Disclaimer.

Eligible Purchasers. The interests in funds will be sold only to “accredited investors” as defined in Rule 501 (a) of Regulation D. It also may be required that interests are sold only to “qualified purchasers” as defined in Section2 (a) (51) of the Investment Company Act of 1940.

Offerings. Interests in the funds are sold in accordance with the exemption provided by Section 4 (a) (2) of the Securities Act and Regulation D promulgated under the Securities Act, and other exemptions of similar import in the laws of the states where the offerings will be made. The funds mentioned in offerings will not be registered as investment companies under the Investment Company Act of 1940.

Past Performance. Past performance is no guarantee of future results. Any forecasts are inherently limited and should not be regarded as indicators of actual or future results.

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Our proven Pre-IPO investment strategy is designed to deliver

The Takeaway

Following our Three Trigger investment thesis, the average return Series D to IPO is 8X**.
The average hold is 39 months
136 new unicorns thru Q2 2021, how to invest in PreIPO investments.
Silicon Valley is gaming the IPO system, and how you can benefit.
Four key risks to consider when investing in
Direct share purchase, Managed Fund or Special Purpose Vehicle (“SPV”)? Which is best for you?

The financial industry has hit fast forward on innovation, and it feels like we’re going from 2X speed to 32X in a few short years. Private capital is one of the areas that has seen significant innovations, giving rise to PreIPO trading. The traditional IPO is no longer what it once was. With increasing frequency, issuers now leverage alternatives such as direct listings and SPAC mergers. They can also stay private with an unlimited supply of private backing from late-stage venture capital “King-Makers” like Tiger Global Sequoia, A16Z, and IVP. Gone are the days when “smart-money” investors opened accounts and vied for IPO allocations from major investment banks. Innovation creates opportunity, and “Smart-money,” i.e. billionaire family offices and their advisors, are leveraging these changes for an edge to earn alpha (higher returns with disproportionately lower risk) by directly participating in PreIPO securities. Run the math on Tiger Global’s last 25 investments from series D to IPO and you’ll get a sense of the level of returns being achieved. They outpace already impressive venture returns on an order of magnitude. The industry jargon is “alpha” or excess return.

Figure 1: Pitchbook- Rolling one-year horizon IRRs by strategy

Figure 2 State of Venture Report – Source: CB Insights, Page 5. August, 2021

So what’s the latest “edge” or “alpha”? How can you participate? Welcome to the “Pre-IPO unicorn market”.

In this article, I will cover the rules of this PreIPO monopoly game. I’ll point out strategies to use, and flag the landmines to avoid. And I will compare PreIPO asset class investment returns to the other major classes in figure 1, in order to demonstrate the potential for superior returns in PreIPO assets.

Pre-IPO unicorn is a term as mysterious to many as Defi (decentralized finance), another disruptive development in the finance world. Historically high returns typically attributed to the IPO market have been replaced by the Pre-IPO market. Google the term and you’ll discover a wide range of interpretations, from start-ups described as PreIPO to multi-billion dollar companies. Technically any company is pre-IPO, but we’re talking about companies valued at more than $1B, the so-called Unicorns, a term coined by Aileen Lee of Cowboy Ventures in 2013. In just eight years, the landscape has evolved into a multi-trillion dollar private securities market featuring not only unicorns (>$1B), but decacorns (>$10B), and even hectacorns (>$100B).

Silicon Valley (inclusive of other centers around the world) is an integrated technology and finance machine that’s minting new unicorns at a rate of over 100 per year. Currently, there are around 560 unicorns. Can you name 25 of them? If you can, you’re better than most! Picture an assembly line in which the best and brightest of top universities, Harvard, Princeton, Stanford, MIT, CalTech, UIT, and many others are developing technologies that are redefining life and business as we know it, filling massive market demand, and delivering on what Alphabet advisor and futurist Ray Kurzweil calls “The Singularity”.

The Unicorn Assembly Line

Silicon Valley has perfected the process of developing unicorns to the precision of a Ford assembly line:

Step One – (Year 0 to 2):

Seed-stage VCs finance and very quickly cull the crop. The best get handed off to early-stage VCs for Series A financing and further development, adding capital and using one of the best human resource selection databases (the VC industry’s secret sauce) to add top-tier managers to build out functional areas in finance, sales, and marketing.

