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What Is a Prospectus?

UTC by Beatrice Mastropietro · 10 min read
What Is a Prospectus?
Photo: Unsplash

If you are thinking about investing in securities, it is important to read the prospectus carefully before making any decisions. This guide will provide an overview of what a prospectus is and explain why it is so important.

A prospectus, sometimes called a “red herring” or “offering circular”, is a legal document that allows potential investors to make informed decisions about investing. It provides detailed information on the company’s securities, its financial statements, and other details of the proposed investment opportunity.

The term “prospectus” is derived from the two Latin words: “prosper,” meaning “to look forward”, and “praescriptum,” meaning “a written document”. A prospectus can include information about a company, its business prospects, financial condition, dividends or other securities it may issue, management or advisers. It can solicit new investors or expand investor interest in a security.

The prospectus must be delivered to anyone who purchases the security. It must be filed with the Securities and Exchange Commission (SEC) before its first sale to the public. The SEC reviews the prospectus for compliance with federal securities laws, ensuring that investors receive material information on direct investment risks as well as how commissions and other fees will affect their return on investment.

The term also describes preliminary documents that the issuer will ever make a final registration statement companies filing for an initial public offering (IPO).

The prospectus requirement applies only to offers of securities for cash, not barter or exchange. It does not apply to “transactions by an issuer not involving any public offering.” In other words, if a company makes a private placement of shares directly to an individual or group of individuals, it does not have to file a prospectus. In some cases, a company may offer securities but not be required to file a prospectus with the SEC. For example, a company might make a private placement directly to an individual or group of individuals. In this case, the company would not have to file a prospectus with the SEC because it is not making a public offering.

Prospectus Understanding

A prospectus is often described as a ‘selling document’ that aims to attract investors who are not yet customers of the issuing company. When an issuer (the company or other entity selling securities) decides to make an initial public offering, they will produce a prospectus to describe themselves, their business, and the proposed securities on offer to potential investors. This helps them decide whether or not they want to purchase shares or bonds on offer.

The issuers of the prospectus aim to convince investors that the issuer’s shares/bonds are worth investing in by providing information on how successful their business is expected to be, thus increasing demand for their share/bond issue. They usually do this by writing reports on market research showing how their business fits within the sector they operate in and its performance so far. Besides, they want to give a fair idea of their assets, liabilities, and financial position by providing details on their existing share capital, debts, and tax status.

A prospectus can be used for any situation relating to securities issuance because it is the document that provides all the information an investor needs before investing money in an activity or company. This includes initial public offerings, rights issues, private placements, etc. The ‘accredited investor’ definition varies across jurisdictions, but these are investors who have particular knowledge about investments which allows them to take more risk than other investors are required to do. For example, in the United States, investors need to have a net worth of at least one million US dollars or an annual income of over $200,000.

A prospectus includes essential information about the issuer and details about its securities offering for potential investors to make informed decisions without needing further research.

Components of a Prospectus

A prospectus typically discloses the names of the issuer and underwriters, a summary of the company’s business operations, risk factors, descriptions of security being offered, pricing terms, financial statements, and other pertinent information.

The following are the most common elements that are included in a prospectus:

  • Business operations of the issuer. This section includes details on the business model for which capital is being sought, market conditions, applicable regulatory environment, and tax implications for investing in this venture. It also entails the philosophy that drives decisions by the issuer’s management and risk factors associated with getting involved in an investment opportunity offered by these managers.
  • Types of securities being offered with their corresponding offering price and amounts. This part of a prospectus discloses what kinds of securities are being offered to investors, including stocks, bonds, warrants, or any other securities available under specific jurisdiction laws, as well as how much they will be available for purchase.
  • Financial statements are submitted at the end of every fiscal year. This section includes income statements, cash flow statements, and balance sheets covering at least three years from the date of filing the prospectus.
  • Description of offering process including timing and obligations for investors to complete a purchase if any have been made by them already.
  • Rights given to existing security holders, if there are any. Suppose a company is publicly traded on another exchange or market but wishes to raise additional capital through an IPO. In that case, this section informs current shareholders about what rights they will be entitled to have purchased shares in previous rounds.
  • Legal and contact information for people to reach out with additional questions.

Types of Prospectus

Let us have a look at the most common types of prospectuses.

