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What is a prospectus?
A prospectus is a legal document used to describe an asset to potential investors. In the United States, it is required by the Securities and Exchange Commission to disclose pertinent facts regarding a company or fund, such as its financial status and its management, to help investors make a decision. Without a prospectus, investors would be making investments blindly, without fully understanding the asset.
In the case of a security offering, the issuer provides a preliminary prospectus with general business and transaction information, followed by a final prospectus, which has more details about the transaction, such as the exact offer price and number of shares being offered. If the investment in question is a fund, then the prospectus gives details on its investment strategies, distribution policies, fees, expenses, fund management and risks.
One of the main reasons for issuing a prospectus is to inform investors of the potential risks of investing in a mutual fund, stock or other asset. Providing this information protects the issuer from claims that relevant information was not disclosed to potential investors beforehand. Some of the facts in a prospectus that help determine risk include the management’s experience and how it is involved in the business, as well as current stockholders and whether they will still hold on to their shares. If stock is in the process of liquidation, then it warns prospective investors that there could be a problem with the business’ finances.
Example of a prospectus
Assume that Company XYZ is making an initial public offering, or IPO. The company starts by filing a registration statement, which includes the prospectus, with the SEC, disclosing all material facts regarding the business. This is followed by a 20-day period that allows brokers to discuss the IPO with their clients based on the information in the preliminary prospectus. Once the registration statement goes into effect, Company XYZ amends its prospectus. The final prospectus contains:
- A general description of the IPO.
- History of the company.
- Information about the management.
- IPO price.
- IPO date.
- What the proceeds of the IPO will be used for.
- Underwriting description.
- Financial information of Company XYZ.
- Risks to buyers.
- A legal opinion on the company.
- Disclaimer from the SEC.
When the final prospectus is released, brokers take orders from interested investors who have studied the preliminary prospectus during the 20-day period. All sales confirmations must be accompanied by a copy of Company XYZ’s final prospectus.