Big Tech and Recent IPOs

Pros and Cons of Pre-IPO Investing

Roshni Khatri

20th Mar'23
Pros and Cons of Pre-IPO Investing | OpenGrowth

When selling securities, the entire lot is made available to the public in an initial public offering, or IPO. Companies sometimes use an IPO to sell their assets to smaller investment firms and even individual investors. IPOs have experienced a lot of speculative activity in recent years. Retail investors frequently simply purchase shares in an IPO even when they have no long-term plans to hold onto them. In this way, IPO prices experience a pump-and-dump effect.

Investment bankers frequently assist their clients with a pre-IPO placement to mitigate this. This article will explain what pre-IPO investing is and how it impacts an IPO's success.

 

Is it good to invest in pre-IPO?

Pre-IPO placements are private placements that take place right before an IPO is scheduled to be issued, as the name implies. During these placements, investment bankers place client shares with major institutional investors. Pre-IPO placements occur at a price that is less than that of the IPO to persuade people to purchase the shares. These deals frequently feature a "lock-in" period, during which the investor buying the shares is prohibited from selling them on the open market until after the IPO has taken place. This lock-in period typically lasts for one year. Besides this you should check some factors before you invest in an IPO

Now we will look at the facts of IPO and analyze if it is good to invest in pre-IPO. 

 

Pros of Pre-IPO investing

Investors frequently employ pre-IPO placement methods. This is due to the numerous unique advantages they present. This is a list of a few of them.

  • Stability of the price

Pre-IPO placements are primarily used to guarantee price stability for stocks after they are listed. The share prices of several companies experienced high levels of volatility soon after becoming public. This is because everyone who receives shares in an IPO tries to sell them as soon as the offering is over.

 

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As a result, an excessive number of shares are sold, falsely lowering the company's valuation. A fixed number of shares will be locked in and will not be available for sale if you invest before the initial public offering (IPO). This stabilizes share prices by regulating share supply.

 

  • Assist with marketing

A pre-IPO investment in a reputable investment firm gives the business whose shares are being sold a stamp of approval. The corporation gains significantly more respect in the financial community. They can sell the remaining shares for more money. As a result, the company no longer has to pay the institutional investor a discount on the pre-IPO placement price. In other words, the pre-IPO placement greatly facilitates the marketing of IPO shares.

 

  • Way of exit for investors 

Many businesses, including Uber and Airbnb, have large investments from venture capitalists and private equity firms. They occasionally wish to sell their investment. Yet if they do so during the IPO, it will result in a greater supply of shares and a consequent decline in price. For investors, the pre-IPO placement strategy offers a simple way out. New investors who want to retain shares for a long time take their place.

 

Cons of pre-IPO placement

Pre-IPO placement is an appealing choice because of the advantages described above. But, pre-IPO investing also has several drawbacks and they are as follows:

  • Extensions with locks 

It's crucial to remember that the lock-in period for pre-IPO investing begins after the shares are listed on a public exchange. Investors, therefore, need to hold onto the shares for a longer duration if the IPO procedure is delayed and the shares are not listed for a longer time frame. This frequently results in circumstances where investors' cash gets stranded for extended periods, lowering the effective rate of return.

  • Problems with cancellation

In addition to being postponed, the issue could be canceled! This indicates that the shares are unlikely to be traded anytime soon. For investors in pre-IPO placements, this can be extremely risky because it would suggest that the invested business no longer has a clear exit strategy.

To mitigate this risk, modern pre-IPO contracts typically contain a buy-back clause. As a result, the seller would buy back the shares at a predetermined price if the IPO didn't proceed through. But, doing so would also expose the investor to counterparty risks. The investor wouldn't have any options if the issuer itself declared bankruptcy.

  • Hefty ticket size

Last but not least, pre-IPO placement is only performed for businesses with enormous amounts of cash. Pre-IPO minimum ticket sizes are sometimes eight-digit amounts! There are therefore very few companies that can gather the necessary funds to benefit from this arrangement. In essence, it makes the affluent even richer!

 

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How do I buy pre-IPO stock?

You must learn how to purchase pre-IPO stocks if you want to get in on the fun. These three methods will help you locate and participate in pre-IPO investment opportunities.

  • Through a specialized broker

In pre-IPO trades, brokers and financial advisors frequently participate. They might represent sellers looking for buyers or have purchased equities that they are eager to sell. Choose a broker who specializes in pre-IPO sales or inquire with your present broker regarding pre-IPO stocks. Here are a few possibilities to consider.

  • Directly through companies

Putting yourself in the position of an angel investor or venture capitalist is another option to purchase pre-IPO equities. You can buy stocks if you give a startup early-stage funding. You stand to make fantastic returns if the company eventually goes public. These are a few methods for acquiring pre-IPO stock directly from businesses.

  1. Identify banks and non-banking financial institutions

  2. Attend the startup events

  3. Watch the news

  4. Register with crowdfunding platforms

  5. Register with the stock tokenization platforms

  6. Buy pre-stocks indirectly

Considering the investor requirements, minimum investment amounts, and hazards associated with investing in firms directly, purchasing pre-IPO stocks certainly looks intimidating at this point. Consider investing in pre-IPO companies indirectly if you don't fit those requirements or the risk is too significant for you but you still want some exposure to the pre-IPO market. There are two ways to do this:

  1. Venture capital firms that are publicly held

  2. Exchange-traded funds for private equity

 

Risks of investing in pre-IPO stock

There are certain risks in investing in the pre-IPO and these are as follows:

  • When you put in a bid for an IPO during the issue date, you run into several risks. This may include the possibility that you could or might not be given any shares. Many investors may not receive any shares if an IPO is oversubscribed. Alternatively, you can receive fewer shares than you requested.

  • For IPO investors who retain the stock for a long time, the stock price correction over time will cause it to decline and get closer to its true value. This will result in losses. Hence, if you want to invest in a forthcoming IPO, you also need to be aware of the overvaluation risk.

  • Another significant risk you must face when investing in the equities market is volatility. Prices for stocks can be very volatile in the early stages of trading.

  • You can have problems determining the actual value of the company if it is relatively new and has only recently begun operations. This is due to the possibility that there is insufficient knowledge of the company and its financial performance. Also, you might not have access to enough historical data to use in your evaluation of the stock of the company.

 

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To conclude, retail investors now have access to a method of investing that has also created a new opportunity for them to earn respectable returns. With these investment strategies, you do not bet on share prices; instead, you rely on the company's internal management and fundamentals, which would result in long-term wealth gains.

Thus it is essential to know how to analyze an IPO as it can help you protect your investment. 

 

We, at OpenGrowth, are constantly looking for innovative and trending start-ups in the ecosystem. If you want to have more information about any module of OG Hub, then do let us know in the comment section below.  

A keen observer, who loves to spend time with nature. A fun loving person, enjoys to explore the new aspects of life. Passionate about reading and learning new things. Roshni is dedicated towards her work and has worked in different professions.

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