Ultimate

Guide to Pre-IPO investing

Democratisation of the private equity market is going to disrupt the industry

Overview

Pre-IPO investments are also known as private equity. Investors like financial institutions, hedge or venture funds are buying large shares of private companies before they go public. Due to the size of the investment and risk involved, shares are sold with a great discount which makes this type of investment extremely profitable. Capital obtained by private companies usually utilised to fund new technology development, workforce expansion or new markets entry.

Private equity market has shown some unbelievable profits for the last decades. However, this market is still relatively closed for retail investors. Due to regulation, non-accredited investors are not allowed to participate in funding rounds. Moreover, private companies are more willing to sell big shares at once to only a few investors, so even if you possess accreditation you better sit on a pile of money. Therefore, the PE market is actually private and not so accessible for investors with low capital.

Recently, fintech companies started to offer marketplaces and brokerage services where investors could participate in funding rounds of such companies as Klarna, Stripe and other big shots of the PE market. Other platforms started to offer a secondary market for shares in private companies (obtained from employees or investment funds). However, the entry ticket through such platforms is still varying from 10 to 50 thousand $ — out of reach.

Thanks to blockchain technology it is now possible to fraction a share in a private company. By using the Ethereum blockchain protocol and proper legal structures there were already issued pre-IPO units for large-cap private companies like SpaceX and Airbnb. Such technology lowers entry tickets into the Private Equity market down to 100 euros for all individuals and investors. So let’s take a closer look at the pre-IPO market

Pre-IPO

Pre-IPO is a private sale of a large share of a company before it goes public. Basically, pre-IPO is another funding round of a company big enough to conduct an IPO. For example, SpaceX never announced an upcoming IPO and the recent pre-IPO process was actually another round of funding. Therefore, any private firm could conduct pre-IPOs, however, they might never go public and continue to attract investments as a private company.

For companies, it is a great way to gain capital for further development avoiding various costs and challenges related to IPO. First of all, to go public a company has to spend a few years for preparations with financial and legal advisors. To conduct a successful public offering, a company has to create an IPO team, develop the emission prospect, plan and execute advertising campaigns (also known as roadshow) and constantly carry out third-party audits.

This expensive and time-consuming process also holds some fundamental risks. What if there is not enough interest from the public? What if the financial regulator will find some violation, which will cause a delay? What if the company’s quarterly results will not meet market expectations? The requirements to become a publicly traded company are very high. After going public any company is obliged to report financial and corporate results to a high number of stakeholders including financial regulators. As a result, private equity firms prefer to stay private as long as possible and focus on company development.

According to research by Jay Ritter, an IPO expert at the University of Florida, the median age for tech companies going public in 2000 was 4,5 years compared with 12 years in 2018. This trend has transformed the private equity market and provided some unbelievable opportunities for investors.

Source: Capital IQ, Pitchbook

Pre-IPO opportunities

For investors PE market is a great alternative investment as it includes several advantages over public equity:

Long-term growth potential

Over an extended period of time, private companies may show higher profitabilities, especially during the stage of active growth. Such periods are followed by a rather high number of funding rounds during a short period, or simply by the inflow of extremely large capital at once.

To illustrate the difference let’s take the example of financial companies like Visa and Stripe. In 2010, the year when Stripe received its first funding the company was evaluated at 22 million $, Visa stock was trading on public markets at 21$ per share. Ten years later Visa has appreciated by roughly 850%, which makes it a great investment with more than 80% of annual return. At the same time, the financial market was transforming and early investors of Stripe have seen the dramatic rise of a private company with today’s valuation equal to $95 billion. What makes the total return equal to 430,000%.

Of course, early investors take the biggest risk, so let’s compare the same indicator but for the last 5 years when Stripe was a 5 billion fintech start-up with a sustainable business model. From 2015 Visa has grown by 185% ( 36% annual return) while Stripe investment has appreciated by 1800% (360% of annual return).

