What is a Prospectus?

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Definition:

A prospectus is a document a company releases when it's issuing a new security (stock, bond, or mutual fund), which tells potential investors about the investment.

🤔 Understanding a prospectus

A prospectus is an important document that a company must file with the Security and Exchange Commission (SEC) to explain the nature and value of the security it is offering to the public. It contains all the necessary information you would need to decide on the investment, like the history of the company behind it, its management team, financial performance, and growth potential. There are two forms of an investment prospectus you may come across — preliminary prospectus and final prospectus. A company normally releases the preliminary prospectus when it’s planning to issue new security — basically, to check how the investors will receive the security. When it finally releases the security to the public, it provides the final prospectus, which has more details, like the total number of the security issued and the price.

Example

When Google launched its IPO (offered its shares to the public for the first time) in 2004, it released a prospectus which detailed the key facts about the company, such as these:

  • The IPO price: $85.00 per share
  • The number of shares offered: 14,142,135 shares by Google and 5,462,917 shares by selling stockholders, for a total of 19,605,052 shares
  • The financial statements from 1999 to 2004, with each year’s revenue stated
  • Major competitors: Microsoft and Yahoo

Source: Google's (now Alphabet) final prospectus for its 2004 IPO

Takeaway

A prospectus is like terms and conditions, but for a company that is about to go public...

Let’s say a fictional company, Rocketly, is about to go public. A prospectus is the required disclosures and overview that are available to potential investors. It tells you the things you need to know about a security being offered, including insight into growth potential and risk factors.

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What is a prospectus?

A prospectus is a document that tells you what a particular investment is about. Whether it is a stock, an exchange-traded fund (ETF), or a mutual fund, any security offered to the public must have a prospectus that explains what a potential investor needs to know.

The company offering the security must file a prospectus with the SEC as part of the registration process for the security. For instance, a company listing on the stock market for the first time must include an IPO prospectus when filing with the regulators.

It's a highly regimented document, which must contain the facts about the company issuing the investment. Some of the information in a prospectus include the number of shares issued, the price, and the company's history, finances, risks, and management team. With the knowledge, potential investors can analyze the prospects of the investment.

How does a prospectus work?

Companies use their prospectus to tell their audience — the regulators, investors, and everyone else — about what they're offering. When a company wants to sell their stock or bond to the public, it includes a prospectus in its S-1 filing — a registration statement companies use for registering public offerings with the SEC.

It explains the nature and prospects of the security and what the company intends to do with the proceeds. The first prospectus a company releases is the preliminary prospectus, which apprises the public of the upcoming security offering. Companies use it to check whether investors would be interested in the proposed security. While the preliminary prospectus contains information about the company's operation, it doesn't talk about the pricing of the security or the number of shares to be issued.

When the SEC approves the prospectus, and the company believes that there's enough interest in the security from the public, it offers the final prospectus when issuing the security to the public. The final prospectus contains more details than the preliminary one, including the offering price, number of issues, potential risk factors, how to compensate the investors (dividend policy), and what it intends to do with the funds it realizes from the sale.

Who prepares the prospectus?

A company offering its security to the public typically creates the prospectus for the offering. It can have its legal and accounting department create it. Or the underwriter (an investment bank that helps a company launch its IPO) it hires for the offering process may do it.

When must a prospectus be delivered?

When a company wants to sell its security to the public, it may release a preliminary prospectus before the regulators approve the offering. Once the security is approved, the company must deliver the final prospectus to the investors at or before the point of sale.

What is included in a prospectus?

Generally, a stock prospectus contains information about the issuing company and details of the stock. Let's break them down for you.

A brief history of the company: An investment prospectus usually has a section that provides a kind of overview or brief history of the company offering the investment. It includes things, like when the company was incorporated, the founders, their vision, and events that have shaped the growth of the company.

What the company does: In this section, you will find the services the company offers or the products it sells, as well as stories the improvements it has made in its services or products since inception.

Company's management team: Here, the company provides information about its management team, outlining each executive's managerial experience, as well as the academic qualifications that make them suitable for their positions.

