All You Need to Know About Pre-IPO Shares: Risks, Rewards, and Strategies

Ever purchased low-price early bird passes to an event only to see them sell for much higher as the event turns out to be exceptional? The satisfaction of such a find is truly unparalleled.

Something similar is experienced by investors when they get early passes to a company through investing in pre-IPO opportunities. Investors can participate in Pre-IPOs and have an opportunity to invest in concepts and ideas that may turn into the next big thing in the industry or that particular sector. These shares are bought in big lots and quantities and offered to institutional investors, high-net-worth individuals (HNIs), or investors via private placements.

The number of pre-IPO placements has risen after two years of subdued activity, reflecting a significant resurgence and growing preference for this method of raising capital. Funds raised in FY24 amounted to ₹1,309 Cr, which was three times the amount collected through this route in FY23 and the highest number since FY17. 

Understanding PRE- IPO

Companies usually raise capital via a pre-IPO route before it goes public.  But why not wait for the IPO to raise money? 

1. Companies often raise funds here to expand and strengthen their operations before going public with an IPO. 
2. The prices set for a pre-IPO are defined by the current market demand and supply of shares.
3. The announcement of a pre-IPO can help attract prominent investors in the industry, which facilitates small and mid-size companies to enhance their credibility by associating with well-known investors.

Why pre-IPO investing is gaining traction?

With a growing number of unicorns emerging in the nation, investors are largely attracted to investing in pre-IPOs. Let’s look at some major advantages of investing in pre-IPO – 

1. Buy at Discount:  Recently Swiggy, an Indian online food ordering and delivery platform which is preparing for its IPO, offered HNWIs shares at a 20% discount to its current valuation.  Similarly, companies typically offer attractive discounts during pre-IPO fundraising to secure the necessary capital. Investors capitalize on pre-IPO opportunities by purchasing shares in early, high-risk stage companies at low prices and selling them at high prices once the company goes public.
   
   Nazara Technologies, a mobile gaming company, issued its IPO at ₹1,101 in March 2021. At the beginning of 2020, when Nazara was still an unlisted stock, it was available for around ₹225, giving pre-IPO investors a whopping 389% absolute return. Today, despite the initial listing price, the stock is trading between ₹940 and ₹950—significantly below its IPO price, leading to substantial losses for many investors. However, pre-IPO investors who acquired shares at the discounted rate in 2020 still generate gains from the stock’s performance.

The table below demonstrates how investors generated returns by investing in companies in their pre-IPO fundraising phase. 

2. Buy quality in quantity – Investors can buy unlisted stocks of quality companies through pre-IPOs. These are no longer limited to only private equity, hedge funds, or big institutions. Often investors can negotiate a cheaper price from brokers as they buy these unlisted, high-risk risk and less liquid securities in large quantities.
3. Invest in Growing Companies – Pre-IPOs give an opportunity to bet on a company at its nascent stage and achieve extraordinary returns. Investors can evaluate the quality of a pre-IPO by observing the involvement of reputable and big Institutional Investors and family offices and judging the company’s potential for success.

Example – Sachin Tendulkar invested early in startups such as FirstCry, Spinny, Musafir, and many more. The cricket icon’s strategic investments have proven highly profitable when his stake in FirstCry appreciated to ₹13.82 crore post-listing, a significant rise from his initial investment of ₹9.99 crore.

Potential risks and considerations in pre-IPO investments

1. Risk of not going public: One of the inherent risks of investing in pre-IPO is the uncertainty of the company going for an IPO. This creates issues for investors trying to liquidate their investments. Several factors could contribute to a company deciding against an IPO, including unfavorable market conditions, stringent government regulations, or the company’s financial difficulties.
   
2. Lack of transparency: Unlisted companies like their listed counterparts are not obliged by SEBI to disclose extensive information as regulations are less stringent, decreasing the market efficiency of pre-IPO shares.
   
3. Challenges in valuation: Determining the fair value of pre-IPO stocks can be complex due to the absence of publicly available financial data. This results in undervaluing or overvaluing a stock. Without proper financial statements, conducting thorough due diligence becomes harder, increasing the risk of poor investment decisions

Strategies

There are two ways by which an Investor can generate returns from pre-IPO

• Exit at listing price: Investors can sell their pre-IPO shares after a specified lock-in period, which varies by the investor category they fit in, in case they believe the current price reflects the company’s true valuation and they should make an exit. Typically, the issue price is higher than the pre-IPO price, allowing investors to realize a profit.
  
• Hold for Potential Appreciation:  This strategy is often employed by investors with strong confidence in the company’s future growth and management.

Conclusion

Pre-IPO gives investors a unique glimpse into a company when it is at its nascent stage and needs the necessary funds to expand its business. This opportunity can significantly increase investors’ chances of generating high returns and standing out.

An investor should be careful while investing in this asset class and strategically make investments in companies offering pre-IPO.