Investing in Start-Ups: Owning Pre-IPO Shares in Your Self-Directed IRA
Opportunities to invest in the next hot unicorn — a privately-held startup valued at $1 billion or more by their investors and is expected at some point to go public — are coveted in Silicon Valley and, increasingly, much of the investing public.
With the media awash in stories about unicorns and ongoing excitement around hot tech startups like Uber, SpaceX or WeWork, I continue to be asked by clients how they can use their retirement dollars to invest in a “pre-IPO” company.
At PENSCO, where we custody alternatives assets for our clients’ self-directed IRAs, retirement investors can hold everything from private company stock to hedge funds to limited partnerships in their IRA. This means it is possible to own shares of hot tech startups in your self-directed IRA.
The bad news is that getting access to pre-IPO shares remains incredibly difficult. Private company stock tends to be obtained by company employees, venture capitalists, friends and family, angel investment groups or syndication efforts aimed at qualified investors.
But this trend is changing, if only slightly. It is being driven by the fact that startups are choosing to remain private for longer, and an increasing number of private securities marketplaces are cropping up to provide investors with a chance to buy private company stock from early-stage investors or employees. And, amid the highly competitive market for tech talent, some pre-IPO companies are embracing these marketplaces to help retain employees and keep them happy.
Why Private Companies are Staying Private Longer
According to research from Stanford Graduate School of Business, the average age of a company completing an initial public offering (IPO) from 1996-2000, was six years old. In the early 2000s, the average age rose to eight years. Following the financial crisis, it has jumped to ten years.
An influx of cash from venture capital firms is allowing tech startups to stay private longer while they grow their businesses, increasing their value when they go public. According to the Stanford research, almost 200 companies globally have a private-market valuation above $1 billion. The largest 15 of these are collectively valued at $300 billion.
But the result of delaying an IPO is that employees and investors in these startups have their private company stock locked up for an increasingly long time, limiting their ability to liquidate their positions to fund living expenses or make another investment.
In the response, numerous secondary private-company marketplaces — like SharesPost, Equidate, EquityZen and NASDAQ Private Market — have launched marketplaces to bring together employees and early stage investors wishing to liquidate a portion of their holdings and qualified buyers seeking to invest in pre-IPO shares.
The size of these private securities marketplaces is substantial. According to transaction data that Stanford collected from SharesPost, Equidate, EquityZen and NASDAQ Private Market, more than $4 billion in transaction volume was executed by these four liquidity providers alone in 2017.
Based on trading data received from SharesPost, Stanford found individual investors made up the overwhelming majority of buyers and sellers, as shown below.
Returns for buyers of these pre-IPO shares can be substantial. Based on a subsample of companies that went public in the year following the transaction, Stanford found the average seller sold equity holdings at a 39% discount to subsequent IPO pricing — meaning the buyer stood to make a hefty return from the pre-IPO shares they purchased.
Buying Private Company Shares: A Risky Business
To qualify to purchase pre-IPO shares on these secondary marketplaces investors typically need to be accredited, meaning they have a net worth of $1 million excluding their primary residence or they have $200,000 in salary or $300,000 for a married couple for the past two years (with the expectation that the earnings level continues).
Many of these private securities marketplaces allow investors to buy private shares using self-directed IRA funds, and pre-IPO shares could be a good match for retirement dollars. IRA dollars tend to be invested with the long-term in mind, making them a good place to diversify a portfolio by holding a rather illiquid asset.
However, while selling and buying private company stock is becoming easier, it is still incredibly risky. On its website, Equidate outlines a number of substantial risks involved in private market investments, including:
• They are illiquid investments, and your capital may be locked up for long periods of time
• They are risky investments, and you may lose some or all of your principal
• There is often little information available on potential investors since access is limited by companies
• There may be legal, regulatory, and tax risks associated with each investment
For investors who buy private company stock, it’s important to be aware not only of the potential upside of owning these pre-IPO shares but also the potential downside. If you go chasing unicorns be sure you understand the potential risks involved in case you happen to catch one.
If you have questions about holding pre-IPO shares in your PENSCO self-directed IRA, please contact us at 800.962.4238.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.