Understanding Pre-IPO Investments

What "pre-IPO" actually means

An initial public offering (IPO) is the process by which a private company first offers its shares to the public and lists on an exchange such as the ASX. A pre-IPO round is a capital raising that takes place before that event, usually in the months or years leading up to a proposed listing.

Companies raise pre-IPO capital for a range of reasons: to fund growth, to strengthen the balance sheet ahead of listing, to bring in cornerstone or strategic investors, or to cover the considerable costs of preparing for an IPO. In Australia, many pre-IPO offers are made only to wholesale or sophisticated investors under the Corporations Act, because the disclosure requirements are lighter than those that apply to a public offer.

It is important to understand that a pre-IPO round is an investment in a private company. A proposed listing is an intention, not a certainty. Timetables change, market conditions shift and some companies ultimately decide not to list at all.

Why investors consider pre-IPO opportunities

The main reason investors look at pre-IPO opportunities is the potential to invest in a company at an earlier stage of its development. If the business grows and subsequently lists, early investors may benefit from any increase in value between the pre-IPO round and the listing.

Pre-IPO investing can also provide exposure to sectors and businesses that are not yet represented on public markets, which some investors view as a way of broadening a portfolio beyond listed shares, fixed income and property.

These potential benefits must be weighed against the risks. A higher potential return is generally associated with a higher level of risk, and early-stage investments can lose some or all of their value.

The key risks

Listing risk. The IPO may be delayed, restructured or cancelled. If a listing does not proceed, investors may hold shares in a private company for an extended period with no clear exit.

Liquidity risk. Private company shares are generally not easy to sell. There is no exchange on which to trade them, and transfers may be restricted by the company's constitution or a shareholders' agreement. Investors should assume their capital may be committed for an uncertain period.

Valuation risk. Private companies are valued differently from listed companies. There is no continuous market price, and the valuation of a pre-IPO round is often set by negotiation. The eventual IPO price may be higher or lower than the pre-IPO price.

Escrow. Where a company does list, pre-IPO shareholders may be required to hold their shares in escrow for a period after listing, meaning they cannot be sold during that time.

Dilution. Further capital raisings before or at the IPO can reduce an existing shareholder's percentage ownership.

Questions worth asking

Before participating in any pre-IPO opportunity, investors commonly consider questions such as:

• What does the company do, and how does it generate revenue?
• What stage is the business at, and what is the proposed use of funds?
• How has the valuation been determined, and how does it compare with similar businesses?
• What is the proposed listing timetable, and what happens if it does not proceed?
• Are there escrow arrangements or transfer restrictions?
• Who are the directors and management, and what is their track record?
• What eligibility requirements apply to the offer?

Keeping it in proportion

Because of their risk profile, pre-IPO investments are generally considered as one part of a broader portfolio rather than a core holding. Concentrating a large proportion of capital in a single private company exposes an investor to the outcome of one business and one listing event.

FPW presents pre-IPO information with the business case, the stage of the company and the key risks set out clearly. This article is general information only and does not take into account your objectives, financial situation or needs. Consider seeking independent professional advice before making any investment decision.