In everyday parlance, a red herring is a decoy. It is meant to divert attention from one place to another, the way a magician asks you to keep a close watch on his clenched left fist while he disposes of the coin he palmed with his right hand. But in the world of investment, a red herring refers to a preliminary draft of a prospectus for selling securities that is prepared by the selling company (the issuer of the securities) as part of registering the offering with the U.S. Securities and Exchange Commission.
The red herring prospectus, which is filed on SEC Form S-1, does not contain all of the information that will appear in the final version of the prospectus. For example, it will give a pricing range but not the actual price of the securities. It is subject to change, upon SEC review, and the possibility of recirculation. The red herring is used by the issuing company to start generating and determining interest in the offering before the securities are approved for sale. How the red herring is received by potential investors provides valuable information for setting the final price of the securities.
The offering prospectus is expected to disclose to potential investors everything they need to know about the company and the offering so they can make an informed decision. The document is broken into multiple sections, each covering a different topic. Topics covered typically include description of the company and its business, details of the offering itself (including the price, rights, restrictions and other terms), risk factors associated with investing in the securities, financial data about the company, management’s discussion of financial conditions and operating results, intended use of proceeds from the offering and management biographies.
By using the red herring prospectus to begin their evaluation of the offering, as opposed to waiting for the final prospectus, potential investors can greatly increase the amount of time available to make an investment decision. Much of the information provided in the red herring is not likely to change based on SEC review. For example, audited financial statements are not likely to change. Additional risks may be added to the risk factors section, but none are likely to be removed. Potential investors can also take this time to evaluate management, the general description of the offering, the security sellers, the underwriters, the company’s business model and the industry.
Potential investors should keep in mind the reasons the preliminary prospectus is called a red herring. First, there is a legend printed on the cover of the prospectus in red capital letters stating that the securities described within have not been approved for sale. Second, the name is a reminder that the preliminary prospectus may be misleading because it is subject to change. Potential investors should always make investment decisions based on the final prospectus.