How To Create An Investment Fund

Here's How a Pre-IPO Investment Helps You Fund Startups

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It's no secret that investing in a company's initial public offering (IPO) is a great way to get in at the ground floor of its success on the stock market. But what if you could invest even sooner? Pre-IPO investing is a technique you can use to invest your money in a company before it officially becomes a publicly traded entity. Before you make the decision to engage in this type of investing, however, it's essential to understand the pros and cons of pre-IPO investing and learn what you need to do to get started.

New Opportunities for Accredited Investors

Pre-IPO investing has long been an opportunity reserved for accredited investors. And becoming an accredited investor is more complicated than it sounds. For years, in order to qualify, you had to have a net worth of $1 million or have earned an income of $200,000 (or a joint income with your spouse of at least $300,000) for two years with an expectation of earning the same amount in the year to come — in addition to meeting a number of other conditions.

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The U.S. Securities and Exchange Commission (SEC) instituted these rules based on the rationale that "investors with enough annual income or net worth are knowledgeable enough in their financial life and can make appropriate decisions to invest in unregistered securities." The rules composed a sort of protective measure to safeguard investors who might not be able to withstand a large financial loss should the startup they invested in ultimately fail.

However, the SEC amended the rules somewhat in mid-2020 to allow people who didn't meet the previous accreditation requirements to make pre-IPO investments. Net worth is not necessarily an appropriate or effective marker of how knowledgeable an investor is about making riskier pre-IPO investments. Thus, the SEC recognized that it was unfair to limit opportunities for individuals who have the extensive financial expertise required to navigate pre-IPO investing but don't necessarily have high net worth or income levels.

That said, while the requirements you need to meet to be allowed to make pre-IPO investments as a private investor have expanded, the rule changes still don't allow everyone to participate. The SEC's changes mean that — even if you don't meet the net worth or income minimums — you can qualify as an accredited investor and make pre-IPO investments as long as you have a Series 7, Series 65 or Series 82 license. You can also become accredited by meeting the $300,000 joint-income limit even if you don't have a spouse. Instead, if you cohabitate with someone, have a relationship "equivalent to that of a spouse" with them and meet the $300,000 income or $1 million net worth thresholds together, you may both qualify as accredited investors.

The Benefits of Pre-IPO Investments

So, why would you invest in a company before its shares are even available on the stock market? The primary reason is that, if the company succeeds, the returns on pre-IPO investments can be incredibly impressive.

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Because of the risks involved in this type of investment — one of the reasons the SEC requires accreditation — companies usually offer pre-IPO shares at discounted rates. If, for example, a company planned to open its IPO at $5 per share on the stock market, you might be able to buy shares for $1.50 apiece if you invest beforehand.

As soon as the company's IPO is made available to the public, your shares could suddenly be worth far more than what you paid for them. At that point, you can either sell them or hold if you anticipate that the company's stock is likely to grow over time. It's similar to buying stock wholesale before it goes to the market. You can often buy far more pre-IPO shares at a much lower price than you'd pay for the IPO.

The Drawbacks of Pre-IPO Investing

Despite the appealing benefits of getting in on the game early, there are also drawbacks to this style of investing as well, namely in the way of substantial risks. This is largely why, until recently, most people weren't permitted to engage in this type of investing unless they demonstrated substantial wealth.

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Pre-IPO investing often takes place anywhere from three months to two years before a company actually "floats" or launches its stock on the market. In some cases, the company might never make it to the IPO stage at all because it's still a startup that hasn't found its footing. There's a larger potential that its business strategy won't work out or that it won't be competitive enough on the market to succeed long term — and the traditional marker of its economic viability and health, its stock price, doesn't exist yet. That's why it's vital to only invest money you can afford to have tied up for quite some time.

Even if the IPO does eventually make it to the market, there's no guaranteed price it'll list at and no assurance about how the stock will ultimately perform. Pre-IPO investing also involves putting a great deal of faith in a company, simply because its stock has never appeared on the market. Consequently, there's no way to gauge how it's going to be received or how well it might do over time.

In general, pre-IPO investing is only something you should engage in if:

You have extra money that you can afford to either lose or have tied up for a long period of time.
You've thoroughly researched the company you're investing in or are already very familiar with it.
You completely understand both the potential pros and cons of making this type of investment.
You don't plan to invest more than 10% of your total net worth.

How to Get Started in Pre-IPO Investing

Getting started as a pre-IPO investor can take some time as you assess the pros and cons of making this type of investment. However, once you've decided to move forward and if you meet the financial qualifications, you can get accredited online in about 10 minutes.

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Once accredited, you'll discover that there are now a variety of websites like Sharepost and Equity Zen that can help you find potential investment opportunities right away. Additionally, there are some brokers, banks and lenders that specialize in pre-IPO placements, and they're worth looking into if you plan to invest a large amount of money.

If you don't meet the qualifications to become accredited, investing in startups is somewhat trickier. Your best bet is through developing business connections, as pre-IPO capital is often raised among acquaintances. Do some networking among friends and colleagues to see if anyone knows of any promising startups that are currently looking for investors. Websites like LinkedIn can also be very helpful in developing professional connections that might lead to opportunities. You might choose to invest in other ways, such as through crowdfunding or other platforms.

Startup Investments for Unaccredited Investors

There are also a few sites geared towards connecting unaccredited investors with startups. Please be sure to read the terms of each thoroughly and understand that most of the opportunities on these sites are intended for long-term investors. Remember that investing in a company in its earliest stages is risky and offers no guarantee of a return.

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Republic: Republic allows anyone over the age of 18 to invest in various startup companies via Crowd SAFE, with minimums as low as $10. If the company ultimately has a "trigger event" such as an acquisition or IPO, then investments are converted to equity.

StartEngine: StartEngine is a similar website that allows anyone over 18 to invest in a variety of startup companies. You can buy equity, debt or even revenue shares that could make you money if the company goes on to be successful.

Wefunder: Wefunder connects unaccredited investors with startup funding opportunities. You can invest via a loan, through an agreement that converts your investment to stock if the company goes public or by purchasing a stock-with-dividend option.