Investment risks in pre-IPO
United Traders producer and video director
Here are the general risks of investing in the majority of private companies.
A seller of stocks (employees and early investors) knows more information than a new buyer. An investor usually doesn’t know the supposed IPO date.
We select companies that demonstrate all the signs of going public within 1-3 years, however, these signs are indirect. News about hiring a new CFO or management’s public statements may point to company’s IPO preparations, but nobody knows the exact date. Moreover, company’s plans may change as a result of new market conditions.
Palantir’s CEO has repeatedly expressed the management’s intention to go public in the foreseeable future. The information appeared in the Financial Times in 2017 and Bloomberg and the WSJ in 2018. In mid-2020, Palantir again announced that it’s likely to go public soon, this time to CNN.
In 2018 United Traders offered its customers to invest in Palantir.
The price per share was $8.35. At the time of writing this piece, there weren’t any shares left.
Asymmetry of information
The seller of stocks (employees and early investors) knows more information than a new buyer. An investor can’t always give an accurate assessment of company’s financial indicators.
Private companies are not obliged to disclose their reports and financials, the way traded companies do. Revenue, customer base, growth rates — this information is known by management’s statements. A more accurate assessment can be made as a company progresses from early funding rounds to later ones, but it is still impossible to verify this data.
For instance, in November 2019 Lemonade CEO announced that the company had reached the $100 million annual recurring revenue (ARR) milestone. The market perceived it as an indicator of net revenue by which a company is usually examined in advance of its IPO. In June 2020, when the company disclosed its financials, its net revenue was actually $83 million. The new information pushed the price down from $47.5 to $23–26. But in the end investors profited in all rounds — Lemonade’s shares opened at $78.20.
An example of investment in pre-IPO stocks. The cursor points to the drop of the stocks shortly before IPO, but in this case it had grown after the start of trading.
If you are dealing with an over-the-counter market to buy/sell shares, you need to look for a buyer. Early exit from an investment may take time: a month or longer.
When you buy or sell public stocks, your application is executed instantly. An enormous number of sellers and buyers make the stock market liquid. But when you buy or sell private stocks, you are looking for a buyer or seller in every case. An over-the-counter market is not so liquid though in recent years the number of participants and size of transactions have been growing.
Liquidity (transaction speed) on an OTC market increases when it comes to selling or buying high-profile stocks like Airbnb, but the majority of companies selected on our platform are no so popular, so finding a seller/buyer proves more difficult. This process takes a month or longer.
Dilution of equity capital
As funding rounds occur and more equity is issued, existing shareholders experience a decrease in their ownership percentage.
This happens if the issue of new shares comes with their price growing disproportionately to the capitalization of a company. However, a dilutive effect isn’t always bad: new shares may be issued at a higher price, and in this event you own a smaller share of a larger company, and the total value of your investments grows.
A funding round in April 2018 for ThoughtSpot valued the company at $880 million (the share price was $9.69). In the following round the company issued 50 million new shares, the share price grew to $13.83 (43%), and its valuation — to $2 billion (by 127%).
We added ThoughtSpot to the platform in December 2019 when by indirect signs we concluded that the company may go public soon.
The share price on the OTC market was $13.83.
Failing to pass ROFR
ROFR, Right of First Refusal — during the approval stage, a company and its key shareholders have the right to buy stocks at the price of a deal.
We post investment ideas on United Traders platform when we have already found stocks and agreed on a purchase. However, according to the rules of an OTC market, we must inform the company about the deal. The ROFR process takes 60 days: if during this time a company doesn’t exercise its right, United Traders will receive the right to purchase these stocks.
We post some investment ideas (often with a higher entry threshold) before ROFR ends. In this way we can collect preliminary subscriptions and perform them faster when the procedure is over. But in this event an investor takes risks: if within 60 days a company buys its stocks, his or her application will get rejected.
Company’s stock may depreciate.
Early investors know that only a few companies will return their money — the rest of the startups will go bankrupt. At the early stages, the bankruptcy risk is higher, at the pre-IPO stage — lower, but risk is always present. Sometimes a company is left with assets an investor can claim, but he or she is likely to get nothing. On our part, we guarantee that if negative news emerges and there is a chance to sell stocks, we will absolutely do it for all investors.
Unfavorable terms of M&A deal
In the event of the acquisition of a failed business, investors of different rounds will receive different returns on their invested capital.
A company featured on United Traders as an investment idea may be acquired by a larger company (merger or acquisition, M&A). In this event the exit conditions depend on the terms of an M&A deal and the funding round an investor joined.
The terms of a deal — the price at which a company is acquired. An “advantageous” merger occurs when a company is purchased with a premium — an investor profits by taking advantage of a price difference. A “disadvantageous” merger describes an acquisition of a plunging business, in a situation close to bankruptcy.
The terms of a round depend on the stage at which an investor joined a deal. As a rule, at later rounds investors have more rights, that’s why we prefer to work with companies’ stocks at late stages.
How we assess risks
We analyze every company and mention the risk level on the investment idea page. The majority of investments in companies at the pre-IPO stage have a medium or high risk:
Medium risk 10%-30%. Medium-risk investment may shed 10-30% — this number falls within the normal range.
High risk >30%. We consider investment in a company to be high-risk if its technology isn’t yet approved or it comes with extra risks.