Importance of investing in pre-IPO companies

Last Updated: 17 Jan 2025

If you follow stock market updates daily, you may have heard about companies going public almost every week through Initial Public Offer. Investors, too, apply and hope for the allotment of good IPOs as they can provide quick and considerable profits in just a week. As the investment amount is also low in IPOs, it is a great way for retail investors to realise listing gains or hold the stock for the long term to earn higher profits.

However, along with this news, there are also instances of investors who invested in the company before the IPO making an immense amount of money. They are the ones who sometimes become millionaires after a successful IPO of a company.

Since retail investors always think to apply in a company’s IPO after careful analysis and believing that it has huge profit potential, why not invest in the company pre-IPO to multiply the gains by a huge margin?

That’s where pre-IPO investing comes in. However, to understand how you can invest in companies before an IPO, it is vital to understand a little about an Initial Public Offer.

What is an IPO?

An IPO, or Initial Public Offering, is when a company sells its shares to the general public for the first time. The shares, previously held by the company executives, are offered to the common people in exchange for money or capital, which the business may use for expansion purposes or to pay off debt. Once the IPO process is complete, the company is declared publicly listed, and its shares can be traded in the open market.

Once a company becomes publicly traded, a part of its ownership is sold to investors. Typically, a company initiates IPO for the following purposes:

• To infuse fresh equity capital.
• To facilitate the trading of its assets.
• To raise capital for various requirements.
• To monetise the investment of its private stakeholders.

What is pre-IPO investing?

Pre-IPO investing is defined as the process of buying the shares of a private or a public company before it goes public through an Initial Public Offer. Even before they go public, companies require huge amounts of funds to expand and create a customer base. If an investor invests in this funding, it is known as pre-IPO investing.

Previously, pre-IPO investing was deemed complex as it demanded high knowledge of the financial market and the current market structure. Hence, investing in pre-IPO companies was restricted to private equity companies, banks, venture capital firms etc. However, now it is open to all and, most importantly, retail investors.

How does pre-IPO investing work?

Companies do not launch an IPO before they have reached certain business goals. Before the IPO, they raise funds from investors who are looking to invest in pre-IPO companies to realise a higher return on their investment than buying the company’s stocks in the open market.

To understand how pre-IPO investing works, consider the following detailed example:

Suppose you invest in ABC company through pre-IPO investing and buy 100 shares offered at Rs 2,000 per share. By this transaction, ABC company will get Rs 2,00,000 in funding from you, which they can use for any business purpose. Now, when the company finally decides to go public, it may have increased in its valuation, with the value of one share rising to Rs 3,500

During the IPO, the company offers one share for Rs 3,500, where you can offer all of your 100 shares for selling to the public, or if you believe that the shares will open at a premium, you can hold the shares for the long term. Now, at the time of the IPO, the following two scenarios may arise:

Scenario 1: You sell your 100 shares at the time of IPO.

If you decide to offer your 100 shares to the public, you will receive Rs 3,500 per share as the public will buy the company shares at this set price. In the transaction, your total received amount will be Rs 3,50,000.

Total Profit: Rs 1,50,000 (Rs 3,50,000- Rs 2,00,000)

Scenario 2:

You hold your 100 shares for listing gains after the IPO. If you decide to hold your 100 shares as you believe the shares will open at a premium, you can sell them after the company completes its IPO. Suppose the shares open at a 30% premium and close at Rs 4,700. You can sell them at this rate at the time of the closing of the market.

Total Profit: Rs 2,70,000 (Rs 4,70,000- Rs 2,00,000)

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

How do I buy pre-IPO stock?

Investing in companies before an IPO is an extended and complex process that needs expert guidance on eligibility, legality, shareholder obligations, future scope etc. For an investor looking to invest in companies before IPO, you need to consider the following:

• Consult a financial advisor such as IIFL that specialises in pre-IPO investing and capital raising. The advisors can provide you with valuable insight into the working of pre-IPO investing and other know-how.
• Be on the lookout for new companies that want to raise funds and are in the initial stage of setting up and expanding their business.
• Consult the local banks or any other VC firm to let you know when a company wants to raise firms and if you can invest in the fundraising.
• Save and make an investment fund, preferably with a huge capital amount. The larger the fund, the higher the chance of you getting to invest your amount in pre-IPO companies.
• You can become an angel investor by increasing your network with the funding community and consulting the present angel investors on the pre-IPO investing process.

Every company, big or small, is expected to list on the stock exchanges sooner or later. With every funding round, the valuation of such companies increases, and the value per share rises too. Thus, if you invest in companies before IPO and they go on to grow and perform well, you can earn a hefty amount as profits at the time of their public listing. However, as the process is complex and needs extensive knowledge, it has its risks too. Numerous companies raise huge amounts of funds only to shut down after a few years. In such a case, there is no guarantee that you won’t lose your invested amount as privately held companies have no obligation to return your invested money if they close their business.