Step Two – (Year 2 to 3):

The best of the best technologists and engineers continue to innovate within the “cocoon” of the business, delivering functionality to reinvent entire businesses, think Blockbuster Video meets NetFlix. Companies are strengthened, marketing and products are reassessed against the competitive landscape, and the highly coveted Series B gets funded if all checks out.

Step Three – (Year 3 to 5):

Revenue growth is carefully monitored and if all checks out again, the series C is funded and the Tigers begin to take note. Many of these companies have significant revenue growth at Series C, and investors begin to have clarity about the competitive landscape and total addressable market (‘TAM’). This is the stage where capital starts flowing from late-stage VCs at a record-breaking pace year after year. According to CB Insights, 367 $100M+ mega-rounds were funded in Q1 2021, and a record-breaking 390 100M+ rounds were funded in Q2.

Step Four – Hypergrowth:

Later stage VCs sit downstream, waiting for series D and beyond. They cherry-pick these gems and stuff them with as much capital as they can use to create unicorns as quickly as possible. A series D, classic VC risk takes on a PE risk profile. Every aspect of the company is well understood, and it’s a matter of racing for market share. This hypergrowth cycle allows late-stage VCs that manage trillions of dollars to put vast amounts of capital to work without the volatility of public markets. It’s a virtuous cycle where VCs can invest billions with full fees and carry interest while enjoying a lower risk profile. For our purposes, this is where the alpha resides because the late-stage VCs control the valuation.

Figure 3 State of Venture Report – Source: CB Insights, Page 6. August, 2021

VCs keep the valuation as low as possible because the public exit is their final gain. Investing at these levels is what PreIPO is all about. That’s where you’ll find alpha!

The PreIPO world is the domain of some of the world’s most powerful VCs such as Sequoia, Tiger Global, Andreesen Horowitz, Tencent, and Softbank, to name a few. Tiger Global has $80B assets under management (AUM). According to CB Insights, “Tiger Global increased its global investments by 8x YoY, hitting a record-high of 81 (or 1.3 deals per business day, excluding follow-on investments).” Can you invest with these funds? In a word, no: Unless you can write a $10M check, and lock that capital up for seven to ten years, most of these funds won’t take your investment.

But in the wake of highly coveted primary rounds available only to a select few VC behemoths, secondary investors are purchasing the same classes of shares from other earlier stage VCs and employees of the issuers as secondary transactions. Unlike primary rounds, proceeds of secondary transactions go to the seller of the shares, not the issuer or company. Why would they sell? Well, unicorns take years to develop. Many are older than ten years. And many early-stage VCs seeing massive 50X gains would rather sell and post the gains than wait for the remaining gains at the public exit. Some also have to sell because the unicorn may outlast the fund life. Employees frequently sell for the same reasons, they are up 50X and want to enjoy the fruits of their labor. The attitude toward employees selling shares has changed significantly in recent years. As a trade-off for the right to stay private longer, companies understand that employees have their own financial needs. Employee sales no longer signify problems at the company.

Figure 4: Key Players in the Silicon Valley Assembly Line

The birth of the PreIPO market started over ten years ago, before Facebook’s IPO. In those days, employees and early-stage VCs with significant paper profits sought an early exit giving rise to the private sale of shares. Facebook’s IPO took place in May 2012, priced at $38 per share. Less than a year prior, in 2011, those same shares were available for less than $20 per share through private sales. In subsequent years, this evolved into an extensive private market where early-stage VCs and employees realized gains without the need for an IPO. Obviously, not all investments produce eye-popping profits, but recent examples have been significant, which is why PreIPO investors keep returning.

Consider Peter Thiel’s Palantir, which went public in 2020 by direct listing. The reference price was set at $7.00 and the initial trades were at $10. Palantir has traded since June 2021 at prices between $21 and $25 per share. Secondary market shares were available prior to June 2020 for less than $6.50 per share. Take note that in many cases, the private shares purchased in PreIPO transactions are frequently subject to lock-up restrictions. This is usually not the case with direct listings, but do your due diligence before purchasing. In general, I don’t recommend PreIPO investing as a strategy to replace traditional IPO momentum trading because of the lock-up potential. Pre-IPO should be a longer-term strategy. In the case of Palantir, you can see from the chart in figure 3 that six months from the initial listing, when all restrictions were lifted (e.g. insiders) the market price came under pressure.