Diversification

Factors that drive returns in the public equity market, such as volatility, investor sentiment, quarterly reporting and seasonality have little or no effect on the private market. Private equity investments are less manipulative, as the valuation is based on assessing the business and the company’s prospects, which makes it a great tool for diversification.

Let’s take a recent example of a pandemic crisis in financial markets and compare two companies from the aerospace industry. Lockheed Martin has depreciated by more than 30% during a panic sell-off in March 2020, while SpaceX valuation was unaffected by the crisis. Moreover, after the Series L funding round in June 2019 all investors have earned at least 5,8% of the return.

According to the Bain & Co. report, over the past 30 years, U.S. buyouts (which are considered the largest subset of private equity investments) have generated an average net return of 13.1%, compared with the 8.1% return of the public markets.

Initial Public Offering

Nevertheless, an IPO has its advantages over the private equity market. For companies, the primary goal of an initial offering is to raise capital for further growth. Some companies invest money into research and development, others spend it on expansion or even to pay back their loan. Despite the reasons why a company goes public, there are some beneficial effects that IPO brings with it.

For companies

• IPO provides the company with a high amount of accessible capital
• A publicly-traded company implied to be transparent for the stakeholders. Transparency attracts more prestigious clients, partners and talent
• For companies that were staying private for too long, IPO is a great way to create liquidity for their stock. Venture investors would use it as an exit strategy and shareholders would have more options to manage capital.

For investors

To participate in a ‘hot’ IPO, you should be a long-standing, established and high-net-worth customer at some famous brokerage like Goldman Sachs. Other IPOs with lower capitalization and less potential are more accessible to investors with different capital levels. Such investments become highly risky due to several factors:

• Requires deep analyses of the market, competitors and macro environment
• The only informative document about a company is a prospectus (written by the company)
• If you have easy access to the IPO, there is probably a reason behind a high number of available shares
• Even after successful participation, there is a risk to become a victim of manipulation. At the very beginning of a trading session, some shareholders would want to execute an exit strategy and the price of a stock will dump
• A company might not meet market expectations when it reveals its financial and corporate performance. A similar case happened to Snapchat IPO when the number of active users wasn’t enough for public investors and the stock depreciated dramatically. Only 3 and a half years later Snapchat stock has overcome its initial price.

Despite all negative aspects, IPO investment strategy still could be extremely profitable. A number of the hottest IPOs in 2020 have gained some handsome returns:

• Airbnb +113%
• Ozon +52%
• C3.AI +228%
• Affirm +101%
• Poshmark +66%

But you can also find some quite unprofitable cases even with well-known companies like Deliveroo IPO on the London exchange. On the first day of trading, the stock has bottomed by almost 30%, forcing major investors to buy a large block of shares to prevent further decrease.

At the same time, the average return of the 2020 IPO portfolio was 190%, and that is not the best performance you could have earned on this market. The IPO market is a long-standing and well-known type of investment, which provides its participants with a great return correlated with the amount of risk.

Pre-IPO investing risks

The private equity market also has a lot of pitfalls and risks attached. Venture funds invest in hundreds and thousands of private companies to increase a chance to become a shareholder of a future Facebook or Amazon. Even though it is still possible to catch a lucky ticket, there are some fundamental risks:

Capital loss

The private company could go bankrupt due to various reasons. A partial or full capital loss is typically subject to the lack of professional management. For example, a company could follow an inefficient expenditure policy and invested capital might be used for the wrong purposes.

Lack of liquidity

In the private equity market, it is quite hard to quickly sell your share in a company. Liquidity increases on several occasions like another funding round or at the cash-out event (IPO). Other ways to sell the asset are more time-consuming or less financially beneficial. But with the help of new fintech platforms, the liquidity for private equity assets is constantly increasing.

