Pre-IPO Investing: Benefits, Risks, Regulations & How to invest

Before a company’s shares are listed on the stock exchanges through an initial public offer (IPO), the shares are known as pre-IPO. Pre-IPO Investing refers to the investments made in the unlisted shares of companies or startups. Many investors often look for companies that can potentially deliver significant returns in the long run.

Through pre-IPO investing, investors can invest in a company early on its lifecycle and capitalise on the potential upside. The early access to a company’s equity and the potential to generate substantial returns have resulted in a rise in the popularity of investing in pre-IPO companies. In this blog, we will look at the opportunities and risks associated with pre-IPO investing.

Understanding Pre-IPO Investing

To better understand pre-IPO Investing, we must understand what the pre-IPO stage of a company is.

A company is said to be in a pre-IPO stage when its shares are offered for sale to investors before it goes public. A company in a pre-IPO stage may often offer its shares for sale to raise funds to support growth and capital adequacy.

Pre-IPO investing differs from IPO investing since the shares of a company are privately offered to a limited number of investors. During IPO investing, various categories of investors can apply to the issue. Meanwhile, in post-IPO investing, the shares of the company are listed on the stock exchanges and can be freely bought and sold.

During the pre-IPO stage, the company’s shares are typically bought by investors like private equity firms, institutional investors, or high net-worth individuals (HNIs). Recently, investing in pre-IPO companies has witnessed a rise in popularity amongst retail investors. The shares of a pre-IPO company are often available at a lower price making it an attractive opportunity for investors to enter into the company before it goes public.

How to Invest in Pre-IPO Companies in India

Investing in a pre-IPO company can be a lucrative investment opportunity. With pre-IPO investing gaining popularity, there are several ways through which an investor can invest in such a company.

Portfolio Management Service (PMS)

A PMS may be a suitable way for an investor to invest in a pre-IPO company. Not only does a PMS ensure professional management of your funds, but they are also well connected with unlisted companies and startups giving investors access to various investment opportunities. An investor should know that a non-discretionary portfolio management service can invest only up to 25% of the capital into unlisted securities while discretionary PMS does not invest in unlisted securities.

Pre-IPO Platforms

There are several platforms that allow investors to invest their money in unlisted shares. Platforms like UnlistedZone and Tyke give investors to access numerous pre-IPO companies and invest in the shares. Moreover, if an investor already holds unlisted shares, they can sell them through these platforms. However, an investor should keep in mind the guidelines and regulations surrounding such platforms.

Alternate Investment Funds (AIFs)

An AIF is a specialised investment vehicle through which investors can invest in various assets including pre-IPO shares. These funds usually require a significant investment and carry higher risk making it viable for high net-worth individuals (HNIs). Depending on the category of the AIF, the fund invests money into securities like unlisted shares.

Angel Investing

Angel investing refers to the investments made by an investor in a startup or unlisted company. These investments are usually made early on in the company’s life and give the investor access to the pre-IPO shares. Angel investing is often done through angel investor networks which.

Employee Stock Ownership Plan (ESOPs)

Several start-ups and companies offer their employees ESOPs. ESOPs are a benefit that gives the employees ownership of the company’s shares at a low or no cost. Depending on the company, the shares can be sold at a specific date and price. ESOPs are a great way for employees and insiders of the company to invest in its pre-IPO shares.

Benefits of Pre-IPO Investing

Pre-IPO investing offers several benefits to investors:

Invest Early in Promising Companies

One of the primary goals for many investors is to invest in companies that offer long-term value and growth. Pre-IPO investing allows investors to invest in promising companies early on before the shares of the company are available to the public.

Higher Potential Returns

Pre-IPO investing is also beneficial since it has the potential to offer substantial returns. If the company’s IPO is successful, an investor can see significant growth in their share price. Moreover, pre-IPO shares are often available for cheap which increases the scope of growth.

Diversification

Investing in a pre-IPO company can help an investor diversify their portfolio. Pre-IPO investing allows an investor to access companies and startups from various sectors and industries. Moreover, these investments are not impacted greatly by market movements, which can help an investor diversify risk.

Risks of Pre-IPO Investing

Although there are several benefits of pre-IPO investing, it is important to be aware of the associated risks:

Liquidity Risks

One of the primary risks of investing in unlisted shares arises through liquidity. Unlike listed shares, pre-IPO shares may face liquidity constraints and an investor may find it difficult to purchase or sell the shares with ease. This can result in your money being tied up in the shares.

Valuation Uncertainty

While investing in a pre-IPO startup of companies, investors often take a bet on a higher valuation of the company in the future. However, the growth in the valuation is not certain and in some cases, the valuation of the company may even see a decline.

Lock-in Period Post Listing

Investors who have invested in pre-IPO shares are often subject to a lock-in period after the shares are listed on the stock exchanges. These investors cannot sell their shares till the lock-in period ends. The share price can fluctuate significantly during this period, posing a risk for pre-IPO investors.

High Minimum Investment Amount

Investing in pre-IPO shares often required a higher minimum investment amount. Since pre-IPO investments are usually for a significant stake in the company, the capital requirements are higher as well. As per SEBI guidelines, the minimum investment for a PMS is Rs.50 lakh while AIF’s have a minimum invest requirement of Rs.1 crore.

Regulatory Risk

In India, there are guidelines to protect investors who have invested in unlisted shares. However, there is no strict regulation, making it a risky investment.

Regulations around Pre-IPO Investing

The Securities and Exchange Board of India (SEBI) has played a significant role in safeguarding the interests of investors looking to invest in pre-IPO shares. Although pre-IPO investing is not illegal, transacting in unlisted shares through platforms not recognised by SEBI violates the Securities Contract Regulation Act (SCRA).

Further, SEBI has also put in place a lock-in period for pre-IPO investors which prevents them from exiting as soon as the shares are listed on the stock exchanges.

How to Evaluate Pre-IPO Investment Opportunities

Before deciding to invest in a pre-IPO company, there are several metrics and factors that an investor should consider.

Financial Performance

Similar to listed companies, it is important to study the financial performance of the companies. Financial reports can help investors track the growth of the company and also benchmark it against its peers.

Management Team

A company’s management is especially important during the early and growth stages of a company. An investor should carefully study the management team and ensure effective leadership is in place to help the company navigate from a pre-IPO to a post-IPO company.

Market Potential

Just like any other company, it is important to know the scope of growth and market potential that a pre-IPO company has. Investing in a pre-IPO startup that has significant potential to capture the market share can prove to be a valuable addition to one’s portfolio.

Exit Strategy

Pre-IPO investors should also consider the exit strategy before investing. An investor can either be in it for the long haul and exit post-IPO or they might offload their shares privately to an investor or institution. The exit strategy is a crucial step while planning pre-IPO investments.

Due Diligence

Conducting due diligence is crucial especially for unlisted companies since these companies are not heavily regulated by regulatory authorities. Ensuring regulatory and legal compliance is met is crucial.

Comparison of Pre-IPO vs. IPO vs. Post-IPO

Conclusion

Pre-IPO investing can prove to be a great way for investors to get their hands on companies that have the potential to deliver long-term value and also generate substantial returns. However, an investor needs to be aware of the various risks associated with liquidity, valuation, and regulation. Further, an investor should assess numerous factors before investing in an unlisted company.