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A pre-IPO offering is when a company offers shares of stock to an investor or investment group prior to it actually going public and making shares available publicly. Such stock deals are usually offered to large investors, hedge funds, or investors with seats on the board of directors of the company at a significantly reduced price to what the initial public offering (IPO) share price will be for a couple of reasons. When large investors buy into a company early, it can encourage buying of the stock immediately after it goes public. The advantage to pre-IPO investors is that significant financial gains will be made if the stock sells for a higher price once it is available to the public.
There are several downsides to getting involved in a pre-IPO offering. The risk is very high due to the fact that the company has no legal obligation to go public after making a pre-IPO offering, which means that the shares would have little to no value if the company failed to attract sufficient interest to engage in an IPO. The pre-IPO stock then becomes illiquid, meaning it is virtually impossible to sell or covert to cash. There is also usually a lock-in period with pre-IPO stock where it cannot be sold for a certain amount of time after the company goes public. If the stock price drops after being offered to the public, the pre-IPO share price might end up being higher than the market price, resulting in a net loss for the investor.
The Securities and Exchange Commission (SEC) in the United States, which enforces federal securities laws, warns against pre-IPO company investments. Marketing of pre-IPOs to the general public is often fraudulent, enticing investors by offering a high rate of return on a company that is financially unstable, fictitious, or not legally registered with the SEC. As well, pre-IPO offerings that have been successful in the past typically offer double- or even triple-digit returns. This sort of performance in a narrow section of the securities market attracts all types of scam artists who promise the same or better returns.
Whether choosing to invest through a standard initial public offering or a pre-IPO, the SEC recommends that any investor take several concrete steps to investigate the company before doing so. This includes checking into whether the securities are listed with a state securities regulator, and how the stock may be restricted by lock-in periods. A detailed analysis of the company should also be done, including looking at what products or services it makes, who its core customer base is, and obtaining copies of its financial statements available through its investor relations department. It is also important to find out who owns and runs the company, as these managers will be on record with the state securities regulator if they have defrauded the public in the past.