How to Read an IPO Prospectus

An IPO prospectus is a document filed by companies attempting to sell shares to the public in an initial public offering, or IPO. It's a critical document for any investors interested in purchasing IPO shares. The prospectus will describe the company's operations, competitive landscape and risk factors as well as the planned uses for the proceeds that are raised through the IPO. Unfortunately, IPO prospectuses are very long and dense documents that contain a tremendous amount of confusing legal jargon. Understanding the key sections of the prospectus will help you get through the document more effectively and will increase your ability to extract critical information from the prospectus.

Difficulty: Moderate

Instructions

1. Review the Business Overview section, which is the first sub-section of the IPO prospectus. The Business Overview section will contain a description of the company's operations, including details regarding the company's products or services. Be sure you understand what, exactly, the company is selling and why you think the company's products or services are better than the competition.

2. Read the Industry section, which describes the nature of the company's industry and provides a list of the company's main competitors. You should conduct some independent research on the company's industry to determine how big the industry is and whether or not it is growing. Pay close attention to the company's competitors; if the company competes with a lot of large, well-known businesses, you should understand what the company's main competitive advantage is.

3. Review the Risk Factors section, which outlines the main risks facing the company's business model. Make sure you understand all of the risks facing the company and think about what would need to happen for the company to fail. Be sure to think about other potential risks and do not rely simply on management's disclosures regarding the risks facing the business.

4. Read the Selling Shareholders section to determine who is selling shares in the IPO. If a number of well-known and highly successful investors are selling their shares in the IPO, you should ask yourself why you should buy shares that other successful investors are selling.

5. Analyze the Use of Proceeds section to understand how the funds will be used. If the company is using a large chunk of the proceeds to pay off debt or pay existing investors a huge pre-IPO dividend, you should not invest in the IPO. It is better to invest in companies that plan to use the proceeds to fund growth or general corporate purposes.

6. Review the bios of the management team, found in the Management section. See what other companies these executives have worked for, and conduct some independent research to determine how the shares of those companies performed during their tenure. Be particularly wary if any of these companies filed for bankruptcy or had other financial problems.

7. Analyze the financial statements, found in the Exhibits section. Pay close attention to trends in revenue growth and margins as well as the strength of the company's balance sheet (how much debt vs. cash the company has). Review the cash flow statement to determine if the company generates significant free cash flow, which can be used to pay dividends.

Tips & Warnings

• The prospectus is only one source of information you should rely on when deciding whether to invest in an IPO. Professional equity research analysts cover IPOs and will publish research reports on different companies, which you can search for on Reuters' Web site. (See Resources below.)

References

• A Look at the Prospectus

Resources

• Reuters Knowledge

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