How to mitigate risk when investing in Pre-IPOs

When targeting the next unicorn for a pre-IPO deal, it’s absolutely vital to pay attention to underlying? investment risks.

Any investor understands that higher returns are often accompanied by bigger risks. The good news is, while no one can predict the future with exact precision, there are steps you can take to mitigate these risks.

How exactly should investors manage and mitigate the likelihood of a poor investment? Start by identifying common investment risks in the pre-IPO sector.?

This article will explore three common risks and how to mitigate them, including the lack of liquidity, asymmetric information, and fraudulent transactions.

Lack of Liquidity

Risk

The first risk facing unicorn investors is that private market pre-IPO shares have less liquidity compared to many other equity investments. Private sales transactions can take some time to complete, meaning that locking in at a certain price can be a challenge and funds are tied up.

This characteristic presents an inherent risk to investors considering their allocation strategy. Ensuring there is sufficient capital to target other deals within a certain time frame can be a challenge.

Mitigation

Investors can mitigate this liquidity risk by investing with a longer time horizon than traditional public securities.

Investors should generally be prepared to hold securities for several years at a time. One common time frame recommendation is to hold shares for two years prior to IPO and six months after IPO.

Investors should also have the mental fortitude to hold stocks throughout highs and lows of a startup’s valuation as long as the company’s underlying fundamentals remain strong.

Asymmetric Information

Risk

Asymmetric information is another investment risk that occurs when either the buyer or seller has more information on the past, present, or future performance of a company. This means that one party has the ability to make a more informed decision with an advantage over the other party.

Public securities are required to report information and statements that describe the structure and details of the company along with financial results. However, there are no such requirements for private, pre-IPO startup companies.

New investors within the pre-IPO market should be mindful that sellers of potential unicorn shares are likely have access to information about the company’s performance. The biggest risk is lack of information and data needed to accurately value a startup company.

Mitigation

While information between parties may not be perfectly balanced, experienced analysts can discern certain facts and data to make informed investment decisions.

For example, common research includes tracking attributes of the specific sector that the company operates in, following news on the company within the context of its competitors and industry, and building relationships to receive third party confirmation of key information.

Institutional investors have the resources to employ dedicated analysts to mitigate this investment risk. Consider a pre-IPO fund that has a proven track record of sifting through information and selecting successful unicorns. It’s what we do best at Venley Capital.

Fraudulent Transactions

Risk

Finally, investors should be aware of the risk of fraud. While unlikely, there have been prominent examples of fraudulent shares offered for high visibility, pre-IPO companies.

For instance, recent scams targeted unsuspecting investors by promoting fake shares of brands and companies such as SpaceX and Starlink.?

Even in deals where shares are legitimately being offered, there is a risk of fraud such as the stock issuer not properly disclosing information about the company such as outstanding debts and liens.

Instances of fraud can cause investors to lose their assets entirely or enter costly litigation battles.

Mitigation

Proper due diligence is the best method to combat the risk of fraudulent transactions. Investors should be familiar with the exact terms specified in the Shareholders Agreement for any particular deal.

Additionally, all pre-IPO deals should be conducted in collaboration with an experienced securities attorney that will review final transactions. A valuable attorney will help uncover any legal risks or ambiguities.

A final critical check is to verify that no liens or Uniform Commercial Code (UCC) filings exist for the company, especially if they were not disclosed during the deal negotiation.

The importance of risk management

These risks are not exhaustive of all possible investment threats for unicorns and private startups.

Following a risk management strategy is critical before taking on any investment. Knowing what challenges may arise and how to limit the likelihood or severity of risks will lead to higher returns as an investor.

At Venley Capital we’re upfront about the risks of investing in pre-IPO private companies, but we strongly believe they’re vastly outweighed by the potential benefits. We can assist you in navigating the process to make sure you’re investing in hyper growth startups in the safest way possible.