Figure 5 Source: https://finviz.com/quote.ashx?t=PLTR Date: 2021/31/8

As a rule of thumb, try to start building a position in PreIPO companies two years before the projected IPO. The earlier the better, and be prepared to hold the securities beyond six months after listing. Avoid purchasing too close to the IPO, e.g. within six months of the listing. Although this may sound like a good idea, this is a common mistake made by first-time PreIPO investors. In the case of Palantir, in the weeks leading up to the listing, shares traded privately as high as $15.00, producing disappointed investors when the initial price was announced at $10.00.

Risks to Consider

By now you’re probably thinking “ok this is a no-brainer, $6.50 to $25.00 in one year, sign me up”. Hold your horses! I’ll share some investment strategies later in this document. But first, there are a few topics that you should take into serious consideration:

Liquidity:

The most significant difference between public securities in an IPO market and PreIPO is liquidity or lack thereof. To participate, investors must accept that the securities are illiquid and that private sales are not quick. In fact, under certain market conditions, a private sale can take months. In addition, investors should be prepared to hold securities for a minimum of two years, sometimes longer, so if liquidity is your thing, PreIPO isn’t for you.’

No Information:

Unlike IPO securities required to file a registration statement that describes the company, management, financial history, and risks in detail, PreIPO secondary sales of securities generally come with no information rights. So investing in PreIPO securities requires an ability to estimate the valuation of the company. Many institutional investors invest millions of dollars in these securities with no more knowledge than the last round valuation. It’s not as crazy as it sounds! They have analysts that track the attributes of the sector, competitive landscape, and other factors such as news on the issuer and additional third-party confirmation that helps to refine their bets.

Due Diligence:

Title and transfer of ownership in private securities require legal due diligence to verify that the seller owns the shares and verification there are no legal

encumbrances such as liens or UCC filings. It is essential to confirm that the seller is on the issuer’s stock record, commonly referred to as “the cap table.” Confirmation that the issuer will agree to transfer the shares is also required. With increasing frequency, issuers have restricted secondary share transfers. The rights associated with transfers are generally described in the Shareholders Agreement that the owner agreed to when the seller initially acquired the shares. I recommend hiring a competent securities attorney to review the transaction before closing. In recent years, fake shares in high-demand companies such as SpaceX have been offered fraudulently. Fraud is a risk management challenge for both issuers and investors. Thorough legal due diligence could save you millions of dollars in losses.

Right of First Refusal “ROFR”:

In almost all cases, the original shareholders of preferred classes have the right to match your purchase price and purchase a pro-rata share of the shares being sold. And issuers are typically obligated to send notification of your offer to existing shareholders allowing them to exercise or waive their purchase right. This process can take up to 30 days in many cases. As a result, allocating capital to complete a purchase only to have the shares purchased by an existing shareholder can be aggravating. Understanding the price level where shares are being “ROFR’d” can help to reduce the chances of shares being ROFR’d.

Ways to Invest

OK, where do you start? There are two ways to invest in PreIPO unicorns: direct share purchases and through funds. Within the fund’s universe, you have managed portfolios, which represent a mix of different securities, and Special Purpose Vehicles (“SPV”) dedicated to one specific issue or company. Your capacity to research, perform due diligence and track issuer progress should help you determine the appropriate entry point into the market. Hedge funds, private equity funds, and other “institutional investors” purchase shares directly from sellers because they possess those capabilities. High net worth investors and family offices generally invest through managed portfolios and SPVs because they offer more protection since professional advisors manage them. As with anything in the investment world, managers can vary, so it’s best practice to invest through a Registered Investment Advisors (RIA) or an Exempt Reporting Advisers (ERA), or for non-US investors, through fund managers regulated by the appropriate regulatory agencies depending on the manager’s jurisdiction.

For a complete novice interested in PreIPO, consider a managed portfolio. There are some interesting options available, and some are even traded publicly. Looking for a tech portfolio that includes PreIPO companies like Elon Musk’s SpaceX? Check out Baille Gifford’s managed funds such as the Baille Gifford US Growth Trust Plc (OTCMKT: BLGFF). As of June 30, 2021, the fund was 15.4% unicorns, including names like Zipline International Inc., Space Exploration Tech Corp “SpaceX”, and Epic Games, Inc. They also own Affirm Holdings and Airbnb, both unicorns that went public. Fidelity Investment and T. Rowe Price also have similar offerings suitable for non-accredited investors. Voila! Fire up the TD Ameritrade app and you’re a Pre-IPO investor, of sorts!

