Unicorn (Image: Shutterstock)

The North American Securities Administrators Association (NASAA) is cautioning investors about the risks of pre-IPO investing in large privately held companies, commonly known as “unicorns.”

“Unicorns are not just the stuff of fairy tales; some financial unicorns exist today. But investing in unicorns is speculative, and generally is unavailable to retail investors,” NASAA states. “Retail investors looking to bet on a unicorn may be able to do so indirectly through a mutual fund, exchange-traded fund or business development company. But beware; investing in unicorns is risky.”

NASAA issued an investment advisory that outlines some of the risks of investing in pre-IPO shares.

“Investing in unicorns carries very real risks … particularly when investing directly into a unicorn,” NASAA states.

As privately held companies, there is no public market to trade the securities of unicorns. This means that the securities are illiquid. With unicorns, there is no guarantee shares can be resold after purchase, according to NASAA.

According to NASAA, weak internal controls and corporate governance infrastructure may lead to fraudulent practices by a unicorn. For example, NASAA explains, a company could create false sales and shipping documents to artificially increase sales numbers.

Another risk is disclosure. Since the securities of unicorns will not be registered at the state or federal level, investors may lack important information to make an investment decision, according to NASAA.

The other risk is that the valuation of a unicorn pre-IPO may not reflect the intrinsic value of the enterprise. NASAA adds that even if the unicorn eventually holds an IPO, there is no guarantee the stock price will rise. “Some IPOs are unsuccessful, and shares fall after the company goes public,” NASAA states.

Historically, investors in start-ups had limited opportunities to sell shares before the company held an IPO and a secondary trading market opened.

However, federal legislation that came into effect on Dec. 4, 2015, eased the way for early investors to resell shares, which allowed unicorns to expand their investor base and develop market awareness prior to making a public offering.

According to NASAA, another regulatory change enacted in 2012 raised the ceiling on the number of investors a private company could have before the company would be obligated to register its securities and become publicly-traded.

This regulatory change helped unicorns stay private for longer periods of time.

— Check out Hedge Funds, PE Could Get Helping Hand From Hot Market in 2018 on ThinkAdvisor.