  • A preliminary prospectus is a document with essential facts about a public offering of securities. It may be filed for an initial public offering (in this case, it will be called a preliminary base-shelf prospectus), or for a primary offering of securities by selling security holders (then it is called a preliminary offering circular).
  • A final prospectus is a long document designed to provide full, true, and plain disclosure for investors. It is filed with securities commissions before an issuer begins offering its securities. The final prospectus becomes effective as of the date that such final prospectus is filed. Subsequently, there must be a preliminary prospectus to make use of a final prospectus exemption.
  • An abridged prospectus is a shorter version of the prospectus that an issuer may file in certain offerings. In general, it must include the same information as required in a preliminary prospectus for the same securities being offered and sold under different disclosure requirements.
  • A deemed prospectus is a document that combines in single document information about the issuer and its securities. The document provides investors with a single source of disclosure for fixed and floating charge mortgages and other important financial information about an issuer that may not be included in either a prospectus or interim financial statements. A deemed prospectus must include a description of the security offered; information about the issuer of the securities being offered; an introduction to the security, including an explanation of how it is categorized, where appropriate; a summary of significant factors that may have a material effect on the value or market price of the securities being offered; information concerning any significant amendments to the prospectus; information concerning any outstanding securities of the issuer, including whether any other class of securities has voting rights or is convertible into securities of another class; a list of all jurisdictions where the offering document is distributed and information about each jurisdiction.
  • A shelf prospectus provides investors with a single source of disclosure for multiple types of securities that the issuer may offer in the future. The most common use of shelf prospectuses is for debt offering (i.e., non-convertible debentures, convertible debentures, etc.) Still, it can also be used for ordinary shares, preferred shares, trust units, warrants, and the exercise of outstanding warrants or options. The use of a shelf prospectus simplifies future filings by eliminating the need to file multiple preliminary prospectuses to take advantage of all types of qualified financing transactions.
  • A statutory prospectus is a document that complies with statutory requirements and contains full, true, and plain disclosure to investors. Statutory prospectuses play an important role in the exempt market because, like final prospectuses, they can be used to facilitate a broad range of transactions without requiring individual exemptions from securities commissions.

Prospectus for Mutual Funds or ETFs

Many investors may be confused when they see a mutual or exchange-traded fund (ETF) filing a prospectus with the Securities and Exchange Commission (SEC). Mutual funds do not issue securities, so why do they need a prospectus?

In most cases, the answer is that mutual funds use a simplified prospectus. Also called an offering circular, this document contains general information about fees and expenses associated with the investment. The only securities the fund issues are the shares of its portfolio holdings, which it creates to represent ownership of assets such as stocks or bonds. Typical shareholders have no right to vote on any company actions related to their investments with the company. In most cases, they can’t even trade shares from one another.

ETFs do issue securities under a variety of structures. Some issuers create shares representing ownership of a specific asset. Other issuers rely on the structure of existing securities to create interests in an entity holding assets such as bonds or stocks. These structures give ETF shareholders certain rights. Many ETFs use prospectuses filed with the SEC to reflect these rights, rather than simplified prospectuses or offering circulars from mutual funds.

Analyzing a Company’s Prospectus

It is desirable to understand the company thoroughly, including its business strategy and model, when considering an investment. This will help make decisions regarding the stability of its financial resources for future projects and its operating performance.

There are several ways to approach this. One of them is analyzing a company’s prospectus or registration statement with its SEC filing. By analyzing the items covered in these documents or registrations statements, you can obtain information about their business operations and exploitation models, compare it with other companies, and assess the risk profile of investing in that particular company through a comparative analysis. Various aspects such as management team background and experience level may influence investors positively or negatively toward the company. Therefore, before buying or selling a stock, it is important to understand how much risk one is willing to assume in their investment. The first step should be to understand the business model of that particular company and its sources of revenues, which will provide investors with an idea about the company’s operational performance over time. Alongside understanding that specific company’s business model, investors should also evaluate other factors such as management team background and experience level to feel more secure about investing in a particular company.

Bottom Line

A prospectus is a disclosure document that must be provided to investors of securities (stocks, bonds, etc.) before an initial public offering, or in some cases, on a more continuous basis. A prospectus must include detailed information about the company issuing the security and the security itself. When an issuer (the company or other entity selling securities) decides to make an initial public offering, they will produce a prospectus to describe themselves, their business, and the proposed securities on offer to potential investors. This helps them decide whether or not they want to purchase shares or bonds on offer.

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FAQ

What is a prospectus?

A prospectus is a legal document that provides key information about the investment.

Why is a prospectus useful for investors?

A prospectus provides the necessary disclosures about the company offering investment and allows investors to make a decision on whether the company is worth investing in.

What information is included in a prospectus?

A prospectus typically discloses the names of the issuer and underwriters, a summary of the company’s business operations, risk factors, descriptions of security being offered, pricing terms, financial statements, and other pertinent information.

Who prepares the prospectus?

A law firm prepares the prospectus. You will be required to make independent inquiries about the services offered statements and decide to hire the firm.

What is included in the prospectus for mutual funds and ETFs?

The prospectus for mutual funds and ETFs is a document that outlines key information on the fund’s identity, investment objectives, risk of loss, fees and expenses, past performance, financial statements of the fund’s portfolio companies, contact information for your investor relations contact at the fund company, contact information for the fund’s independent auditor, and more.

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