A best practice is to invest through brokers, advisors, and fund managers registered and regulated by the securities regulators in your jurisdiction, e.g., in the case of the US, the SEC. Fiduciary requirements bind regulated advisors and regulated fund managers. In addition, they can offer insight into valuation, and due diligence, and usually have better access to information. Some SPV fund managers are below the AUM level (Assets Under Management) required to file with regulators. You should

check your state and federal requirements to understand if a manager is required to file. I recommend sticking to registered advisors. At a minimum, the SPV fund itself should be filed with a securities regulator. In the case of the US, most SPVs are filed under a Reg D exemption.

Ultra-high net worth investors and family offices that qualify as accredited investors can invest in Special Purpose Vehicles that are company-specific. SPVs offer several advantages: for example, you can create your own portfolio by investing in a number of company-specific SPVs. You are usually not subject to ROFR, and since you are not listed on the cap table, you have anonymity, which many family offices value. Additionally, in most cases, you can control the exit. For example, it may make sense to hold on to securities well after they go public. Taking the SPV approach allows you to be your own VC, effectively “stalking” some of the most prestigious venture capitalists, picking their winners and avoiding their losers. How do you pick the winners? That’s a topic for a much longer paper. Professional advisors all have their unique approaches. One simple method is to invest in Series D rounds where the same top-tier VCs are investing in multiple rounds from B or C onward. For example, many will start with the series B round and continue. If they are in three or more rounds it’s a significant indicator. There are also certain VCs that invest at a very late stage only. Their participation can help to understand when the issuers will begin seriously pursuing a public exit.

Is it worth the annual management fees and the carried interest to go through professional managers? Well, that depends on what the SPV manager offers. Some managers have exclusive access to certain companies. For example, with companies in high demand such as Tanium and SpaceX, the issuers only work with a few SPV managers. In many cases, issuers desire to limit the number of direct investors on their cap tables and have some control over where secondary issues are sold. Managers that have exclusive access generally charge fees because they control the market for a particular issue. Other managers are thematic, offer research, and blogs and focus on discovering lesser-known unicorn names. Those management teams also charge fees and carry to compensate for those services. Many managers discount fees for investment over certain levels. In addition, many managers have robust compliance infrastructure, provide statements, updates, and mark positions to market. Also, for you advisors out there that are considering this asset type for

your clients, many managers offer their SPVs with reduced fees for advisors, kind of like a fund of funds structure, so that the total fees and carrier charges to the client are not excessive.

Review SPV offering documents carefully. At a minimum, the offering should have a complete Private Placement Memorandum (“PPM”) which describes the structure, fees, use of proceeds, management obligations and rights, management background, and risks. Additionally, the PPM should accompany the Operating Agreement for the SPV. Review your rights regarding liquidation or distribution of the shares upon a liquidity event. Make sure you have the right to have the shares transferred to you on notice of an exit. And if the manager controls liquidation, understand how liquidation is managed before investing. Finally, avoid SPVs with documents indicating a manager’s intent to hypothecate, or borrow against the shares. Hypothecation is a fancy term from the securities industry indicating that the fund manager can borrow against the fund. It’s common in publicly traded ETFs where derivatives are involved. But it’s a red flag in private SPVs. If an SPV has not filed a Form D exemption with the SEC it can be a red flag.

What do you own in an SPV? When you’re investing in an SPV, like any fund, you are not purchasing shares in the issuer (or company), you are buying an interest in the SPV. In other words, you are purchasing an equivalent interest in the underlying shares. Most SPVs are series LLCs (limited liability companies) in which each series is dedicated to one issuer with one set of terms. Each series has a certificate of designation which describes the securities, price, and terms. Be sure to understand how many “equivalent shares” you are purchasing as well as any fees that will be deducted from liquidation proceeds, or charged in addition to your investment. If you are unsure, ask for a side letter that states everything in plain language. In addition, make sure that the series is clearly referenced in the subscription agreement, and that the series corresponds to the Certificate of Designation for the series. Once you gain familiarity with an SPV manager, particularly with regulated managers, the process runs smoothly. But first-time investments with any manager should be reviewed by an attorney.

Three Trigger Investment Strategy

If you read this far, you probably know more than most investors already in the PreIPO market. I baited you with the eye-popping returns earned by many in the Palantir example earlier in this article. Unfortunately, many PreIPO investors invest without following a clear methodology and fail to achieve favorable results. I’d like to offer my Three Trigger Strategy as a guide to identifying targets and as a guide in terms of timing:

Trigger 1: When you see a top-tier VC reinvesting across three or more rounds, flag the name and wait for Trigger 2.