Financial details of the company: In a bond or stock prospectus, the issuing company must provide details of their financial statements over the years, which includes typically gross revenue, profit before interest and tax, net profit, and others. Investors often use this data to compute the financial ratios and analyze the prospects of the investment.

Offering details: A prospectus also contains the details of the security, such as the number of securities the company is issuing, the price per security, when the security would be available to the public, and how investors can buy it.

Use of realized funds: The prospectus usually states what the company behind the security intends to do with the proceeds from the sale of the security. Most times, it will be to grow its operations, expand to a new market, or acquire new products.

Capital structure: The prospectus gives investors an idea of the company's capital structure. With that knowledge, potential investors can assess how the new offering can affect the present capital structure and potential returns.

Dividend policy: For a stock prospectus, there is information about the dividend policy in the company. While the company may change the policy later, investors, at least, know where they're starting from.

Voting rights: An IPO prospectus will clearly state the various classes of shares the company is offering to the public. Some companies structure their common stock into Class A and Class B stocks, with the voting rights concentrated in the Class B stocks. The founding investors may choose to keep the Class B stocks for themselves and sell the Class A stocks, which have fewer voting rights. In Google's 2004 IPO, for example, the founders offered only Class A stocks, which has 1 vote per share, to the public, and kept Class B stocks (with 10 votes per share) to themselves.

Source: Google's (now Alphabet) final prospectus for its 2004 IPO

Risk factors: There's a section in a prospectus that discusses the risks associated with the company's line of business. The risk factors may be in the form of fierce competition — Google, for example, stated in their 2004 IPO prospectus that they face serious competition from Microsoft, Yahoo, and other internet companies. Risks factors can also include stuff like pending legislation, tariff, exchange rate risks, and the prevailing economic situation.

How do you read a prospectus?

The prospectus helps you to evaluate the quality of any investment and determine whether it fits your risk tolerance and investment goals. So, before investing in a new offering, you should read the company's prospectus to get the basic facts you need.

Here are the things to look out for when reading a company's prospectus:

  • First, try to understand what the company does, its business model and its goals
  • Next, go through the risk factors and consider whether you can stomach that level of risk
  • Check what the company plans to do with the funds it gets from the offering and see if that's in line with its business model
  • Finally, consider how this security can affect your investment portfolio — does it help you diversify your portfolio or not?

What are the types of prospectuses?

You may come across different types of prospectuses, depending on the security you're dealing with.

Here are the common types:

  1. Preliminary prospectus: You can also call this prospectus a red herring prospectus because companies often use it to attract investors. It's the first prospectus a company issues when planning to sell stocks or bonds — It typically contains just the details of the company's business and the security it's proposing.
  2. Final prospectus: This is a well-detailed copy that companies issue when they’ve released their stocks or bonds to the public. It contains details about the price and number of security issued, in addition to the information in the preliminary prospectus.
  3. Shelf prospectus: The information in this type of prospectus is only valid for a year at most. Only finance-related businesses can make this prospectus.
  4. Abridged prospectus: You can also call it a summary prospectus because it kind of summarizes the information in the main prospectus, producing an easy-to-read version.
  5. Statutory prospectus: You see this type with mutual funds or ETFs. Unlike the summarized version, the statutory prospectus contains plenty of details about the fund it’s selling.
  6. Deemed prospectus: Here, the company doesn't directly issue security to the public. It allots the security to an issuing house, which later sells the security to the public. The document the issuing house uses to offer the security to the public is seen as a deemed prospectus.

What’s in the prospectus for mutual funds and ETFs?

A mutual fund or ETF prospectus is similar to those of stocks or bonds. But in the mutual fund prospectus, the information is generally centered on the following:

  • Objectives of the fund
  • Its investment strategies
  • Its performance over the years
  • The associated risks
  • The management team
  • Distribution policy
  • Management fees

The prospectus could be a summary prospectus — with only the necessary information. It could also be a statutory prospectus, which contains plenty of details about the fund.

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