Pre-IPO Startup Investing Explained: Can You Beat the S&P 500?

As kids, we were taught that unicorns don’t exist. Sorry mom, not only do they exist, but there are over half a thousand of these mythical beasts roaming the startup fauna today. And depending on how early you catch one (and if you catch the right one), you too could achieve legendary gains—like Garry Tan’s 6,000x return on investment with Coinbase.

But how can normal people like you and me break into the exclusive world of pre-IPO startup investing? Well, since we’re trying to get in on the ground floor, it’s only fitting that we build our understanding from the ground up. Here goes.

A startup may need to raise capital years before they’re profitable. For this reason, they’ll usually reserve a large block of shares to sell to private investors. 

Once a startup is generating $100 million more or less, their next step might be to go public and get listed on the stock exchange through an Initial Public Offering (IPO).

So in short, pre-IPO startup investing is when you buy shares in a startup before it has gone public. Now we’ve already covered why a company would want to sell pre-IPO shares. But why are investors clamoring to buy shares in startups that, in many cases, haven’t even proven themselves to the market yet?

Chinese company Bytedance is currently the most high-valued startup in the world at over $400 billion. With sky-high valuations like this and trillions of dollars more on the private market, it’s easy to see why everyone wants in.

But investing in potential unicorns is not all sunshine and rainbows. The oft-cited statistic is that 90% of startups fail, with 70% of them shutting down during years two through five.

So, saddle up and let’s explore the good, the bad and the ugly of pre-IPO startup investing. Cue the Wild West whistle.

The stock market has returned about 10% per year on average for the past century. Buying an index fund and doubling your money in just over 7 years ain’t a bad deal considering it’s totally hands-off. 

But if you’re looking to make parabolic gains, here’s how pre-IPO investing could be your ticket to riches:

• Buy at a discount: The main appeal of pre-IPO investing is getting in early while shares are still underpriced, so you can ride the wave up as they become fully valued on the public market. Venture capitalist Ozi Amanat, for instance, invested in Alibaba’s pre-IPO at $60 per share and got a 50% return on day one of the Alibaba IPO. 
• Market-beating returns: Don’t get it twisted, not every IPO is going to lead to huge gains. But just last year, IPO returns across 10 sectors in the US averaged 59%, outperforming the S&P 500 by over 3x. 
• Low correlation asset: While they’re not a completely uncorrelated asset, pre-IPO investments are less affected by stock market crashes and black swan events like the 2020 pandemic. This means pre-IPO shares could bring some much-needed diversity to your investment portfolio during a bear market.

Your rising dopamine levels may be telling you to buy into a pre-IPO right now, but hold on there, partner. Let me get my Molly Bloom on and explain the dangers of this high-stakes game first.

There’s a concept in economics called the greater fool theory, which states that an investor will buy an asset (even if it seems overpriced) as long as they believe that someone else (the greater fool) will buy it for an even higher price afterward.

In other words, most investors buy into pre-IPOs so they can sell those shares for a profit once they’re liquid. But that might not be possible if the IPO flops.

Uber, valued at over $72 billion pre-IPO, is one of the well-known cautionary tales. With so many big-name investors on board, Uber seemed too big to fail. But when push came to shove, Uber stock barely rose above its IPO price and even tanked as much as -50% in its first year of trading.

It’s one thing for an IPO to flop, but canceling the whole IPO isn’t out of the realm of possibility either. But why would that happen?

• The IPO gets delayed: WeWork, for instance, had to delay its IPO due to legal battles and losing investor confidence.
• The startup gets shut down: This happens for countless reasons, like developing a product that no one wants, in-fighting among team members, running into legal regulatory issues and so on.

In these cases, Pre-IPO investors get wrecked due to:

• Illiquidity: You can’t just offload your pre-IPO shares when you realize that something doesn’t smell right. Like some kind of forced marriage, you’re in it until the IPO do you part—at least in most cases. And I’d hate to break it to you, but these days, it takes an average of 13 years before a company IPOs.
• Irreversible loss: The discount that investors get on pre-IPO shares is actually a risk premium, on the off chance that the company goes bust before it goes public. If that happens, then the value of your shares goes up in flames too.

If at this point you’re still itching to try and beat the market with pre-IPO investing, here are 4 ways to get in.

As an accredited investor, you’ll be able to buy shares in private startups directly. But what does it take to become accredited? 

Well, financial institutions like to make it seem like you need to be part of some sophisticated breed. The reality? In most cases, you just need to have more money than the average person, which means:

• Having $1 million net worth, or
• Making $200,000/year for two years as an individual or $300,000/year for two years in joint income.

Pre-IPO brokers are companies that buy shares from early investors who want to cash out before an IPO. These companies then sell the shares to other investors through auctions and Special Purpose Vehicles (SPV), among other methods.

Public companies participate in private fundraising all the time. So it stands to reason that you could benefit from private investments if you buy stock in a public company that has a large stake in one or more private startups.

GSV Capital, for example, is a publicly-traded company that invested in companies like Palantir, Lyft and Spotify when they were still private.

Just 9 years ago, pre-IPO investing was only available to Qualified Institutional Buyers (QIB) like commercial banks, venture capital firms and hedge funds. 

But thanks to the Jumpstart Our Business Startups (JOBS) Act of 2012, everyone and their grandmas can buy pre-IPO shares today via crowdfunding. Here are some of the best platforms.

Republic has empowered 1 million retail investors to buy into vetted startups, some of which are valued at over $100 million. 

Quick Facts about Republic:

• Sweetest opportunity: Sugarfina, an artisanal candy experience for grownups
• What’s the minimum investment? $100
• How much do I have to pay in fees? $0
• When do I make money? If the startup IPOs or gets acquired at a high valuation
• How long is my money locked up? 1 to 5 years

Wefunder was built to empower anyone to vote with their dollars on the future they want to see.

Quick Facts about Wefunder:

• Out of this world opportunity: Solstar Space Company, developing Wi-Fi for astronauts
• What’s the minimum investment? $100
• How much do I have to pay in fees? 2%
• When do I make money? If the startup IPOs or gets acquired at a high valuation
• How long is my money locked up? 1 to 5 years

StartEngine is the largest equity crowdfunding platform in the US, backed by famous Shark Tank investor Kevin O’Leary.

Quick Facts about StartEngine:

• Mouth-watering opportunity: Piestro, a robotic artisanal pizza shop
• What’s the minimum investment? $100
• How much do I have to pay in fees? 0%
• When do I make money? If the startup IPOs or gets acquired at a high valuation
• How long is my money locked up? 1 to 5 years, but investors will soon be able to trade shares on the StartEngine Secondary market

AngelList was founded by the mega-successful investor of 10 Unicorn companies, Naval Ravikant. Over $1 billion of VC money has flowed through AngelList, but it is unfortunately only available to accredited investors.

Quick Facts about AngelList:

• Thoughtful opportunity: A startup crafting premium, customized corporate gifts
• What’s the minimum investment? $1,000
• How much do I have to pay in fees? 2%
• When do I make money? If the startup IPOs or gets acquired at a high valuation
• How long is my money locked up? 1 to 5 years