Red Flags to Avoid When Investing in Pre-IPOs

Red Flags to Avoid When Investing in Pre-IPOs

Investing in Pre IPOs, or private companies before they go public can be a winning strategy for retail investors. The process of an initial public offering (IPO) is onerous, although it opens up the company to a far more comprehensive range of suitors—retail investors. As such, growing private enterprises are able to realize their true value by raising capital on the public market.

Investments in private companies with a plan to go public are called?‘pre-IPOs,’?as they’re an opportunity to take a stake in an enterprise before the public market can. The potential benefits of doing so are numerous, including the upside exposure to capital gain, diversification from traditionally listed assets, and the ability to access a range of additional investment opportunities.

Investing in many but not all pre-IPOs has delivered extraordinary returns to those who have picked the right company at the right time.?One of the most recent examples is Palantir—on September 30,?2020, it went public at an IPO price of $7.50. Their stock closed at $10 on their first day of trading. Six months later in February, shares were trading north of $25. But, in the pre-IPO market, shares were trading in the?$4.50 to $6.50?.

Palantir has performed spectacularly since then as it exhibited almost all the hallmarks of a successful pre-IPO opportunity. Not every pre-IPO investment stacks up the same; many carry significant risks that you need to look out for. Here are some major red flags you need to be aware of before diving into any pre-IPO investment.

Pre IPOs are Unregistered Securities and a lack of liquidity

The main difference between a pre-IPO investment and an IPO is the ability to trade shares freely on the public market. Naturally, pre-IPO shares (via private placements) are often unregistered and not given the same legal protections as public stock. If, for whatever reason, you change your mind about your investment, need to sell your holding, or are misled by management, you will face a challenging outcome.

There is very little liquidity for pre-IPO shares. You can’t sell your holding to other retail investors on the public market, and it becomes complicated to offload your shares to other private investors if the company’s fortunes go bad. If you are able to sell at all. Ensuring your pre-IPO opportunity is close to its public listing date is one way to avoid, or at least limit, the risk of holding a stale investment for long.

The company does not have a clear plan to go public

As with any investment, there is no guarantee of any return at all. Pre-IPOs are no different. The investment thesis lies in the expectation that the private company successfully completes an IPO. In some instances, this never eventuates, leaving pre-IPO investors holding the bag, wondering what went wrong.

There are many reasons why this may happen. Numerous hurdles present themselves when it comes to an IPO, such as registration from the SEC, approval from the exchange, and meeting a long list of financial documentation and criteria. The process may be delayed by regulatory oversight, such as what occurred with?Ant Group?IPO late last year.

Without the public liquidity event of an IPO, the upside for any pre-IPO investment is heavily limited. Risks will always remain, although you can do your due diligence to avoid a disaster. Consult the company’s plan to go public: Do they have one? How detailed is it? What needs to happen before it can go ahead? What’s the timeline? Answering these questions now may save a massive headache later.

An inexperienced management team

One of the best indicators of a successful IPO is the team behind the company. Executive management, as well as the?necessary personnel?to complete the IPO process, are critical to the outcome of your investment. Take a closer look at the executive team, including their background and experience. If they have little experience running a company and no history of growing a company or completing the IPO process, it?may?be a red flag that the team is not up to the job.

Furthermore, every IPO needs a team in place to go public. This includes the formalities of an appointed Board of Directors, CEO, legal teams, accountants, and advisors. If the prospective pre-IPO company does have these resources in place, the likelihood of a near-term IPO is extremely low. Avoiding companies that lack trustworthy and experienced management teams may save you from a disaster.

Massive valuations not backed up by reality

Pre-IPOs can be great deals, and they can also be massive flops. A business is worth what the market is prepared to pay, usually based on projected sales and profitability. Valuing businesses is a complex process, although, at the headline level, the valuation should at least make sense.

No matter how good an idea a private company has, it will struggle to gain investor support in the future if it cannot detail an effective business model that generates a profit after sufficiently scaling revenue. According to?Goldman Sachs, profitability is increasingly in focus, “IPOs with annualized sales growth above 40% from year one to year three and positive net income in year 2 have the highest likelihood of outperformance.” The closer a company is to turn a profit, the more likely it is to succeed.

Accessing pre-IPOs is best done with the help of knowledgeable providers that filter out opportunities presenting multiple red flags. Investing in quality?pre-IPOs as a retail investor?is also more accessible than ever before.?HUDSONPOINT Capital provides retail investors with the platform they need to access a wide range of alternative investment opportunities, including pre-IPO’s.?By pooling investor’s funds, HUDSONPOINT can access unique investment solutions with risk-adjusted return profiles designed to meet your financial goals as a retail investor.

If you’re interested in adding pre-IPOs to your portfolio, please?schedule a call?to learn more about the?pre-IPO?shares we have available right now.