Scarcity of dividends

Compared to the public market, private companies rarely pay dividends as both investors and company management prefer to reinvest all of the income. That usually depends on how far the company can expand. For every new region entry, for every new side project development a company needs financial capital, therefore expenditures will always surpass revenues.

Lock-up period

Investing in late-stage pre-IPO also brings the risk of the lock-up period. This is a period when investors are not allowed to redeem or sell the shares in a company after IPO. The lock-up is set by an issuing company, for example, Airbnb has set a period for 121 days from IPO. In this case, the risk of lock-up has paid off and the investment has more than doubled since the initial offering.

When the lock-up period is over, the fund will sell underlying shares and distribute proceeds among unitholders.

Pre-IPO company valuation

The valuation process is vital for investor returns, corporate governance, the ability to hire and retain talent, and the ability to raise future funds. The evaluation process combines several steps:

Market analysis

Most start-ups operate in innovative and growing industries, however, there are many submarkets with very different performances. Investors aiming for the short term should investigate fintech or edtech markets. While long-term investors may be interested in biotech or artificial intelligence start-ups.

Comparable public companies

The easiest way to understand the level of a company is to look at similar companies and their valuations. The most common metrics for comparison are the size of a company, operating markets, number of active users/clients, partners etc.

Financial and operating performance

Private companies keep this information out of the public eye and only potential investors like venture funds have access to it. Thus, it could be useful to see the list of investors and check on their legitimacy. Also, there are some famous names in venture capital like Sequoia Capital or Y Combinator. So if you see them on a list of investors, be sure they have checked the financial and operation performances.

To understand the mechanism of valuation, let’s take a well-known company Revolut with capitalisation equal to $5.5 billion. Revolut has conducted 4 rounds of funding with a total investment worth $900 million. By simple calculation, we can conclude that venture funds have purchased around 16% of a company remaining 84% to the founders.

Pre-IPO process

As it was described earlier the pre-IPO process is a private sale of shares before the company goes public. However, we have gone further and implemented blockchain technology and developed a legal structure to make the private equity market more affordable.

To purchase a share in a private company, we use pooled investment vehicles managed by a general partner, in our case, it is a parent company Rasion Asset Management, regulated by SEC US. To obtain shares in a company we create a separate investment fund with a singular purpose of holding the only company in its portfolio.

Afterwards, to create small fractions of a fund, partnering with Ambisafe we use Celo Foundation blockchain protocol (ERC-20) and issue units tied to the investment fund. Unit’s smart contract guarantees that 1 unit is equal to 1 share and secures the right of your ownership. The process is highly transparent due to blockchain technology. You can double-check your ownership on etherscan.io and in our annual reports.

The investor has the right to own the shares of the company and the right to receive dividends if it's paid by the company. By purchasing units of the fund, the Raison user is enrolled in the register of its shareholders, which is maintained on the blockchain.

The fund itself is in the register of shareholders of a private company — for example, SpaceX. Thus, the holder of funds units becomes the holder of the company’s shares on its balance sheet. As unitholders are direct shareholders in the fund, they do not get voting or information rights from the private company

Our successful experience with SpaceX and AirBnb pre-IPO units was a revolution in the private equity market. In the upcoming year, the Rasion marketplace is targeting to add 30 more private companies.

Pre-IPO how to buy

1. First of all, to have access to private equity investments you should register at Rasion in our app or on a desktop.
2. As we operate under European and US regulations we are obliged to proceed with the KYC process for every investor. The process doesn’t require a lot of time and is highly automated, the only thing you should have is a document like a bank statement, utility bill or certificate of residency and a nice selfie.
3. The next step is to top up your account at Raison. It could be easily done via credit card or if you are an EU citizen it is cheaper to make a SEPA bank transfer.
4. When the deposit reaches your account you choose a company to invest in and purchase digital units.
5. Also, don’t forget to try our referral program which will reward you with 5 EUR for each invited friend + 50% from their transaction fees regularly.