What Is a Prospectus?

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What Is a Prospectus?
What Is a Prospectus? (Image: Steve Woods)

If you are considering making an investment, familiarizing yourself with the company's prospectus will be an important first step in ensuring that you are making a wise investment. A prospectus is used to make sure that investors are given all the pertinent facts regarding an investment. The prospectus is also used to protect the company from claims that it did not fully disclose all of the potential risks of the investment.

Identification

A prospectus provides potential investors with detailed information about a specific investment opportunity. The prospectus is a legal document and is commonly used for stocks, mutual funds and bonds. A prospectus must be filed with the Securities and Exchange Commission and by law must be made available to anyone considering making an investment.

Types

The preliminary prospectus provides information on the investment opportunity before a final price is determined for the offering. It includes a preliminary price, information about the company, the type of business it conducts, biographies on key employees and company directors, financial statements, a list of property owned, and information about any current litigation against the company. The preliminary prospectus is sometimes referred to as a "red herring" because of the disclaimer printed in red on the cover.

The final prospectus includes all of the information from the preliminary prospectus, plus it contains the final price, potential risks to buyers, number of shares to be issued, the delivery date for shares and information on the underwriting spread. The underwriting spread is the difference between the cost per share that an issuing company receives from an underwriting company and the offering price that the underwriting company offers to the public.

Features

A prospectus contains several sections of particular interest to investors. Recent Developments will alert you to any problems, challenges or recent successes of the company. The Risk Factors section includes a general section that explains the amount of risk inherent in any investment, but may also include information about risks unique to the investment. These risks may include such things as heavy debt, patent disputes, strong competition or a recent downturn in profit.

The Use of Proceeds section will tell you how the company plans to use the money they raise through the sale of stocks, bonds or mutual funds. Read this section carefully and make sure that you have a clear understanding of how your money will be used. The Dividend Policy explains if you will receive regular dividends, while the Business Section provides details about the company's business plan, method of operation, strategy, competitors and future plans.

The Selected Consolidated Financial Data section provides further details on the financial information found in the summary. The Management Discussion section is a particularly important section to read as it describes management's past and present performance and its goals for the company.

Considerations

While large, well-known companies are usually good choices for investments, smaller companies may also offer a good rate of return. Look for smaller companies that are offering new technologies or products with relatively few competitors.

Warning

If shares are being made available because the original stockholders are selling out, beware. These people may be selling for a good reason and it would be wise to conduct more research on the company and the offering before investing. Proceeds from the offering should be used to further the work of the company. If the proceeds are being used to eliminate debt or pay bonuses to shareholders, this is a red flag that could indicate poor management practices.

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