Pre-IPO Investing Tips

Pre-ipo equity is the issuance of equity by a company prior to a stock market listing. Don't confuse this with 'private investment' or 'angel investing'. The line is not as fine a one as some would have you believe.

There are many companies offering pre-ipo investments that aren't really what it says on the tin. They are deals that might, one day, go to IPO. True pre-ipo deals are those that are virtually already geared to go to an IPO. These have taken on brokers and advisers to take them through the process or have put in some mechanism that ensures (as such as it can be) that the company will be listing.

So here are some guidelines that may help you to find deals and what to lok for when choosing what to invest in:

1. Listen to Everybody. This is probably a controversial one to start off with, because there are so many jokers and dreamers out there who have zero chance of getting their issue, or that of their clients issue (in the case of brokers) off the ground. However, if you are new to this area then reading prospectuses of those that are rubbish will give you an insight to those that are viable. Talking to everyone will also give you a regular deal flow of ideas and, sometimes, will give you access to people in these small companies that are serial deal doers which is what you need (see 2).

Talking to everyone will also allow you to get a feel for who is good in the space and who isn't when dealing with brokers. I read an excellent quote on the net the other day "Even a blind squirrel sometimes finds a nut in the forest". This is a good quote to bear in mind when you are dealing with brokers you don't rate. Sooner or later they may stumble on something interesting.

2. Cultivate you list of 'players'. This list is not necessarily static. Like a football player, sometimes they have a bad season, sometimes they have a good season.

You need to look for the player that is on form. But most importantly you need to know who they are in the first place. Looking on the net is a good place to start. Choose your search term "successful entrepreneurs" etc etc. But drill down through the press dross and find out whose names keep occurring and in what sector. You will find that these players have a 'fan club' who follow their investments. You want to be in the 'fan club' of as many of the players as you can.

It doesn't mean that the 'players' are just individuals, some firms have a good track record and should be watched.

For example, a recent survey of the best and worst performing NOMADS (Nominated Advisers) on AIM was released by Lombard Asset Management and Growth Company Investor. This is a key list to look at when considering pre-ipo companies looking at AIM floats. Obviously some of the info was skewed by the number of issues, but it is a good place to start. Basically if you are looking at a pre-ipo deal and the NOMAD taken on does not have a great track record then it may be a factor in your decision.

Join mailing lists of firm that do deals so that you can receive updates on transactions they are involved in, if you see something interesting then you can make the contact. HF Capital have an 'alert service' among other small corporate fnance firms.

3. Read the prospectus. Obvious? Most people don't get beyond the nice blurb in the first 20 pages.

The best places to look are 'Risk Factors' and 'Statutory and General Information'. Risk factors will, more often than not, be generic but may bring up something for further research.

The 'Stats and Gens' should give you a better idea of the company itself. Look at the history section. This should tell you how many shares are authorised (meaning how many shares they could issue) and the issued share capital (meaning how many shares they have issued). The issued share capital will tell you, for example, that there have been 10,000,000 shares issued and they are fully paid up (meaning that if the basic price of the share is 1p - called the 'nominal' price, then £100,000 has been paid for these by the founders 10mn / 1p). If you are being asked to pay £1 for these shares then you may want to have a look at why you are paying 99p over the initial price for the shares, is it worth £10mn?

Also something to look out for is that the shares are 'partly paid'. In the UK, for example, the minimum share capital for a PLC (the issue has to be a PLC to be offered to the public) is £50,000 but only 25% of that needs to be paid up meaning a PLC can have only £12,500 paid in by the original shareholders. If the shares are partly paid up ask yourself why the rest hasn't been done when you are being asked to pay a premium.

On this subject, look for issues that have been 'fluffed up' by the directors/founders saying that, as an example. £2mn has been paid in by the directors as 'sweat equity'. Sweat equity is affectively the work that has been done for not much, if any money, by the founders/directors, and this is a way of them trying to capitalise it. I do, however, look very closely at how this is calculated, and you should too. I saw a prospectus a number of years ago where the founder had worked on the project for two years before raising funds. He had charged the company £10,000 per week for 'services', (which it didn't have, of course) he then wanted to capitalise this in the business for 'sweat equity' of over £2mn. If this was Steve Jobs or Warren Buffet, I could stretch to that. This guy had never earned more than £50,000 per annum. It was a pass.

If there is a clause in the prospectus (which there generally is) saying that pre-emption rights (basically pre-emption rights is the right for shareholders to be offered shares first before new investors) have been suspended up to £X. That means that the company can issue shares up to that level without asking the shareholders. For example if the authorised capital is 100mn shares and the offer is for 10mn, and the company has suspended pre-emption rights up to 100mn shares. You could be investing and then be diluted massively by the issuance of a further 90mn shares.

Check out and 'loans from directors'. There simply shouldn't be any. I would be hugely suspicious if there were any outstanding loans because why would the directors be asking you to invest at a certain price but would not be prepared to capitalise their loans? They either believe in the company or they don't. If they haven't converted their loans it would be a pass for me.

Check out if any director has been involved in companies liquidated previously. This is point that I argue with people on. Some see failed companies as a bad thing, I believe that people grow by learning from their mistakes, don't write the company or director off because he has made errors, but do look at the circumstances of these errors.

Check out how much management owns of the shares. If its above 75% after the offer, be careful, there are a lot of things that can be done by someone holding 75% of the shares that may be against the interest of shareholders. If it is less than 30%, ask yourself whether there is enough to lose or gain from the success or failure of the company for the directors. I like to see between 40%-60% (obviously depending on the size of the company and the stage of investment).

On the subject of shares, be very, very careful of warrants and convertible debt from the management or outside investors. Convertibles are a fabulous tool for investors when used correctly, but when they are not they can be a nightmare. For example, lets say there is a loan for £200,000 to the company that is convertible into shares at 1p. f you are buying shares at 3p hoping for the IPO price to be 6p, look at the dilutive affect those warrants will have. I am not saying dismiss any issue on this basis, because the guy who put in the £200,000 may have been taking a huge risk when he put the money in and now the company is OK, but do look at these carefully.

Check out other shareholders. If you see Warren Buffet in there, chances are it is a good one to look at. If you see 'Bodgit and Scarper Investments' you may wish to take another look.

What are the transfer rights? In a small number of prospectuses I have seen odd transfer rights stated in the docuemnt. Ones where transfers are restricted. In a private investment you don't want this and, frankly, there is no good reason for it. If it's in there ask why.

4. Do your Research. An obvious one, but a crucial one. Check out the sector, the management, the investors, the concept, the product, the accounts..everything. If you find that the information you come up with is beyond your knowledge then ask someone who knows about such things. If it is still beyond you and you cannot rely on other known investors to have done the research, pass.

5. Make a Move, but don't Over Do It. By all means, if you think you have discovered the next Google and want to invest your life savings, go ahead. But don't complain if it doesn't work out. In our accounts we aim to be spreading investments in these kind of deals across a range of shares.

6. Define what your objective is with each issue . Remember we are talking here about pre-IPO's. So, there will be a decision to make when the company actually lists. Is it good for a quick sale after the float? Or is it worth hanging on for a defined period of time? These are questions that will be answered by the research that you have done. If it is a 'keeper' you will know by now.

By following the steps above you may lose out on a few '10 baggers' but it is a little like playing Blackjack. If you play the odds and take the odd flyer when things look good, then you will win. If you bet on getting 21 every time, you are going to go broke very, very quickly.