What Are Pre-IPO Risks?
Although investing in pre-ipo companies can be a great addition to your overall portfolio there can be some risks involved in acquiring these private shares. You need to understand all of these risks before you even consider making any investments into a private company. As you know, any type of investment whether it is equity, a debt or even real estate there is a risk and reward profile attached. While researching more than 100 private equity investments we have found that the reward was always greater than any other asset class but so were the risks attached. Our goal isn’t to scare you away from investing in pre ipo shares instead want to make sure you make the most informed decision.
We have compiled a list of some of the most important risks that you should consider.
Most Important Pre-IPO Risks
Table of Contents
The Pre-ipo company you invested in may never go public – This is always a risk in investing in the pre-ipo companies but you should also consider the age of the company itself. Since there is no market to trade private securities you can not sell shares until a liquidity event such as an IPO. Back in the early 2000s the average age of a company going to do an IPO was roughly 3 years. Fast forward to today, the average age of a pre-ipo company going to the public markets was 13 years. What’s the reason for the change? More and more of these unicorn companies are able to access the capital they require in the private markets. This allows them to grow their company without needing to go to the public markets. However, most of these companies do want to become a public company as it is important for their capital structure in the long term.
The public markets have a huge factor in these companies going to the public markets. If the market is going through a downturn or has increased volatility the number of new initial public offerings drop. There is a direct correlation. On the flip side if the public markets are on a bull run and every IPO that is coming up opens up at a huge premium then the line of companies wanting to go public will also increase. It is important for a pre-ipo company wanting to go public to time this transaction right. During this time, the private shareholder of this company will have to be patient and wait for them to make the final decision. The individual shareholder has little to no control of deciding when a company may go public so risks tying up your capital for an unknown amount of time. You should always consider the amount of time you’re typing up capital before making any investments into private companies. Make sure you understand the complete timeline of an investment before you make the final call. Follow the news surrounding these late-stage companies as they most likely will talk about a public market debut and most times give an estimated time.
Initial Public Offerings don’t always open up at a huge premium – We have followed over a 1,000 IPOs over many years and realized some factors on why some companies outperform others on the first day of trading. You need to realize that regardless of the pre-ipo company itself or the market conditions, the IPO will not always go as planned. Before any IPO, the private company, especially if it’s a Unicorn company will do a roadshow usually 2-4 weeks before the IPO date. They do this to attract interest as well as new investors to buy into the IPO. If it is a company that is in a hot sector at that type this might make it easier for them to do so. We’ve found that companies who already have competitors or comparables in the public markets usually have a better IPO. This is due to the fact of the ability of investors and underwrites such as Goldman Sachs or Morgan Stanley to price the company correctly. If they do so then there will be a premium made.
In some recent case studies, we have found that investors who invested in the last round of financing before a company’s IPO the return was mostly flat. If you are investing in a late stage pre ipo company around 6 months before the IPO you are taking a huge risk solely based on the company’s IPO. If you on the other hand had invested between 12-24 months before a company’s IPO you have more upside protection and can handle first day volatility. Based on numbers we recommend you stay away from private shares of companies too close to an IPO event.
Read more about how IPOs are priced and the complete process here.
Does a private company have the right management team in place? This is an important factor to take into consideration when investing in some of these private companies. You want to have security in the management team put in place to have the ability to execute the business. We have found that the Founder/CEO types are more influential within the business and in some cases can take the business to new levels of growth. For example, Brian Chesky, the Founder and CEO of AirBnB has proven many times that he is the right leader for the company and has the ability to operate the company correctly. You want to make sure there aren’t any conflicts of interest or mismanagement in the company you are looking at.
As a company gets closer to an IPO you will see management changes as well as shifts. Most late stage companies attract new CEOs, CFOs, and COOs who typically come from public companies and have experience in that arena. You want these individuals in place to help the company transition into a public entity. Experienced public executives know how to operate the business correctly through this transition and can oversee necessary steps. When you start to see this move in management in any pre-IPO company it is a sign that the company will be looking to do an IPO soon.
What happens when the pre-IPO company faces disruption – Investing in disruptive companies that have huge growth can be very attractive but you need to evaluate the validity of the company’s business model. Technology risk is usually associated with early stage companies and isn’t a huge factor in late stage private companies. Early stage companies need to prove a sustainable business model without the chance that another company can come in to copy the product or service. The greater the moat around a business the better. Some examples of this type of risk is if a product or service is no longer viable in the market. If a newer product can solve the same problem more efficiently than the existing company’s market share will reduce. Technology risk is a major factor in investing in certain companies due to the unfortunate cause of the company going out of business. That’s why we rarely recommend anyone from investing in seed stage or angel stage investments due to the nature of huge risks associated. Buying private shares of established businesses who have technology that is unlikely to be distrubale is a far better investment strategy.
If a company raises more capital will I be diluted? The short answer is yes- in most cases when private companies go through additional capital raises the existing shareholders are diluted. The amount they are diluted is typically calculated by the amount of new shares the company is issuing. The rate of dilution risk is higher in early stage companies because of the number financing rounds the company will inevitably go through. If you are a cap-table member of the company you will have the right to purchase more shares to maintain your ownership percentage.
As an individual investor purchasing pre ipo stock in secondary markets you most likely won’t be granted the same capabilities as an institution and will most likely be diluted. Even if this doesn’t sound ideal, the amount of return you may see in any private investment will be reduced by a smaller percentage. If you are investing in later rounds of a company than dilution risk will also be a smaller factor when weighing out your investment decisions. Make sure you know the type of shares you are purchasing and the rights you have as a shareholder before you make any investment decisions.
What is Regulatory Risk? In some industries regulation plans a huge part of a private company’s growth and viability. Government regulation changes can impact a business in a huge way, in some extreme cases putting the company out of business. A recent example we’ve seen in a recent IPO company was Uber. Uber as well as Lyft have been fighting regulation for many years both as a private and public company. They’ve been impacted so much so that they’ve had to exit certain markets from operating. In New York City they were limited to the amount of uber drivers that were allowed to operate. Uber has also gone through issues battling their drivers as independent contractors instead of employees. These types of regulatory issues can impact a company’s ability to execute and operate in the market. Although it is a hard risk to foresee we advise you to make educated decision on industries that may be affected in the future.
To Learn more about common risks involved with pre-ipo investments make sure to view the SEC’s website.