A legal document in accordance with Securities and Exchange Commission (SEC) guidelines, provided to investors before the issuing of securities – stocks or mutual funds, is called a Prospectus. It includes details about the issuing firm’s financial and operational data, information on major stakeholders, details about the number of shares on offer, price per security, the fee for buying, and the risks associated with the investment. For example, a Prospectus on mutual funds contains information on it’s assets value, investment strategy, historical performance, distribution policies, transaction costs, risks, and the management of funds.
A Little More on What is a Prospectus
A standard Prospectus includes
- The stock or mutual fund issuing company’s name.
- Total number of securities.
- Type of securities on offer.
- Stock Exchanges where the securities will be listed.
- Total number of shares available for sale.
- The nature of the offering – public vs. private.
- Underwriting firm’s fee.
- Bios of Principals and their holdings value.
- Financial and operational data.
- SEC approval and other relevant details.
Detailing the Fee Structure
A table at the beginning of the prospectus tabulates the fee structure for the investments. This is especially helpful when deciding to invest in mutual funds that have high transaction costs eating into the profits. Fee charged for purchase, sale, and moving amongst funds is listed. It simplifies comparisons between mutual funds. Funds with expenses below 1% are termed low-cost mutual funds, while those with a fee of 1.5% or higher are termed high-cost.
Risks Disclosure in a Prospectus
Informing investors about the potential risks involved in investing in a particular stock is one of the central goals of issuing a Prospectus. It safeguards the stocks or bonds issuing company from future claims of misleading information or hiding critical details that would sway the investors’ decision in buying the stocks.
A brief overview of risks is presented at the outset in a Prospectus. Details follow much later with the inclusion of facts like the age of the company, management engagement level with business and operations, their experience and expertise, and the capital holdings value. List of people who own major stakes in the firm is also included giving investors a rough idea of who owns how much and whether all the principal’s involved still hold their stocks or have liquidated their holdings, signalling financial turmoil within the firm.
Example of a Prospectus
When Snap Inc. was going public in March 2017, a document highlighting the operations of the company, it’s capital structure, financial data, risks and profits forecasts, and details on the IPO, were issued to investors and public in the form of a Prospectus, a month prior in February. Informational snippets provided in this Prospectus included details like the fact that Snapchat is used by 158 million people everyday, and it’s annual revenue for the year 2016 was $404 million.
References for Prospectus
Academic Research on Prospectus
IPO prospectus information and subsequent performance, Bhabra, H. S., & Pettway, R. H. (2003). Financial Review, 38(3), 369-397. This paper looks at the forecasts and predictions made in an IPO Prospectus, using data from 1987 to 1991, and posits that this data has minimal effect on the one year performance of an IPO.
Investment bankers and IPO pricing: does prospectus information matter?, Daily, C. M., Certo, S. T., & Dalton, D. R. (2005). Journal of Business Venturing, 20(1), 93-111. This paper examines the impact of the information contained in the Prospectus on an IPO’s performance.
Prospectus earnings forecasts: evidence and explanations, Lee, P., Taylor, S., Yee, C., & Yee, M. (1993). Australian Accounting Review, 3(5), 21-32. This paper takes a closer look at the explanations and evidence provided in Prospectuses to support forecasts.
Possible factors of the accuracy of prospectus earnings forecast in Hong Kong, Chan, A. M. Y., Sit, C. L. K., Tong, M. M. L., Wong, D. C. K., & Chan, R. W. Y. (1996). The International Journal of Accounting, 31(3), 381-398. This journal examines the accuracy of forecasts in Prospectuses in the Hong Kong trading market.
The decision to voluntary provide an IPO prospectus earnings forecast: theoretical implications and empirical evidence, Bilson, C., Heaney, R., Powell, J. G., & Shi, J. (2003). Cahier de recherche, Australian National University. This paper studies Prospectus disclosures regarding forecasts and risks, and posits that new and riskier enterprises avoid including negative information in their Prospectuses.
Analysts’ use of qualitative earnings information: Evidence from the IPO prospectus‘ risk factors section, Balakrishnan, K., & Bartov, E. (2010). unpublished working paper. This paper takes a look at the factors that influence the forecasts and predictions outlined in an IPO’s Prospectus.
Intangibles and Italian IPO prospectuses: a disclosure analysis, Cordazzo, M. (2007). Journal of Intellectual capital, 8(2), 288-305. This paper analyses the information disclosed about intangibles in Prospectuses in the Italian IPO industry.
The effect of IPO prospectus earnings forecast errors on shareholder returns, Henry, D., Ahmed, K., & Riddell, A. (2002). Journal of Corporate Communications, 4(1), 1-27. This paper examines the errors regarding risks and profits forecasts in an IPO Prospectus and the resultant effect on ROI for investors.
Information asymmetries and IPO underpricing: the role of voluntary disclosure of forward-looking information in the prospectus, Bozzolan, S., & Ipino, E. (2007). This paper examines the voluntary disclosure of information in a Prospectus, pertaining to risks and probable returns, and correlates it to the underpricing of IPOs, suggesting an inverse relationship between negative information and price of a security in an IPO.
Asymmetric Information and the Role of the Underwriter, the Prospectus and the Analysts in Underpricing of IPOs: The Italian Case, Fabrizio, S., & De Lorenzo, M. (2001). This paper sheds light on the role of the Underwriting firms in underpricing IPOs with a deep dive on the Italian Case.
The institutional determinants of IPO firm prospectus length in a developing context: A research note, Hearn, B. (2013). Research in International Business and Finance, 27(1), 52-65. This is a research note on the impact of the length and details of a Prospectus determined by institutional factors like the quality of an IPO firm.