Clients often ask us if a pre-IPO round is worth it and in this article we consider the risks and rewards of such a strategy.
What is a pre-IPO round?
It can be any type of fundraising which seeks to raise funds prior to an IPO which is planned in the short or medium term (usually within 6 to 18 months). These investments generally follow one of two forms:
- Debt – a bridge style investment which is either repayable on IPO or more likely converts into equity on IPO or is accompanied by equity warrants which provide the kicker. The equity element will generally give access to an IPO investment at a variable price and at a discount to the IPO price, which allow negotiation of valuation to be postponed until the IPO process. The level of the discount depends on the proposed time period before the IPO and the risk of it not happening.
- Direct equity – a subscription for shares in the private company. This requires a valuation to determine the stake in the company the pre-IPO investors will obtain and this type of structure is potentially no different to any other private company round. It enables the issuer to organise itself more efficiently as the new investor fits into its existing share and governance structure.
Why do it?
The immediate answer is cash. A growing company will have a myriad of uses for finance, not least funding the company's own IPO. These include the IPO process itself but also those behind the scenes preparations such as preparing historic accounts under the correct accounting standards and adopting appropriate management systems and controls. Pre-IPO funding can also assist the company with satisfying its obligations to have sufficient working capital available for the 12 (or more likely 18) months of its life as a public company.
Another reason is that pre-IPO finance puts the company in the driving seat when picking a time to carry out its IPO. The company can continue to grow whilst it is going through the IPO preparation process and also decide to wait a few months and wait out difficult stock market conditions if this is required.
Why would investors want to participate in pre-IPO rounds?
The obvious answer is that it provided access at a lower entry point for investors than the IPO round. Compared to earlier investment rounds, the pre-IPO round should be more liquid and less risky and is often portrayed as offering investors (almost by definition) a quick turn-around. If a private company has an IPO on the horizon, it is likely to have passed through its early and most risky phase of development, has proof of technological concept and will be revenue generating and possibly even profitable. The IPO should give the opportunity for explosive growth and this is why participation in pre-IPO rounds has historically been reserved for the best clients of those investment banks sponsoring the flotation.
Striking the balance
The pre-IPO round is a useful tool for companies looking to be in the driver's seat when considering an IPO in the short to medium term. The most difficult aspect of pre-IPO financing is to strike a balance between the interests of investors in the pre-IPO round and the likely response of investors once the IPO comes round. Get it wrong and IPO investors will balk at the discount offered to the pre-IPO investors for taking on little or no additional risk. Get it right and a company can attract cornerstone investor(s) who lay down a marker for a positive valuation and validate the IPO prospects by agreeing to buy into the impending IPO story.
If you'd like to discuss any matters relating to this article please contact Saul Sender or your usual Mishcon contact.