OpenIPO: Prospectus Guide
The following guide highlights some of the major portions of a prospectus. It is for informational purposes and is not all inclusive.
What is a prospectus?
A prospectus is the offering document included in the registration statement filed with the SEC. The contents are laid out as required by the SEC, and provide a description of both the issuing company as well as the terms of the deal.
The preliminary prospectus (also known as the “red herring”) is issued after an offering is filed with the SEC and serves as the primary marketing document for the deal.
The final prospectus is issued after an offering is priced. It includes the final terms of the deal and a list of all underwriters. This document must be distributed to all participants in an offering.
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Why should I read the prospectus?
Investing in an initial public offering carries with it an inherent degree of risk. Conducting adequate research is the most effective way to mitigate this risk.
The prospectus is a good place to begin, as it contains key information about the issuing company’s history, current health, and future prospects.
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What are the key sections of a prospectus that I should focus on reading?
A prospectus for a small offering averages about 80-100 pages. For larger offerings, it can be even longer. Here is a brief roadmap of where to begin:
The Cover
The prospectus cover provides a summary of the general terms of the offering, including the number of shares being sold, a suggested price range for the shares, and a list of the underwriters. The final prospectus will list the offering price of the deal.
Prospectus Summary
This section provides a quick snapshot of the deal, and can be a good place to determine whether or not a specific offering is of interest to you and warrants further research. It includes a brief summary of the business history and strategy, as well as highlights of the financials.
Risk Factors
This section is meant to highlight the specific risks that an investor faces in a particular offering. This can be a good place to glean a list of concerns to consider as you read deeper into the prospectus.
Use of Proceeds
This section provides a breakout of the expected use of the funds generated by the offering. This list often includes items such as debt repayment or construction of a new facility.
Capitalization
This table provides an estimate of what the company’s balance sheet will look like if the offering is completed in its entirety at the midpoint of the filing range printed on the cover.
Selected Financial Data and Management's Discussion and Analysis
These two items are the keystone for dissecting the company’s financial position. Included here is income statement and balance sheet data dating back as much as five years, the most recent quarterly financial results, and an analysis of the company’s financial performance.
Business
This is the segment of the prospectus where management attempts to explain its business strategy, the industry in which it plays, and its competitive positioning.
Management
In this section is a list of the company’s senior managers and directors. The most informative pieces here are generally the management bios and the breakout of management’s compensation.
Principal and Selling Shareholders
Here you will find a list of the equity ownership of senior management, directors, and other persons who own 5% or more of the company. More importantly, this is also where you will find the list of shareholders who are selling stock in the offering, if there are any.
Underwriting/Plan of Distribution
For OpenIPO® offerings, the Plan of Distribution is a valuable source of information about how WR Hambrecht + Co employs an auction-based method to price and allocate its deals. For traditional offerings, the section still lists the underwriters involved and details about the execution of the offering.
Financial Statements
The final section of the prospectus is meant to be a complete set of standard financial statements, including the balance sheet, income statement, and statement of cash flows.
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What areas should I review in more detail?
As you read through a prospectus, you may want to keep an eye out for the following concerns (Please note, this is only a partial list of potential concerns, and each investor needs to find his or her own comfort level with an investment):
Declining revenue or declining margins
These concerns can be signs of serious problems with a company’s growth strategy. You may want to refer to the Selected Financial Data and Management's, Discussion and Analysis section to read the explanation for these problems.
Other financial concerns
A number of other signs of financial distress can be found in a prospectus, such as a working capital deficit (where current liabilities are greater than current assets), inventory or accounts receivable rising far more rapidly than revenues, highly seasonal revenue patterns, a large amount of debt on the balance sheet, or negative cash flow from operations. Again, check the Selected Financial Data and Management's Discussion and Analysis section for an explanation of these issues.
Large number of shares in the offering coming from selling shareholders
This can be a concerning sign, as the company does not receive the benefit of the cash raised from the sale of stock from existing shareholders, plus this raises the question of why these insiders would want to sell their holdings if the company’s prospects are strong.
Proceeds being used to pay for the past, not the future
If the Use of Proceeds section lists debt repayment or a dividend to pre-IPO investors, this cash is essentially going to clean up past obligations, versus providing funding for future growth opportunities.
