Unlisted share markets have gained popularity over the years in recent history. Investors with sound wisdom, strong financial health, and a long investment horizon buy stakes in growing companies, even before their IPO, and see the real magic of compounding. This has lured many new-age investors to head to the pre-IPO market, without proper knowledge and guidance and invest a big chunk in the unlisted. In this article, we will try to explain to you how an unlisted market actually works and how one should make the strategy to invest in this market. We will focus on the various dimensions of unlisted shares and their features so that it becomes easy for you to decide whether this market is for you or not. Key features of unlisted stocks: 1. Not traded on Exchanges: Unlike the listed peers, shares of unlisted companies are not traded officially on a particular exchange. There is a separate market for this segment, where buyers and sellers operate via dealers. 2. Dematerialized: Just like listed stocks, unlisted stocks are also transferred within your Demat account. One can check the status of the unlisted shares bought via the depository participant account, where they are available at face value. 3. Price Mechanism: Unlisted markets are a pure game of supply and demand, which actually test the wisdom of an investor. Since the exchanges are not involved in this mechanism, the fair price discovery is always under scrutiny. The price of a share is fixed by mutual understanding between dealer and buyer. 4.Growth factor: Unlisted markets enable investors to buy stakes in the company's which are either new in terms of technology or business model. Thus, the pricing is much more reasonable than the listed space. If you want to see the company evolve over a period of time, unlisted space is your cup of tea. 5. Liquidity issue: More often than not, liquidity issues are a concern in unlisted markets. However, investors usually do not liquidate their position taken in an unlisted market. Who can invest in the Pre-IPO market? Earlier, only limited hands could buy pre-IPO equity stakes but now the stage is open for all. However, nothing is so easy for the smaller investors with limited capital as an investment even today, goes via multiple stages of funding and retail participants can only after a certain level. So when a business looks for funding in the initial stage, it goes through seed capital funds where global funds finance the company, backing their business idea. There are different types of seed funding which include series A, B, C, D, and thereon. Ant Financial, Softbank, Alibaba are prime examples of seed funding investors. After this angel investors and venture capital funds take a stake in the company, which is purely based on making profits. Then comes private equity, where retail investors can participate. They buy stakes at a higher valuation compared to early-stage investors in seed funding rounds. Thus, even if you are buying shares in an unlisted market, that does not mean that your cost of acquisition will be very less. Though it is highly possible that you may get stocks at cheap dirt valuations, but conservative pricing is not a guarantee. After private equity, companies generally look for primary markets and the stake is open for all. Types of unlisted stocks: There are three types of unlisted companies which are available in the unlisted space. Investors can look at the details for the same to understand the business prospects of the company: 1. Parent Backed: Such companies are owned by a strong and renowned parentage, which is already listed on the stock exchanges. For example, Reliance Retail is the retail arm of Reliance Industries, HDB Financial Services is a subsidiary of HDFC group, Tata Technologies is backed by Tata Motors. 2. New Age Companies: These are internet-based companies, which are often referred to as startups. Such companies are focused on niche segments like e-commerce, gaming, fintech, etc. OLA, Paytm, Nykaa, Mobikwik are key examples of the same. 3. Independent Businesses: This segment includes the companies which have conventional business models without parentage. They are pure business players without being subsidiaries of any other listed entity. B9 Beverages, Bazaar India, Cochin International Airport, Hicks Thermometers are prime examples of them. Valuing the unlisted companies Since shares of unlisted companies are not freely traded on stock exchanges, there is no fair or exact market price. Instead, a fair value of the share is arrived at by buyers and sellers. There is no formal market for unlisted equities. Unlisted shares enter trading is usually done when there is diluted equity for sale by existing shareholders, promoters or employees of the company. Sometimes, promoters offload their stake for working capital requirements, without opting for private placements. While raising equity from private equity/strategic investors, the company is valued by these companies and can be used as a reference point. The prices of unlisted shares are initially fixed by the primary seller, based on the fundamentals and growth of the company and later on-demand and supply also play a vital role. Investing in unlisted space There are multiple ways of investing in the pre-IPO markets but all of them have their own pros and cons. Investors must factor in all before taking a call. 1. From startups: Startups (which are not eyeing an IPO) offer their stake to private investors but their ticket size is very high. Investors usually need a fund of more than a crore INR to buy a stake in such companies and even then there is no surety of getting the desired stake. The cost of acquisition is very high. 2. From employees: Investors can buy shares of an unlisted company from employees of the company, who have been offered stakes under ESOP schemes. This gives employees a decent opportunity to exit and liquidate their position and sell shares privately. 3. From Promoters: Promoters of the company usually go to private places with banks, merchant bankers and wealth managers to offload their stake. However, there is a significant amount of stake, which is offloaded and shares are sold. 4. From PMS/AIFs: Multiple wealth management companies are buying pre-IPO equities on behalf of their clients via PMS funds or alternative investment funds. However, their ticket size is quite big for a retail investor to participate in and the fee for management of funds is a big blow to your returns. 5. From Crowd Funds: Individuals make an investment in a new business venture in exchange for common or preferred equity when it goes public. Comparative Analysis 1. Taxation: Unlisted shares attract more taxation as investors have to pay 20% tax on the profit with indexation benefit in the off-market deals for holding the stake for more than two years. 2. Process: Unlisted deals are more cumbersome, more paperwork is required in a few cases. There can be a delay in delivery. 3. Due diligence: Unlisted companies demand more due diligence as there is no regulatory framework. Also, there is a lack of transparency in the financials of the companies. 4. Risk: Unlisted market requires a high-risk appetite to reap higher rewards. 5. Valuation: Unlisted markets give a scope of negotiation for pricing based on future earnings growth, right buying price etc. Professionally managed companies or companies having non-promoter institutional holding are seen as less risky bets. What should retail investors do? A retail investor should seek a strong balance between greed and fear while investing in unlisted stocks. One should allocate a small proportion of their wealth in the unlisted market. If an investor has excess surplus wealth, he can put a fair amount of shares in this space, but only after due diligence and risk assessment. An investor shall understand his investment horizon, goal, and objective of investment. Before making a random call in unlisted markets, one shall see tax liability and the dealer's commission as the brokerage is much higher in this space. If needed, investors can seek professional help as well. There is nothing wrong with trading unlisted shares. However, there are some unhealthy practices in this business. Just the kind of thing that needs regulatory attention before many small investors are misled into unsuitable investments.