Four ways to buy pre-IPO stocks

Venture investors used to be the only ones who could invest and make money on startups at the pre-IPO stage. But such investments gradually became available to a wider range of investors. Denis Ivanov, CIO of Digital Horizon, an international venture investment company, shares his ideas on how private investors can invest in stocks like Klarna, Stripe, Revolut, and other companies that are about to go public.

What are pre-IPO companies?

Pre-IPO companies are large used-to-be startups that escaped the “valley of death”, found their product market fit, built an effective business model and reached scale. These are mature tech businesses that plan to go public within the next 12–18 months. Take, for example, fintech startup Klarna, food delivery service Market Kurly, fund management software Carta, and retail analytics platform Trax Retail. These companies have recently raised an impressive amount of capital in investment rounds that involved private investors. Now, their shares are available on the secondary market.

Investments at the pre-IPO stage can potentially bring high returns. For example, the online food delivery service DoorDash did an IPO in December 2020 at a valuation of $32 billion. Six months before that, the company’s shares could be bought in a private round at a valuation of $16 billion. Following expiry of the lock-up post IPO (6 months), the company was valued at $48 billion, and now it is worth $72 billion.

Lead investors at the pre-IPO stage are large venture funds that carry out a detailed financial analysis of the company, conduct heavy due diligence, etc. In these private rounds these investors often have more information and time for assessment than investors have during the IPO. Therefore, investments in pre-IPO rounds and at the time of the IPO actually have a similar level of risk. But in case of pre-IPO investments, the returns may be higher.

Shares of the future “unicorns” can be bought during official funding rounds — when institutional investors come into play — and in the secondary market, from earlier investors. The first scenario is less risky. In the second scenario, it’s important to pay attention to the valuation (also versus last funding round) and choose the intermediary carefully to minimize risks. When an investor buys shares on the secondary market, there is often lack of visibility on specific rights attached to those shares, as well as true market value of business — as a result such investment can be loss making.

While buying private shares in general becomes easier over time, doing it successfully and making profits is still difficult.

Private investors need to have a good network in the venture capital space to find the right seller, or invest several million dollars to become investor in one of the larger VCs.

The situation started to change last year: new ways have emerged to enter pre-IPO deals that make the process easier for private investors. Apart from classic VC funds, new structures are deal-by-deal funds and syndicates, marketplaces, and private brokers.

Classic venture funds

Funds that specialize in late-stage investments like Coatue, Silver Lake, and Tiger usually manage portfolios worth several billion dollars or more. They have great connections in the market, direct access to rounds, and large teams to analyze companies before investments.

The standard investment period in classic venture funds is 5–10 years. Typical investors of such funds are counterparties with long investment horizon and large tickets, e.g. pension funds or asset managers.

Pros: direct participation in investment rounds; diversified portfolio of 20–30 companies; good long-term yield (18.3% per annum on average) with minimal involvement from the investor.

Cons: requires substantial ticket size to access the fund — usually starting from several million dollars; long-term commitment; inability to influence which companies the fund will invest in.

Deal-by-deal funds / syndicates

A new format has been developing in the last two or three years — funds that are put together for certain deals. They allow investors to invest in each company separately without depositing money into the fund in advance. As soon as the post-IPO lock-up period ends, the fund either transfers shares to investors or sells them and distributes the profits.

Such entities often appear alongside large VCs. They are created by former partners at funds or founders of startups — people who can find access to good deals. The growth drivers of deal-by-deal funds are platforms with automated infrastructure for venture capital investments, as well as communities of industry professionals. AngelList is a striking example — their tech solution allows you to remotely create and manage funds (syndicates). It only took five years to grow the value of assets managed on the platform from $0 to $2.5 billion.

Pros: direct participation in investment rounds; small checks (starting from $1,000); short investment horizon (1.5–2 years); separate decisions for each deal; with the right fund — guaranteed involvement of its team and correct assessment of the target company.

Cons: good deals get closed quickly, so there is often little time to make investment decision — within a week at the most.

Marketplaces

Platforms like Forge are showcase websites that offer information about a wide variety of tech companies. For example, if you want to buy Stripe stock, you need to leave a request and wait for the platform to find a seller (if it does) — this is essentially a classifieds platform. Typically, there are not many stocks available for a quick trade.

Any information posted on marketplaces must be double-checked, including whether the shares are reasonably priced (since the seller sets the price). If an investor does not have access to the necessary data, they have to rely on assessments made in the last round, and this option is not always viable. For example, the shares of fintech company Marqeta cost $8–9 during the funding round in 2019. Then in spring 2021, they were selling at $35 by brokers, however, the IPO in June was priced at $27 per share, which means investors who bought overpriced secondaries lost money.

Pros: low entry threshold — starting from $20,000 for direct deals; if you want to invest through funds created by these platforms, it starts from $5,000-$10,000.

Cons: no information about the financial performance of companies; limited offers; non-transparent pricing (the seller dictates the price); high commissions — 5%+ from the transaction amount on average.

Asset managers and brokers

Asset managers and private banking departments within large banks have access to pre-IPO shares primarily through venture capital funds or directly from companies. They can either buy shares for themselves and repackage them (turn them into their own product for retail investors) or give their high-net-worth clients direct access to the funds that sell them and charge a commission.

If you need shares of a particular company, you can also contact private intermediaries, i.e. brokers. These private brokers usually have a minimum deal ticket of $100,000 and, of course, a solid fee, which is often impossible to benchmark. Company analysis is not included in such services.

When contacting brokers, carefully examine the terms of the deals. The class of shares in the deal is less important since all classes would be converted into ordinary shares after being listed on the stock exchange. However, instead of buying shares outright, brokers may offer derivatives or forward contracts, or indirect deal structures. Forwards are essentially the seller’s promise to transfer shares to the buyer at a predetermined price when the company is sold or goes public. The investor will own the shares in the future (e.g., two years) or never at all since these documents can be challenged, for one, by the company itself if they banned forward contracts (some companies prohibit not only transfer of shares, but also execution of any forwards). Also, brokers can sell shares via SPVs which could be owned by fraudulent managers. This can make getting access to your shares difficult.

Pros: low entry threshold; simple access.

Cons: the cost of shares is usually noticeably higher compared to the last round or even the secondary market; a small selection of deals — 1–2 per month; requires an account at a specific asset manager / bank; the structure of the deal (its reliability) depends on the quality of the counterparty.

What investors need to consider

When choosing your pre-IPO investment, also remember about the risk of listing possibly getting postponed or not happening at all (it’s good to invest with someone who has access to management of the target company). Before making an investment decision, consider all the pros and cons again: do you have enough reliable information about the company, are the terms of the contract clear, are you happy with the price, are you ready to make a long-term investment for 1.5 years or more? If the answer is “no” to any of these questions, it’s better to look for another option.