A pile of American dollars

Pre-IPO Stocks, Explained

During the craziness of the dotcom days in the 1990s, initial public offerings or IPOs (aka when private companies make their big debut on Wall Street) got a little wild. Back then, people could invest their money into just about any IPO and could be guaranteed returns (well, at first). Stockholders that had the foresight to invest in and out of these businesses made investing look easy. Unfortunately, many newly public companies experienced big first-day gains, but typically ended up disappointing their investors later on.

Shortly after, the tech bubble burst and the IPO market returned to normal, which means that investors couldn’t expect the double- and triple-digit gains they got in the early tech IPO days by just flipping stocks. These days, investors can grow their money by investing in IPOs, but the focus has shifted. Now, some investors can grow their money by investing in pre-IPO stocks.

What is pre-IPO stock or pre-IPO investing?

Even before a company goes public on the stock exchange, it typically sets aside large blocks of shares to institutions like private equity firms, hedge funds and individual (retail) investors to help raise capital. These shares, called pre-initial public offerings, or pre-IPOs, are a popular way for private companies to raise capital in advance of a public offering. Pre-IPOs differ from IPOs in that investors are still investing in a private company, not one that’s just become public.

Few individual investors take part in pre-IPO placements. They are generally restricted to 708 investors (aka sophisticated investors), as the IRS calls them. These are notable individuals with a lot of knowledge about the financial markets.

Pros and cons of pre-IPO stock

With an IPO, buyers can get in on the action early in a company’s timeline, but with pre-IPOs, investors get in much earlier, where shares sell at a discount. These shares are mostly discounted due to the risks associated with the investment, including a lack of liquidity and transparency since the company will still be private. The reduced price is meant to compensate for the uncertainty.

But the upside potential is very high. As an example, Alibaba held a pre-IPO and the shares sold below $60 per share, but after its IPO on the first day of trading, the stock closed at $90.

To keep things balanced, several laws were created to prevent investors from immediately cashing out on the first day in case the stocks of the companies they invested in soar once it opens on an exchange. To prevent this, stocks that are bought by investors are subject to a lock-up period so that buyers are unable to sell their shares for a certain number of days.

While the potential gains are massive, there are no guarantees that a company’s stock will do well. To top it off, investments can be held hostage until the IPO is finalized, which sometimes never happens. Additionally, even if a company’s stock has a great first day, the stock price could still drop below what investors initially paid for it later.

The bottom line

Pre-IPOs can be exciting. If you’re eligible to invest in some and you’re tempted to get in on the fun with some of your own money, make sure it fits into your larger investing strategy. Just be sure that you’ll be OK financially (and emotionally!) if the investment doesn’t pay off.

Leave a Reply

Your email address will not be published. Required fields are marked *