Dependency on too few customers or suppliers
If the majority of a company’s revenue is coming from one customer, this places a great deal of the company’s fate in the actions of that customer. In a perfect world, a healthy company also has a diverse supplier base, in the event of product shortages at any one supplier.
Competition
In the Business section of the prospectus, there is usually a subsection called Competition or Competitive Analysis. Check this list to see who the company competes with in their industry. Take particular note of larger, well-capitalized, well-run competitors.
Overvaluation
While the underwriter’s estimates of sales and earnings going forward are not made available until after the end of the 25-day quiet period following pricing, you may want to use historical financials to analyze valuation. For example, you can take the number of shares expected to be outstanding after the offering and multiply that by the expected offering price, to find the expected market value after the offering. Take that number and divide by the sales for the last 4 quarters to find the price-to-sales ratio for the past 12 months, or divide by profit for the last 4 quarters to determine price-to-earnings for the past 12 months. You may then want to compare these figures to the data from that of other publicly-traded competitors.
Other risk factors
As you become accustomed to reading prospectuses, you will begin to pick up on other potential red flags, including litigation, overcompensated management teams, nepotism, patent disputes, illogical business plans, etc.
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What are the risks involved in investing in an IPO?
As we previously mentioned, investing in an initial public offering carries with it an inherent degree of risk. While diligent research may help reduce the degree of risk, there are many unforeseen factors that could influence the outcome of your investment. Before participating in any IPO, you should evaluate how the loss of your entire investment would impact your portfolio.
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Glossary
Aftermarket Performance
The performance of a newly public company’s stock relative to its offering price.
Balance Sheet
A snapshot of a company’s financial condition, listing assets, liabilities, and shareholder’s equity at a given moment in time.
Best Efforts Deal
An offering that can be canceled if the underwriter cannot sell all of the shares. This is in contrast to a firm commitment deal.
Book
The list of buy orders that the lead underwriter puts together for a specific offering.
Broken Issue
A newly public company whose stock has fallen below the initial offering price.
Capitalization
The mix of equity and debt that finances a firm’s operation.
Cash Flow Statement
A listing of the sources and uses of cash for a firm during a given period of time.
Dividend
The portion of a firm’s profit paid to shareholders.
Firm Commitment Deal
An offering in which the underwriter is obligated to buy all of the shares from the issuing company and takes financial responsibility for reselling those shares to investors. This is in contrast to a best efforts deal.
Greenshoe
The section of the underwriting agreement that allows the underwriter to purchase additional shares from the issuer (usually up to 15% of the offering size) during a fixed period of time immediately following the offering. This option is typically exercised only in deals that are oversubscribed.
Income Statement
The breakout of a firm’s revenue, expenses, and income generated over a specific period of time. This can also be called the Statement of Operations.
Lead Underwriter
The underwriter in charge of managing the book of orders, setting the price, and allocating the shares of an offering.
Lock-up Period
The period of time after an IPO during which insiders at the newly public firm are not allowed to sell their stock. This period is generally agreed upon to be 180 days.
Offering Price
The price which investors pay for shares in an offering.
Opening Price
The price at which the shares of newly issued stock begin trading in the open market.
Oversubscribed
This is the term given to a deal which has more demand than the number of shares available for sale.
Premium
The difference between the offering price and the opening price for a new issue.
Pro-forma Financial Statements
Financial statements (usually balance sheet or income statement items) adjusted to reflect an event, such as a projected transaction or round of financing.
Prospectus
The offering document included in the registration statement filed with the SEC, which explains all aspects of a firm’s business.
Quiet Period
The time during which issuing firms are restricted by the SEC from saying anything that is not included in the offering prospectus. This period starts when a firm first files an S-1, and lasts until 25 days after the new stock starts trading.
Roadshow
A marketing trip taken by the issuing firm to pitch the offering to institutional investors. A roadshow typically lasts 2-3 weeks.
Red Herring
The nickname given to a preliminary prospectus. This serves as the marketing document that is distributed to prospective investors in an offering.
SEC
The Securities and Exchange Commission, the regulatory agency that oversees securities transactions.
Selling Shareholders
Investors in a firm who sell a portion (or all) of their holdings as part of a stock offering.
S-1
The document filed with the SEC announcing a firm’s intention to sell shares of stock. This document includes the prospectus. It is also referred to as the registration statement.
Syndicate
A group of broker-dealers that buy shares in an IPO to sell to their customers.
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