The best way to ensure your investments are protected is through consulting IIFL. The IIFL Asset Management Fund (IIFL AMC) has launched numerous alternative investment funds, each one of more than Rs 1,000 crores, to invest in pre-IPO companies. Having raised thousands of dollars from investors, IIFL has provided hefty returns for investors who want to invest in pre-IPO companies. If you are looking to invest in companies that are not public yet, you can contact IIFL for expert guidance.

Risk Factors of Pre IPO Investings

It is vital to understand the amount of risk in a pre-IPO share along with how does pre IPO work.

1)Loss Of Capital: Capital loss Startups and early-stage companies have an advanced propensity to fail. These are innately parlous investment options. Investing in a company that hasn’t been tried and tested can result in a complete capital loss.

2)Inaccurate Valuation: Estimating the accurate value is important in pre-IPO investing. However, it is a difficult task to do. The value is often relying on projections and assumptions that may cause under or over-valuation.

3)Liquidity Issues: Unlisted companies have a lesser chance of selling their shares. Selling off shares will not be easy until a company goes public. It may take several years or may not occur at all.

4)Declined Dividends: Dividends generate regular income that boosts an investment’s value. This is done by creating a regular income. Pre ipo investing may not be done if a company chooses to reinvest dividends for quicker growth.

5)Dilution: Profit chances are lessened if a company chooses to dilute its shares to issue extra shares in order to gain excess capital funds.

Advantages of Investing in Pre-IPO Companies

High-Profit Possibility: Non-listed companies can give advanced openings for substantial returns when they go public. Early investors can profit from buying the companies’ stocks at a lower valuation before they come intimately listed.

Access To New Companies: These companies regularly work on imaginative innovations and offer items and administrations that can disturb the market. You can end up being an early investor by giving seed capital and gaining a noteworthy return when they become open companies.

Discounted Rates: You can purchase the stocks at reduced rates, giving profit from the distinction between pre and post-IPO values. You can figure out higher benefits when the company goes open.

Diversification: You can diversify your portfolio by adding pre-IPO company shares. Generally, the performance of the non-listed companies isn’t concerning the broader market, which helps reduce the overall threat.

Early Investor Perks: Some companies offer perks to early investors. These could be discounted stock rates, access to unreleased offerings, and participation in shareholder events.

Disadvantages of Investing in Pre-IPO Companies

1. High Risk: Investing in an unknown company without an exchange or execution history includes high hazard. Without sufficient information, it is troublesome to foresee the company’s future. Numerous new companies come up short, and contributing to these early-stage companies can lead to critical losses.
2. Less Information: Individuals would not have information on how does pre IPO works or about a company when they do not have a stockbroker along with them. This makes it risky to venture into pre ipo investing.
3. Absence Of IPO Plan: There is no confirmation that the company will go public, particularly since propelling an IPO includes fulfilling criteria, which can take 2-3 years.
4. Liquidity Issues: These companies’ stocks aren’t traded like listed company stocks, which may mean locking in your fund for an extended period. It can be a debit to invest in non-listed companies.

Frequently Asked Questions

1. What are Growth-oriented companies in pre-IPO?

Growth-oriented companies in pre-IPO are those companies that are looking to raise funds for expansion. These companies do not focus primarily on making profits but want to expand to newer territories and increase their presence along with the customer base. Growth-oriented companies use the funding to grow their business, even if they incur losses.

2. Is pre-IPO legal in India?

Yes, pre-IPO is entirely legal in India. Numerous angel investors invest in pre-IPO companies and make hefty profits when the companies go public. If you get an opportunity to invest in pre-IPO companies, you can do it legally in India. However, it is always wise to consult a financial advisor to know all of your obligations before you invest in companies pre-IPO.

3. What is the meaning of pre-IPO?

Investing in pre-IPO companies means that you buy the shares of a company that is not yet publicly listed. Generally, retail investors apply to a company’s IPO to buy its shares. However, through pre-IPO, an investor can buy the shares even before the company is listed on the stock exchanges and sell them in the open market after the completion of the IPO.

4. Who sells shares in pre-IPO?

In a privately held company, the executives such as the CEO, CFO, CTO etc hold the shares of the company and offer their stake to the investors at the time of pre-IPO investing. With these transactions, the executives lower their stake in the company against the funding amount they raise by selling their held shares.

5. Do Pre-IPO investments make good long-term investments?

Pre-IPO investing can be of high risk or give a high reward. While they offer potential for substantial returns, they also come with significant risks, including lack of liquidity and market volatility. Due diligence and a long-term perspective are crucial.