Investing in Pre-IPO Shares Via Private Markets

Getting ahold of shares in private companies before they go public through an initial public offering hasn't always been easy. Historically, access to private-company shares was limited to a fairly restricted circle: company founders, employees with stock options, and institutional investors like venture capital or private equity funds.

That may be changing, thanks to the rise of specialized private marketplaces. These avenues are giving more eligible individual investors access to this otherwise rarefied asset class.

After all, what investor wouldn't want early access to companies that could one day be valued at hundreds of billions of dollars? That's not to say all private companies are destined for greatness, of course—most venture-backed startups fail. As with any alternative investment, the risks of owning private-company stock are significantly higher than those of your average publicly traded security, but sophisticated investors with the resources and ability to identify appropriate candidates may still wish to explore this asset class.

Here, we'll take a closer look at the potential benefits and risks of private shares and some options for trading them.

In short, private company stock is an equity, or ownership, stake in a privately held company like a startup. This differs from public company stock, which refers to publicly listed securities that anyone can buy or sell on secondary markets like the New York Stock Exchange.

You can think of a private stock's lifecycle like this: initially, a company's founders might own 100% of a new company. Then, to raise money to expand, the owners might sell shares to institutional investors such as venture capitalists, private equity funds, or other select—generally wealthy— investors via private placement. Private companies can also issue private stock to employees in the form of employee stock options, restricted stock awards (RSAs), or restricted stock units (RSUs).

The company's goal might be to one day sell additional shares to the public through an IPO, at which point private investors typically become free to cash out by selling their stakes. (Companies can also choose to list their shares directly, without creating new ones, or they may be acquired by another company, which can likewise give early investors an opportunity to sell.) Before that day comes, though, the company will keep tight control over how many shares are available and who can own them.

That's not to say private shares never trade hands prior to an IPO. Employees with private company stock might decide to sell shares so they can cash in some value or diversify their holdings. Institutional investors who participated in early fundraising rounds might also sell some shares. In such cases, a private company (and its major shareholders) may retain the right of first refusal, which gives it the contractual right to buy back any shares that shareholders (including employees) might want to sell before a public listing.

However, some private, pre-IPO shares can also become available for qualified outside investors to buy via a secondary market for private shares.

The primary market refers to where shares are created and placed with investors or employees. A secondary marketplace is any market where the shares trade afterward.

Secondary markets for private company shares work similarly to public markets in that they offer a venue where buyers and sellers can meet to trade. This can mean trades between individuals, or tender offers, in which a large buyer offers to buy a set number of shares at a specific price and time. However, unlike public markets, private company shares are generally less liquid, may be subject to transfer restrictions, and often involve longer transaction and settlement timelines. Matching a limited pool of qualified buyers and sellers, completing transfer documents, and ensuring regulatory compliance typically adds up to a 45-to-60-day process, though the timeline depends on the circumstances.

As the name implies, private secondary markets aren't available to all investors. To buy shares in a private secondary market, you generally must be an accredited investor. That means you must meet certain financial or professional requirements, such as income over $200,000 (or joint income of over $300,000 with a spouse or partner) in each of the prior two years, with a reasonable expectation of the same for the current year. A net worth over $1 million (excluding primary residence) is another way to meet accredited investor requirements.

Generally, secondary marketplaces for private company shares are regulated entities, though they can operate under regulatory frameworks that don't provide the same investor protections as one would find in a public market. Some marketplaces may also be broker-dealers registered with the Securities and Exchange Commission (SEC) and members of FINRA/SIPC.

We've touched on some potential benefits above. They include:

• Early access opportunities. While there's no guarantee that a startup will increase in value if it conducts an IPO (and virtually any investment, especially startups, can lose some or all of its value), you at least have the opportunity to get in early. If the company grows, an investor could participate in that growth over the long term.
• Potential for outsized returns. Related to the benefit of getting in early, pre-IPO investments can offer the potential for outsized returns. Even if a private company is well known and has already reached "unicorn" status of a $1 billion valuation, it could still become even more valuable down the road. Just as publicly traded companies can deliver significant returns, such as when they beat earnings estimates, privately held companies can also provide outsized returns if they eventually go public and investor demand drives up the share price. It may also be possible to acquire private shares at appealing prices from sellers looking to liquidate an otherwise hard-to-sell stock.
• Bypassing the "J curve." The J-curve refers to the sequence of potential returns on traditional private equity investments. Investors in private equity funds often see their investments dip in a fund's early days as managers deploy capital, before potentially seeing more significant gains later on as those investments bear fruit. (If you plotted this on a chart, the initial dip resembles the bottom curve of a J, while the growth phase resembles its vertical stroke.) That turnaround can take several years. In contrast, investors who acquire private company stock on a secondary marketplace can potentially skip stagnant early years.
• Diversification. Given the unique dynamics affecting the prices of private shares, assets traded in a private market could be considered a separate asset class from publicly traded stock. Accordingly, having some pre-IPO stock could offer additional diversification on top of a standard portfolio of stocks and bonds.

As you might imagine, many of the features that make private stock unique also create particular kinds of risk.

• Liquidity. Private companies often have the right to prohibit any trading of their shares entirely. Even when trading is permitted, the right of first refusal means that in any proposed sale, the company or a significant stockholder can step in as the purchaser after exercising their rights within a certain time period (typically between 15-60 days). Unlike public markets, where investors can buy or sell shares in seconds, private market investments may require holding periods of several years—or longer—before an acquisition or IPO provides a path to cash out. Secondary marketplaces can help by connecting buyers and sellers, but it's still worth understanding that private share transactions typically take dramatically longer than trades involving public securities.
• Higher risk of failure. Both private and public companies face the risk of failure, but private companies generally experience a higher failure rate. This is often because fledgling companies have more limited access to capital, relying on a smaller pool of investors compared with public companies that can raise capital through stock offerings.
• Valuations and pricing can also be more complex. Without a daily market price, private shares are typically valued based on recent funding rounds, independent appraisals known as 409A valuations, or secondary market transactions. That means prices generally do not reflect real-time changes in a company's performance or risk profile. Investors should be aware that valuations can fluctuate significantly and may be impacted by broader market conditions or internal company developments.
• Dilution risk. This is the risk that a company will issue more shares, leaving investors with a smaller stake. Private company stock tends to carry much higher dilution risk than publicly traded stock, since public companies have more ways to raise money than issuing shares. Private companies can also experience "down rounds," issuing new stock at lower prices than in a previous funding round. This makes each share worth less, while the company must create more shares to raise a set amount of money.
• Transparency. Privately held companies aren't subject to the same strict disclosure rules regarding finances, risk factors, and strategic plans that public companies are. As a result, investors may have less access to detailed or current information, making it harder to fully evaluate a business's health and prospects.
• Accreditation requirements add another layer of consideration. Given the higher risk and complexity involved, private market investing is generally limited to accredited investors—those who meet the specific income or net worth thresholds mentioned above. These guidelines are designed to help ensure participants can absorb potential losses and understand the nuances of investing in a less regulated environment.

Investing in private shares before an IPO can make sense for investors who value the potential benefits—but who also meet the strict requirements and can tolerate the unique risks. As with any alternative investment, it's best to talk things over with a qualified professional before moving ahead with any investment plan.