Investing in unlisted shares can be an enticing proposition for those looking to diversify their portfolios and gain early access to potentially high-growth companies. These are shares of companies that are not listed on a public stock exchange, often including start-ups and pre-IPO firms. While these investments can offer significant rewards, they also come with a distinct set of risks that investors need to understand before diving in.
Risks of trading in unlisted shares
Limited Liquidity
One of the primary challenges with unlisted shares is limited liquidity. Unlike listed shares, which can be easily bought and sold on the stock exchange, unlisted shares are traded through specific mediums. The market for these shares typically consists of long-term investors, which means there is a smaller pool of potential buyers when you decide to sell. This can make it difficult to quickly liquidate your investment when needed, leading to unfavourable sale conditions.
Lack of Information
Unlisted companies do not undergo the same level of regulatory scrutiny and disclosure requirements as listed companies. As a result, investors often have limited access to comprehensive information about the company’s financial health, strategic plans, and industry positioning. Many unlisted companies only provide end of year performance reports, making it challenging to gauge their actual performance throughout the year. This lack of transparency can significantly increase the investment risk.
Lenient Regulation
The market for unlisted shares is less regulated compared to listed markets. The Securities and Exchange Board of India (SEBI) does not directly regulate unlisted shares, which decreases the credibility of these shares and increases the risk for investors. The lack of stringent regulations opens up more opportunities for fraudulent activities, making it crucial for investors to tread carefully.
Lock in of Shares
When a company announces an IPO and its shares are listed on a stock exchange, shareholders typically face a lock-in period of six months. During this period, shareholders, including pre-IPO investors and employees who received shares through stock options or grants, are restricted from selling their shares on the open market. This lock-in period is intended to stabilise the share price and prevent significant volatility immediately after the IPO. It also provides assurance to potential investors about the commitment of existing shareholders to the company’s long-term growth, as they cannot quickly exit their positions.
Market Risks
It’s important to note that unlisted shares also face market risks similar to listed equities. Factors such as market fluctuations, economic conditions, and investor sentiment can impact their valuation. Although both types of investments carry risks, the volatility and unpredictability of start-ups and pre-IPO companies are generally higher than those of listed equities.
How to mitigate the risks?
Investing in unlisted shares can be a rewarding venture, but it comes with inherent risks. To navigate these challenges effectively, it’s crucial to adopt strategies that mitigate these risks. Here are some steps to consider:
Don’t Over-invest – Mitigates the Risk of Limited Liquidity
Investing in unlisted shares means dealing with limited liquidity. Unlike listed stocks, which can be easily bought and sold on the stock exchange, unlisted shares have a smaller pool of potential buyers and sellers. This can make it challenging to liquidate your investments quickly if needed. To mitigate this risk, it’s essential not to over-invest in unlisted shares. Only allocate a portion of your portfolio that you can afford to lock away for an extended period without needing immediate access to those funds. By doing so, you ensure that your financial stability is not compromised in case of an emergency where you need quick access to cash.
Conduct Due Diligence – Mitigates the Lack of Information
One of the significant risks with unlisted shares is the lack of detailed information about the company’s financial health and performance. Unlisted companies are not required to disclose the same level of information as listed ones, making it harder to assess their viability. Conducting thorough due diligence is crucial in mitigating this risk. This involves:
- Reviewing Financial Statements: Obtain and analyse any available financial reports, balance sheets, income statements, and cash flow statements. This helps you understand the company’s financial position and performance over time.
- Understanding the Business Model: Gain a clear understanding of how the company operates, its revenue streams, cost structure, and competitive advantage. A robust business model often indicates a higher likelihood of success.
- Assessing Growth Prospects: Look at the company’s growth strategy, market potential, and industry trends. This includes understanding the market size, target audience, competition, and any barriers to entry that might affect the company’s growth.
By performing due diligence, you can make more informed investment decisions and reduce the risk of investing in underperforming companies.
The unlisted shares market remains a largely unexplored territory, presenting both significant opportunities and challenges for the discerning investor. While unlisted shares offer unique opportunities and the potential for high returns, they also come with considerable risks. Investors must be aware of the challenges such as limited liquidity, lack of information, valuation difficulties, regulatory gaps, the possibility of fraud, and higher uncertainty.
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