No one will ever confuse a prospectus with the Great American Novel.
The typical prospectus is dull, tedious and difficult to read. Most investors react predictably – they scan the prospectus briefly, or not at all. In the end, they invest based principally on what their broker has told them and not on what they have read about the company. Maybe they get lucky and find that they invested wisely.
But what if the broker’s advice is not so sound? Worse yet, what if the broker’s motives are suspect? How does an investor make his or her own thoughtful decision about a new company or a new stock issue? One tool is available to every potential investor. The prospectus. Read it carefully – and know what to look for and where. Beneath all of the legal jargon and cautionary language is a wealth of information.
In this series of articles we help you navigate the prospectus. In particular, we offer pointers on what to look for, where to look for it, and what some of that confounding "legalese" really means. Where do we start? With the cover page, of course.
The Company’s Name
What’s in a name? Maybe nothing. Generally, the name of a company has no bearing upon the quality of its business or its profitability. Occasionally, however, the name sends a message. When a company adopts a name that reflects current trends it may be time for the investor to take a closer look. The clearest example? Today’s dot com fascination. The Internet frenzy has motivated businesses to append a dot com to their name, or to spin off an internet-oriented subsidiary. Investors need to be cautious. Is the company simply trying to take advantage of a "hot" trend and favorable market conditions, or is the business truly related to the Internet? Carefully, review the section of the prospectus titled "Company" or "Business" to determine the historic nature of the Company’s business. Has management recently abandoned existing operations or a less sexy business plan to jump on the Internet bandwagon? And if it did, how successful, or unsuccessful, had the company been in its earlier endeavors? Be wary of a struggling operation that is grasping at the Internet straw. Does it appear that insiders are simply trying to increase the value of their own shares through an Internet stock play? If so, don’t play along.The company’s name may send out other signals as well. Does it sound similar to the name of another, better established business? If it does, the investor should probe further. Occasionally, management will adopt a familiar sounding name in order to benefit from someone else’s reputation. If you’re thinking of an investment in one of these "sound alike" companies pay extra attention to its history and business plan. Is the company a start-up, or does it have an operating history? One rule of thumb – if the company is new and unproven, its operations are not well established, and its financial condition is precarious, the similarity of names is far less likely to be merely coincidental.
The Offering
The cover of the prospectus will tell investors how many shares (or other securities) are being offered to the public, at what price, and by whom. Note carefully – are the shares being sold by the Company or by a group referred to as "Selling Stockholders" (sometimes referred to as "insiders" or "inside stockholders")?" Or by both? The term Selling Stockholder is used to refer to any individual or entity whose shares are being registered as part of the public offering. Sales by Selling Stockholders are instructive. The circumstances and terms of those sales may offer clues about the Company which can help you weigh the merits of an investment.For example, just who are these Selling Stockholders? Are they planning to sell all of their holdings, or just a small percentage? An investor may be justifiably concerned if the Selling Stockholders include people who founded the Company, corporate executives, or individuals who are running its operations. Why, you will certainly wonder, does management seem to be bailing out? What can this possibly mean to the long-term prospects for the Company? An early exit by these corporate insiders may signal that they are more interested in profiting from a "pop" in stock prices immediately after the offering than in developing the business over time.
The Selling Stockholders may consist of venture capitalists and other financiers who helped the business get started. In that case it is not unusual for those stockholders to seek to recoup their investments or just cash out at the earliest opportunity. Even here, however, there are questions to ask. How long have these investors held their stock, and how much did they pay? Be concerned if they acquired their shares only recently, at a bargain price, and with little risk. In that case the public offering may only be a convenient vehicle for these individuals to reap profits. Does enriching a group of investors appear to be a priority, or does the Company seem more devoted to achieving its business goals? The Company that you invest in should always place its business first.
Often, the company and its underwriter will require Selling Stockholders (together with the Company’s executives and management) to sign a "lockup agreement" before the offering. Although their shares will be registered as part of the IPO, these stockholders agree that they will not sell the shares for a fixed period of time.
The lockup would appear to provide some assurance that all of these shares will not flood the marketplace. But review the terms of the lockup with care. Is it meaningful, or merely cosmetic? Lockup agreements prevent the stockholder from selling the shares for a fixed period of time (usually between 6 and 24 months). In some cases that time period is absolute – the stockholder may not sell under any circumstances until the lockup period has expired. In other instances, however, the lockup is conditional – the underwriter has discretion to release the lockup early. Why would an underwriter reserve this right? Typically, the underwriter wants to know that it has access to additional shares in the event of market demand. Where discretion exists, don’t be surprised if it is soon exercised, and the shares are released from the lockup early. This, of course, results in immediate dilution to the public.
How can an investor determine whether this is likely to occur? Look at previous offerings by the same underwriter. Has the underwriter routinely reserved the right to release lockup agreements? If the answer is yes, check the public filings for those companies in the months immediately following their IPOs. (If the Company files its financial reports with the SEC, this information is available at www.sec.gov).
What should you look for? In some instances the Company will clearly disclose whether the Selling Stockholder shares were released early. If the Company fails to address that issue directly you can still determine whether the shares were released by reviewing the company’s quarterly financial reports. Check out the public float (that detail is included in the financial statements). Then look at the prospectus, which will specify how many shares were held by the public immediately after the offering. Compare the two numbers and you should be able to determine if any of the Selling Stockholders were permitted to sell before their lockups expired.
Once you have identified a pattern you will have an idea how that underwriter is likely to approach lockups in the future.
Enough for now. And we’re still on the Cover Page! In our next installment we look at the Underwriter and focus on the body of the prospectus.
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