achieve some size before gaining some market share. 

Investing in pre-IPO companies requires patience. Returns from such companies, if at all, will take some time. Even when these companies are listed, one cannot be sure that the market would be as generous in giving them the valuation that a pre-IPO investor did. 

Having said that, if one manages to get their bet right and invest in a company that turns out to be a strong performer, it is nothing short of winning a lottery.