Investing Pre-IPO; a checklist

Several years ago, I came to the conclusion that anyone with serious money was unlikely to have the majority of it tied up in bonds and savings accounts available on the high-street. After all, those with above average wealth are unlikely to be handling their wealth in the same manner as the average investor – otherwise, they wouldn’t be ‘above average’. I started researching alternative strategies for my money and quickly became excited by pre-IPO opportunities. I imagined myself as one of the Dragon’s from Dragon’s Den, buying into fledgeling businesses; an arena where just a single good pick could turn me into a millionaire.

Of course, finding those opportunities proved to be a challenge; after all, if it was easy, everyone would be doing it. I’ve spent years reviewing opportunities and am yet to find something which really excites me financially. Here are a few of the things I’ve picked up.

What is a pre-IPO stock?

Firstly, let’s cover the details of what a pre-IPO stock is. When a business is founded, it’s capitalised by private shareholders; individuals or entities who provide cash in return for a share of the business. These shares are ‘private’, in as much as that a regular investor can’t go to a stockbroker and ask to buy one in the same way that they could with a share of Google or Tesco. If they’re the one providing the cash, being an initial investor, they could be pushing the business will grow sufficiently to be listed on a stock market like the London Stock Exchange. This process is called Public Listing, where the business launches an Initial Public Offering (IPO); the first chance for investors other than those who launched the business to buy shares in the business.

When the initial investors bought into the business, they’ll likely have paid a few pounds, maybe even pennies per share, but when the shares are listed, it’s usually for a high multiple of the original price, netting you an enormous ROI. One of the big challenges for IPO investors is trying to identify whether a business will ever actually get to the IPO stage. Usually, investors only become aware of these businesses when they’ve already been listed, with more sophisticated investors perhaps getting information on upcoming IPOs from a brokerage. But by this point, it’s already too late – an investor buying into the business at this point will be buying at listing price, rather than the initial share creation price.

Why does this matter?

When a business is initially founded, it is usually little more than an idea, a small team of individuals and the promise of a lot of work. The first few years are crucial to survival; the team needs to win customers, create a sustainable cash flow and maintain profit margins whilst fighting off the competition who are looking to squash them. Consequently, the initial share price is usually relatively low, reflecting the lack of assets owned by the business, as well as the lack of revenue and significant odds of the initial capital being lost entirely.

If the company survives those first few years, revenues will grow, profits will be generated and assets acquired – owning a share of the business is now more valuable, so the shares are worth more. When they’re listed, it’s usually for a huge multiple of the original share price, generating massive returns for those who risked their capital at the beginning.

The risks with pre-IPO stocks

I found this logic extremely compelling, but it’s not all massive cash upside with IPOs. There are plenty of risks involved and an unsophisticated investor could easily miss them.

  1. Any company ‘could’ be pre-IPO. A good sales person could make the case for just about any company in existence being ‘pre-IPO’, enticing an unsophisticated investor with the prospect of ‘getting in before it goes public’. Technically, he wouldn’t be wrong. Your local fish and chip shop could be ‘pre-IPO’, but the truth is that it’s exceptionally unlikely to ever be more than a small, local business. Be cautious of firms that market themselves as having the potential be publicly listed. Some will have that potential, but if it’s your only option for exiting an investment, you should probably move on.
  2. Listing on public markets is pretty easy. Contrary to the perceived glamour of investment bankers, massive deals and front-line coverage, listing a business on a stock market is pretty straight forward. There are numerous small exchanges around the world that will accept a listing for a fee, but have the downside of being extremely illiquid. Simply being listed isn’t enough to cash out your investment – you still have to have an active buyer on the market willing to pick up your shares.
  3. IPOs are not always huge money earners. Not all IPOs are a success, even when they list on a reputable market (like the AIM). If there isn’t a demand for the shares, the price can fall through the floor on listing day as investors try to off-load their holdings. GT Solar and Rackspace Hosting, two companies listing on American Markets in 2008, saw share prices plummet as soon as they went public.
  4. The shares can be illiquid until the IPO. Shares in your friend’s ‘Man with a Van’ business would be pretty difficult to sell on if you needed your cash back. If the company never went public, you could end up holding onto your shares for a very long time, so these investments can be unsuitable for those who might need access to the capital in the short-to-mid-term.
  5. The business could be going public to keep its head above water. Businesses don’t go public because it seems like fun; they do it because they want more cash. Sometimes, that’s because they need capital to fund expansion and growth plans, but other times it’s because they’re struggling. Consequently, an IPO isn’t simply a cause to crack out the champers and celebrate; the shares could still fall in value and the business could still collapse.

Ultimately, the decision to pursue pre-IPO shares was one which I couldn’t capitalise on in any meaningful way. The reality soon struck me that the chances of investing in a serious business which would list on a major exchange is just too slim, and if I watered down my due diligence then I open myself up to unacceptable risks of buying into a poor-quality business from which I’d never be able to retrieve my initial investment. Instead, I’ve concentrated on building a portfolio of high-quality investments with a more acceptable level of liquidity. This doesn\’t mean that I haven\’t got an eye open for an investment opportunity with the potential to be \’pre-IPO\’, simply that my expectations of actually finding on have changed.

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