Trigger 2: Series D is completed.

Trigger 3: If any Series D or later round is over $100M with the participation of the four names mentioned earlier, start accumulating a position in secondary shares.

Let’s study the example of UiPath, which went public in May 2021. UiPath is the sector leader in RPA (Robotic Process Automation). This is a phenomenal SaaS company trading at about 47X sales. The public market rewarded this company with such an impressive multiple because Annual Recurring Revenue is growing at just over 70%, which is serious growth for a company of this size. One of the top technology investors “rhymes with Park”, has a 10% position in the company, which speaks volumes!

UiPath was listed in May at $65 per share, a whopping $33B valuation. Four months later, the company is trading at around $62. Prior to listing, UiPath raised $750M through Series F, which was completed three months prior to the IPO. Series F was

Figure 6 Source: https://finviz.com/quote.ashx?t=PATH&ty=c&ta=1&p=d Date: 8/31/2021

priced at $62.28. Analyzing the funding history we can see that Accel Capital, a top-tier VC, started investing in the Series A-1 round, and invested in seven more rounds right through the Series E. Clearly a lot was going right for that to happen. Accel’s participation through the Series D trips the trigger to start seriously looking at the secondary.

Series D was closed in April 2019 at $13.12 per share. If you bought the secondary in 2019, you achieved a 370% return with a 30-month hold (assuming purchase of secondary Pre-IPO shares at series D pricing around the time of the series D close). So the strategy of investing in the series D in this example puts us within the desired range of the exit window.

Let’s review the three trigger approach: Trigger one consisted of a top-tier VC reinvesting across three or more rounds. Trigger two was the completion of the Series D, our entry point. Finally, trigger three saw several late-stage investors pile on, e.g. Tiger Global, IVP, and Sequoia entering at series D or later, a solid indicator that an exit was coming within 36 months.

Figure 7 Source: Forge : UiPath (forgeglobal.com) 8/31/2021

Fundamental analysis should accompany the Three Trigger Approach. Many advisors own positions in the companies from primary rounds and may have access to information to assist with the evaluation. Although the strategy is effective, supplementing with other confirmatory evidence. For example, how is the target performing against its peers in the competitive landscape? Is there evidence of a technology shift or competitive shift that may impact growth?

Exercise discipline in PreIPO investing and the rewards can be significant. Avoid chasing the “Top 20” names that become popular because of speculation that an exit is near. That is not an investment approach, and it opens the door to risk and losses. Case in point, in the months after Series F was completed, many investors paid over $80 for UiPath.

In addition to target analysis, any investment approach should include exposure to business sectors where technology is likely to create the most disruption. Consider geopolitical risk, cultural risk, regulatory risk, and liquidity risk. And finally, PreIPO is but one asset class to include in a portfolio of diversified investments customized to meet the needs of a particular investment objective. Care should be taken to avoid overweighting the PreIPO asset class. Remember that as a rule, the higher the returns, the higher the implied risk.

Word from Author

Thank you for reading this article. I hope you found it to be of some value. I wrote in the first person because I’d like to get to know more of my readers, and it’s a more inviting style. I have a genuine enthusiasm for technology and technology investing. I wrote this document to address a general audience and create a knowledge baseline for existing PreIPO investors and newcomers alike. In my travels, I’ve come across many investors versed in super-sophisticated topics, “the Greeks” for example, but who know little to nothing about private markets and unicorns. And frankly speaking, if you asked me to define a unicorn five years ago, I’d have described a one-horned horse-like creature found in myths and folklore. There are many aspects of PreIPO investing that are too complicated to cover here.

Additionally, there are many other facets of investing and risk management in PreIPO, including understanding and mitigating risk at even earlier stages, e.g. Series B and C. I plan to continue to cover the more nuanced aspects in future papers. Additionally, I will reveal my disruption-based sector strategy and profile and analyze companies approaching series D.

If you enjoyed this material and would like to receive updates regularly, please email us at: hello@venleycapital.com

Thank you,

Christos Erics

References

State of Venture Report – Source: CB Insights, Page August 2021
State of Venture Report – Source: CB Insights, Page August 2021

** 9.8x was computed based on nine selected exits within a pool of VCs in the Three Trigger list. The exits occurred between April 2021 and September 2021. We believe the multiple is purely a reference point and is by no means statistically accurate, nor does it imply that future performance could be similar.

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