Is Pre-IPO Investing Worth the Risk? Here’s What You Need to Know

With the markets operating at lifetime highs, companies are lining up their IPOs to get the highest possible valuations for their shares. New IPOs hitting the markets are often over-subscribed multiple times these days and the pricing is seen sky-rocketing to incredible levels. In times like these where demand is high and the shares that can be subscribed are low, many investors never receive any shares despite repeated applications.

There is a way to get around this conundrum but it is fraught with many risks. Investors can if they see a great opportunity, choose to buy shares from the unlisted market or invest in companies in the pre-IPO stage.

The pre-IPO market till very recently saw limited participation from HNIs. However, the situation is now evolving and increased participation from retail investors is becoming the new normal.

Pre-IPO investing is taking off in India, and how. According to data unveiled by a prominent pre-IPO investing firm, the gross transaction value of the top 10 share traders operating in the unlisted share trading zone has gone up by Rs 17 crore in FY19. In the current financial year, the total transaction value has leapt to over Rs 40 crore and is rising. The pre-IPO market helps companies that are slated to go in for an IPO in the medium to long term garner more investors and tap into the abundant liquidity on offer in the unlisted market in India.

How does investing in the pre-IPO market work?

A buyer interested in purchasing pre-IPO stock can contact an unlisted share dealer who will provide the current price at which the shares can be bought. He will also state the brokerage that will be charged by him. If the price and brokerage are agreed upon, then the buyer remits the consideration amount to the seller, and subsequently, shares are transferred from the seller to the buyer by T+0 evening or T+1 morning. The deal is complete when unlisted shares reflect ISIN numbers in the demat account of the purchaser.

Currently, no statutory or legal limit has been set on the number or worth of shares that can be purchased or sold. As the unlisted shares market expands in India, the earlier set minimum limit of transacting above a few lakhs has come down to a few thousand now. Contrasted with the earlier dynamic when only a few bigwigs, industry captains or HNIs would make their presence felt, there are many more retail buyers, ESOP sellers and brokers in this segment now.

A key reason why investors get pulled into buying pre-IPO shares is the unique chance of snagging the next big opportunity in the market before it actually hits the market. Sure, many investors could grab a piece of the action when the IPO goes live and the shares are listed on the market. However, an intelligent yet cautious investor can earn exponentially higher returns if he can smell an opportunity before everyone else wakes up to it.

Risks that investors ought to know

The pre-IPO investing domain is no different from other investment avenues where risk and reward walk hand-in-hand. Agog investors excited to invest their savings in the pre-IPO market hoping to make big bucks real quick must understand that there are a lot of risks and chances of a bet turning dud are quite considerable.

First and foremost, the company that has declared its plans to go live with an IPO might not come true on its commitment or its plan of unveiling an IPO could derail. In the case of a delay, you run the risk of locking your capital for an unpredictable period without any return. It is always better to enter into a dialogue with the company management in terms of their IPO roadmap.

Secondly, the pre-IPO market, unlike the secondary market, does not have liquidity. Once you are invested, you will have to stay invested till the shares are listed on the bourses. Only then can your capital be unlocked and you may or may not earn a return on the capital invested depending upon the reception of the IPO. The low liquidity is because the pre-IPO market operates from over the counter and not through the mechanism of an exchange market.

Additionally, the investor will have to ensure that he is not purchasing the shares at an inflated valuation. The apt valuation of the unlisted shares can be arrived at by comparing them with the valuation of other peers that are listed. Any investor who foregoes an exhaustive valuation protocol risks paying a premium far higher than the one that the unlisted shares deserve.

A new investor will also have to be careful and ascertain that he is not being duped by brokers. Investors should ideally pay a maximum of 1-2% on the cost price as brokerage. It always helps to cross-check with other brokers on the standard brokerage rate prevailing in the market.

Also, do remember that buying the pre-IPO shares means that your stake will be locked in for one year. If the company does list its shares in the secondary market in that period, investors will not be able to sell their shares during that time window and might miss out on the gains, if any. Alternatively, if there is a major disruption in the fundamentals of the business, then the investor will not be able to sell his stake and exit the company.

Lastly, the possibility of being defrauded by the broker also hangs like a Damocles’ sword over the head of the investor. That is why it is all the more necessary to deal with a trusted and reputed broker in this market segment.