LESSON 5 · 4 min read
Risks of Investing in Pre-IPO
In addition to the risks associated with investing in a particular company, there are general risks of investing in the private market.
Listing Time Uncertainty
Neither Dizraptor nor our counterparties and stock sellers can guarantee that the company will go public after a certain period of time.
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.
We estimate a variety of indicators, but the exit also depends on factors that cannot be foreseen.
Asymmetry of Information
The seller of stocks (employees and early investors) knows more information than a new buyer. An investor can’t always get an accurate assessment of a company's financials.
Private companies are not obliged to disclose their reports and financials, the way public 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.
Low Liquidity
There is a chance that early exit from an investment will take more than a month. Early exit at investor's initiative is possible only if he or the organizer has bidders for the purchase of his share in the SPV.
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. Private market is not so liquid though in recent years the number of participants and the size of transactions have been growing.
Liquidity (transaction speed) on a secondary market increases when it comes to selling or buying high-profile stocks. The investment philosophy behind Dizraptor implies investing in fast growing private companies with potentially disruptive technologies. These may be small companies, hardly known to general public, which makes finding a seller/buyer more difficult.
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.
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 deal's price.
According to the rules of a secondary market, in case of a direct transaction the company must be informed about the deal. As part of the ROFR procedure, the company approves the transaction. However, in rare cases, it can exercise its right and buy the shares that the SPV is targeting to buy.
Typical ROFR process takes 30 days: if during this time a company doesn’t exercise its right, the SPV will receive the right to purchase these stocks. But if the company buys its stocks, the money returns to investors or they are offered alternative terms for purchase.
Bankruptcy
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.
Unfavorable Terms of M&A Deal
In the event of acquisition of a business, investors of different rounds will receive different returns on their invested capital.
A company may be acquired by a larger company (merger or acquisition, M&A). In this event, 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.
Investment in a Special Purpose Vehicle (SPV)
An investment in an SPV (or fund) and its strategy involves significant risks, including those associated with investments in SPV's targeted industry and market. An investment in an SPV is speculative and involves a high degree of risk – an investor could lose all or a substantial amount of investment.
SPV's performance may be volatile and is suitable only for persons who can afford fluctuations in the value of their capital. SPV has limited liquidity and there are severe restrictions on an investor's ability to withdraw and transfer interests. It is suitable only for persons who have a limited need for liquidity and who meet the suitability standards specified in applicable memorandums of SPVs.
Read more about investment security in the Q&A section.