Importance of Investing in Pre-IPO Companies: A Comprehensive Guide

If you are a regular stock market investor, you probably know there are two main ways to buy shares of companies.

• The first way is through the primary market when a company launches its Initial Public Offering (IPO). However, getting shares through an IPO isn’t guaranteed, especially if the IPO is oversubscribed, in which case shares are allotted through a lottery system.
• The second way to buy shares is through the secondary market, where you can place buy and sell orders anytime during market hours.

But did you know there is another way to buy a company’s shares even before it announces its IPO?

What is Pre-IPO investing?

Pre-IPO investing means buying shares of a company before it officially sells them to the public through an IPO. An IPO is when a company offers its shares for public sale for the first time. Sometimes, companies sell some of their shares to selected investors before the IPO to raise money and build an investor base.

In the past, pre-IPO shares were only available to wealthy individuals, banks, private equity firms, and other big institutions. But now, thanks to Demat account and trading account, all types of investors can buy shares of pre-IPO companies.

How Does a Company Raise Fund Pre-IPO

There are primarily two ways a company can sell shares privately to Investors

• Companies offer new shares to venture capitalists, angel investors, and high-net-worth individuals (HNIs). Investors can also put their money into venture capital funds that focus on pre-IPO companies. However, these funds typically require high minimum investments and come with lock-in periods.
• Another way to invest in pre-IPO shares sold by existing investors or employees is through the secondary market via off-market transactions. It is crucial to work with a reliable and reputable intermediary to reduce counterparty risks.

Pre-IPO shares are often sold by employees and company founders. Startups and private companies may face liquidity issues due to limited market access. Selling privately held shares helps them raise funds and manage financial needs.

Here’s How Pre-IPO Investing Generally Works

Companies do not launch an IPO until they have reached certain business goals. Before the IPO, they raise funds from investors who are interested in pre-IPO opportunities to potentially earn higher returns than they would by buying the company’s stocks in the open market.

To understand how pre-IPO investing works, consider this example:

Suppose you invest in XYZ company through pre-IPO investing and buy 100 shares at Rs 500 per share. By doing this, XYZ company receives Rs 50,000 from you, which they can use for their business needs. Later, when the company decides to go public, its valuation might increase, raising the value of one share to Rs 1,000.

During the IPO, the company offers shares at Rs 1,000 each. You can choose to sell all of your 100 shares to the public at this price if your shares are included as a part of IPO offering, or if you believe the shares will continue to increase in value, you can hold onto them for the long term. At the time of the IPO, the following two scenarios might occur:

Scenario 1:

If you decide to sell your 100 shares to the public at the IPO price of Rs 1,000 per share, you will receive Rs 1,00,000 in total. (Your shares should be included as a part of the offering at the time of IPO)

Total Profit: Rs 50,000 (Rs 1,00,000 – Rs 50,000)

Scenario 2: 

You hold your 100 shares for listing gains after the IPO.

If you decide to hold your 100 shares, anticipating that the shares will open at a premium, you can sell them after the IPO. Suppose the shares open at a 30% premium and the price rises to Rs 1,300 per share. You can sell them at this rate.

Total Profit: Rs 80,000 (Rs 1,30,000 – Rs 50,000)

This is how pre-IPO investing works, allowing investors in India to potentially make better profits compared to buying shares during an IPO.

Is it Advisable to Invest in Pre-IPO Investing?

Investing in pre-IPO shares may be profitable, often offering high returns. Technology stocks, in particular have great growth potential.

But remember, pre-IPO investing carries risks. Startups can fail, leading to losses with no returns. To balance this risk, companies often offer shares at a lower price. This attracts investors and provides the company with funds, even if the IPO doesn’t succeed.

Benefits of Pre-IPO Investing

Given below are some of the major benefits of pre-IPO investing

• High-Profit Potential: Investing in pre-IPO shares can may lead to high returns. These are newer companies or startups with significant growth potential. For example, investing in emerging sectors like electric vehicles or technology startups can offer impressive gains.
• Less Impact from Market Fluctuations: Pre-IPO shares are less affected by stock market volatility. They aren’t influenced by market events like financial crises or pandemics. Their value depends mainly on the company’s performance, not broader market swings.
• Guaranteed Share Allocation: With pre-IPO investments, you can secure shares before they are publicly available. This is beneficial since IPO shares may not be guaranteed if there is high demand. Although you might pay a bit more for pre-IPO shares, you could earn significant profits when the company goes public.
• Offloading of Shares: You can make a profit by selling your pre-IPO shares when the company launches its IPO. For example, if you buy shares for Rs. 120 each and the IPO price is Rs. 180, selling your shares at the IPO price can give you a 50% return.
• Cheaper Purchase Prices: Pre-IPO shares are often sold at lower prices compared to their IPO prices. Companies offer these shares at discounts to attract early investors. This means you can buy shares at a lower rate before they become more expensive in the secondary market.

What is a Good Way to Invest in Pre-IPO Stocks?

Here are some points to keep in mind to investing optimally in pre-IPO stocks –

• Consult a company that specialises in raising capital and pre-IPO investments. They can offer you guidance and advice on how to invest in pre-IPO companies effectively.
• Keep track of the latest news to learn which startups are doing well. This will help you identify promising pre-IPO investment opportunities.
• Speak with your local bankers to find out which businesses are looking for funding. They may have insights into upcoming pre-IPO opportunities.
• Work on building and expanding your business network. Networking can help you connect with people who have information about pre-IPO investments and provide valuable opportunities.