Pre-IPO Investing

An initial public offer (IPO) is a method of selling securities wherein the entire lot of securities is offered for sale to the general public. An IPO is often used by companies when they want to sell their securities to smaller investment organizations and even retail investors.

In the past few years, IPOs have seen a lot of speculative activity. It is not uncommon for retail investors to just buy shares in an IPO even though they have no intention of keeping these shares in the long run. This leads to a pump and dump effect on the IPO prices.

In order to mitigate this, investment bankers often help their clients undertake a pre-IPO placement. In this article, we will understand what a pre IPO placement is and how it affects the success of an IPO.

What is a Pre-IPO Placement?

Pre-IPO placements, as the name suggests, are private placements that happen just before an IPO is about to be launched. During these placements, investment bankers approach large institutional investors with the stock of their client. In order to induce them to buy the stock, pre-IPO placements happen at a price that is lower than that of the IPO. These transactions often have a lock-in period, and the buying investor is not allowed to sell their shares on the open market for a period of time after the IPO has taken place. In most cases, this lock-in period is for one year.

Advantages of Pre IPO Placement

Pre IPO placement methods are widely used by investors. This is because they offer many distinct advantages. Some of them have been listed below:

1. Price Stability: The main reason behind using pre-IPO placements is to ensure price stability for stocks once they have been listed. Many companies have witnessed high levels of volatility in their share prices soon after listing. This is because all the people who are allotted shares in an IPO try to sell them shortly after the IPO has been completed. This leads to an excess number of shares being sold, and the valuation of the company is artificially reduced. Pre-IPO investing ensures that a certain number of shares will be locked in and hence won't be available for sale. This helps control the supply of shares and hence stabilizes their prices.

2. Marketing Help: A pre-IPO investment with a well-reputed investment company provides a seal of approval to the company whose shares are being sold. The credibility of the company in front of the investing community increases considerably. In fact, they are able to sell the balance shares at a higher price. This makes up for the discount that the company had to give the institutional investor in a pre-IPO placement. In short, the pre-IPO placement makes the marketing of IPO shares much easier.

3. Exit Route For Investors: There are many companies, such as Uber, Airbnb, etc., in which venture capitalists and private equity firms have a significant stake. Sometimes, they want to sell out their stake. However, if they do so in the IPO, it would lead to more supply of shares and hence lower prices. The pre-IPO placement route provides an easy exit for investors. They are replaced by new investors who intend to hold shares for long durations.

Disadvantages of Pre IPO Placement

The above-mentioned advantages make pre-IPO placement a tempting option. However, there are several disadvantages of pre-IPO placements as well. They have been listed below:

1. Lock-In Extensions: It is important to note that the lock-in period related to pre-IPO placements starts after the shares have been listed publicly. Hence, if the process of IPO is delayed, and the shares are not listed for a longer time, the investors are forced to hold on to the shares for a longer period of time. Oftentimes, this creates situations wherein investors' capital ends up being stuck for long periods of time, reducing the effective rate of return.

2. Cancellation of Issues: Apart from being delayed, it is also possible that the issue might get cancelled! This means that the shares will not be listed in the public domain in the foreseeable future. This can be very dangerous for investors in pre-IPO placements since this would mean that now there is no clear exit route for the investing company. Modern pre-IPO contracts generally include a buy-back clause to counter this risk. Hence, if the IPO doesn't happen, the seller would buy back the shares at a pre-determined price. However, this, too, would mean that the investor will be exposed to counterparty risks. If the issuing company itself goes bankrupt, then the investor would not have any recourse.

3. Big Ticket Size: Lastly, pre IPO placement is only done for companies that have huge sums of money. The minimum ticket size for pre-IPO is often in eight-digit numbers! Hence, there are only a handful of organizations that can marshall the resources to take advantage of this arrangement. In effect, it helps make the rich richer!

The bottom line is that pre-IPO is a strategic tool that can be used effectively to manage the IPO process. However, the success of the pre-IPO strategy also depends upon the strength of the network of an investment banker. A weak investment banker cannot successfully pull off a pre-IPO placement.