EquityZen's Blog On Startups and Their Economics

EquityZen's Guide to Investing in Pre-IPO Tech Companies

Phil Haslett | May 15, 2015

Are you new to secondary investing in private companies? It can be a daunting but ultimately rewarding asset class to invest in. We’ll cover a variety of topics to consider when investing.
  • What is Secondary Investing?
  • Financials
  • Metrics
  • Current Investors
What is Secondary Investing?
Companies can raise capital by issuing stock: this is called a “primary” capital raise. Companies will issue new stock to investors, effectively offering up a percentage of their business in exchange for a cash investment.

When those issued shares are traded or sold to a new investor, we refer to it as a “secondary” offering. The market for secondaries is between current private company shareholders (employees, early investors, founders) and investors looking to own a piece of the company. Most public stock trades are secondary transactions.

You may be asking, “why don’t I just invest in the primary capital raise?” Simply put, late-stage private companies normally raise primary capital from institutional investors, such as venture capitalists and blue-chip companies (“strategic investors”), and in large amounts (typically greater than $10 million). The analogy in public markets is the Initial Public Offering (IPO), when a company first issues shares to the public. That primary capital raise is typically reserved for institutional investors.

Secondary investing allows smaller investors the opportunity to invest in a proven, private company.

One assumption about private tech companies is that there's no available financial information, especially revenue. That's not usually the case: some digging through public news updates can often shed more light on the situation. The following private companies provide detailed updates on their finances:
  • Lyft ($1 billion in gross revenue in 2015)
  • Nutanix ($300 million in a bookings run rate)
  • Wish ("single digit billions" of transaction volume, 2016)
  • AppDynamics ($150 million in bookings in 2014)
There are many others, too. Of note is that these companies publish their own numbers, and should be taken more seriously than articles that point to a "close source" for revenue numbers. 

Some companies have also posted milestones that let us know approximately how many people or companies are using their services: 

  • Practice Fusion (5,000 new active practices in 2015)
  • 23andMe (one millionth customer in 2015)
  • Dropbox (400 million users in 2015)
  • Uber (one billionth trip in 2015)

The most common metrics to track in the late-stage tech world are annual revenue and revenue growth. Annual revenue is simply the top-line cash coming to the company from its clients. It should not be confused with profit, which is the amount of cash that the company actually keeps from the revenue.

To compare a company's metrics against another, analysts often see what multiple of the trailing 12 months' (TTM) revenue the company is being valued at. As an example, Wish was last valued at about $3.7 billion, and had an estimated $450 million in 2015 revenue. This corresponds to an 8.2x multiple of TTM Revenue. A lower multiple is desired, as you're "paying" less to invest in the corresponding revenues (similar to value investors seeking low P/E Ratios in the public markets)

Armed with this multiple, we can compare this to other competitors in the sector (e-commerce), especially public companies:

  • Etsy: 2.4x
  • Wayfair: 1.34x

At first glance, Wish looks like a richer investment compared to Etsy and Wayfair. But we must consider growth as well.

Revenue growth looks at how annual revenue is increasing (or decreasing) year-over-year. The reason investors have been willing to invest in unprofitable tech companies is their ability to grow revenue to a point where the company can eventually generate cash flow. Successful tech companies exhibit triple digit revenue growth in their early years, and it tends to slow down (though still grow) in later, more established years as the company has dominated market share. Tom Tunguz, a VC at RedPoint Ventures, has some excellent analysis on the correlation of market cap to revenue growth.

With all this being said, keep an eye out for a few things:
Source of finance data: is it "rumored" in TechCrunch, or actually being announced by the company?
The right competition: are you comparing metrics to competitors, or companies in a different sector that may trade at different multiples?
Bookings vs Revenue: Bookings are when a company gets paid upfront for future services, whereas Revenue is realized when the company actually delivers the service. The difference is important, and you can learn more about it here from OpenView VC's blogpost.

Current Investors
Available information about private, venture-backed tech companies can be limited when you're assessing a secondary investment. However, the company's roster current professional investors is usually well-known. EquityZen provides this information on our Trending page, and you can also check Crunchbase.

Investor Type
There are a few different types of professional investors to keep an eye out for. It's important to understand the difference as different investors have different motivations.
  • Venture Capital: VC's are looking for outsized returns, and have non-permanent capital. That means that the money they have raised from their Limited Partners (LPs) needs to be paid back in a finite amount of time (10 to 12 years). Because of that, VCs are motivated by liquidity: they need their portfolio companies to eventually be acquired or go public, so that they can cash in and return $$ to their LPs. (Examples of VCs: Sequoia Capital, Andreessen Horowitz, Index Ventures)
  • Strategic Investors: Strategic investors are usually large companies from a similar sector that are investing to establish a relationship with the private company. "Strategics", as they are known colloquially, do not have LPs and can typically be more patient with their investments. Additionally, the involvement of a Strategic can provide a private company with a natural acquirer down the road. (Examples of Strategics: Salesforce, Google, Facebook, Oracle)
  • Institutional Funds: Institutional investors include Hedge Funds and Mutual Funds. These investors typically invest later in a company's lifecycle, once they've had visibility into a proven revenue and growth model.  (Examples of Institutional Investors: BlackRock, Tiger Global Management, T. Rowe Price)
The Investor's Track Record
While past performance is not always indicative of future results, it would make sense to follow the investments of successful firms. Fortunately, VCs have a knack for bragging about their investment portfolio, usually on their own website. Some VCs have even offered up their historical return: Institutional Venture Partnersboasts their incredibly impressive 43.2% IRR on their website.

Some researchers in the space have also published the most successful investors (Check out CB Insights' piece: "Which Venture Capital Firms are Best at Spotting Unicorns Early?").

What Stage is the Company In?
Investors invest at various stages of a company’s lifecycle. For example, YCombinator acts as an accelerator and early-stage investor. Therefore, expect lower valuations and a longer time to eventual exit. Institutional Venture Partners, on the other hand, looks to invest in companies "with over $10 million in revenue". By knowing what stage the investors typically invest in, you can get a handle on when a company may be looking to go public or get acquired.

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