EspressoLogy

Pre-IPO (initial public offer) investing involves investing in companies that are preparing to go public (list on the stock exchanges) soon. By entering at an early stage, investors have an opportunity to participate in the company's growth trajectory at the outset and benefit from potential increases in share value once the company goes public.

Let’s understand this with an example. Imagine a well-known company is all set for an IPO in a year. You buy 10 shares for a total of ?10,000 at a per-share cost price of Rs 1,000. The IPO hits the market later that year and the company’s shares list at ?1,500 apiece. If you sell these shares at this point, you make a neat profit of 50%. This potential profit is a reason why many choose to invest in pre-IPO stocks.

Another reason for the increasing interest is pre-IPO investing is the guaranteed allotment of shares unlike in the case of an IPO where a lot depends on the demand.

However, there are risks attached to pre-IPO investing that can go beyond risks in the listed market. What are these risks and what should you keep in mind before investing in pre-IPO companies? Here’s your guide to pre-IPO investing.

How pre-IPO investing works

The rise of angel investing, driven by India's thriving startup culture, has played a significant role in the recent growth of pre-IPO investing. Once reserved exclusively for banks, hedge funds, etc., pre-IPO investing is now accessible to anyone with a demat account and has, therefore, caught the fancy of even retail investors.

The way it works is simple. Any investor with a demat account can contact a broker to buy pre-IPO shares. These brokers can be independent platforms or can be linked to reputed financial companies. Some asset management companies and portfolio management firms also offer opportunities for indirect investment in pre-IPO companies.

Benefits of pre-IPO investing

Private companies are generally believed to create much of their value in the early stages of development. This is because they have more freedom to operate, face less scrutiny, and can pursue more aggressive growth strategies. By investing in pre-IPO shares, investors can tap into the company’s growth potential right from the get-go.

Investing in pre-IPO opportunities can also provide access to specialised markets that may not be accessible in the public market. Think industries like SaaS, EdTech, Fintech, and others, where technological advancements are rapid. By entering early, investors gain valuable experience to navigate the market effectively as it reaches its full maturity.

Buying pre-IPO shares can eliminate the volatility in price you might face when buying IPO shares.  

Risks of pre-IPO investing

The biggest risk involved in pre-IPO investing is not knowing for sure whether the company would eventually go public. If the company’s IPO gets deferred or put off indefinitely for any reason, investors may not be able to exit, or will be able to exit at a loss. Further, any such deferment could lead to the value of the pre-IPO shares falling.

The second thing to remember is pre-IPO shares are not as liquid as IPO shares, and you might face difficulty in finding buyers for them. 

Determining the accurate valuation of pre-IPO shares can also be complex. The risk of overvaluation or undervaluation can affect the returns investors may realise once the company goes public.

What to keep in mind for pre-IPO investing

• Assessing the IPO readiness: This is the most crucial step. Whether or not the company has a clear roadmap and strategy for its IPO, can impact its ability to transition successfully to the public markets. Look at the company's revenue growth, profitability, scalability, and corporate governance practices to assess how likely the company will file for a successful IPO.
• Scan the macro environment: Gauging the macro trends of the industry the company operates in, competition, etc. can help you make a fair assessment of its future potential.
• Remember to diversify: Allocate only a portion of your investment capital to pre-IPO opportunities. Diversification can help mitigate risks.
• Evaluate your exit options: Since pre-IPO investments are typically illiquid, it may take several years for the company to provide you with an exit opportunity. Understand your investment horizon and available exit options.
• Understand taxation: The taxation for gains arising from pre-IPO shares may be different from those in listed market. Make sure to talk to a taxation professional to understand what to expect.

Strategies for pre-IPO investing

Pre-IPO investing comes with a lock-in period during which the shares cannot be sold. Once way of selling your shares after the lock-in expires is doing a private off-market transfer to a buyer after negotiating a price. The transfer takes place directly between your and the buyer’s demat account.

The company’s IPO is another exit route. You can offload your pre-IPO shares in the IPO as part of the offer for sale (OFS).

If you expect consistent returns in future, holding on to the shares even if the IPO offers significant gains may not be a bad idea. You can also sell a portion of your holding during IPO. This can be a good risk management strategy.

Conclusion:

In conclusion, pre-IPO investing in India can be a rewarding investment strategy for those seeking early-stage investment opportunities and potentially high returns. By investing in private companies before they go public, investors can benefit from the growth potential and the possibility of increased share value once the company is listed on the stock exchange. However, just like with any other investment, investing in pre-IPO shares requires thorough research and due diligence.

Frequently Asked Questions:

Q: Is investing in pre-IPO companies legal?

Yes, investing in pre-IPO companies is completely legal. Several brokers, asset management companies and portfolio management services are registered to offer investments in pre-IPO shares.

Q: How long do pre-IPO investments typically take to realise returns?

It can take many years for a company to go public or provide an exit opportunity. It is also likely that the companies may eventually call off the listing altogether. There is also typically a lock-in period of 1-2 years during which investors cannot sell these shares.

Q: What happens if a pre-IPO company fails to go public?

The company can explore alternative funding options, such as private equity investments or acquisitions. If nothing pans out, the value of your pre-IPO shares could fall.

Q: Are pre-IPO investments suitable for all types of investors?

Pre-IPO investments are more suitable for experienced and sophisticated investors who are comfortable with the risks involved with pre-IPO shares. However, even novice investors who have done their due diligence can stand to profit from pre-IPO shares.