Can the individual investor successfully navigate his or her way through a ponderous prospectus? In our first installment in this series, BUYER BE WARY – BETWEEN THE LINES PART I, we began to look at some of the questions that a thoughtful investor may want to ask. We continue that process, beginning with a few thoughts about the underwriter
The Underwriter
The name of the underwriter or underwriters appears on the cover of the prospectus. The IPO underwriter may be a household name with a national reputation or an obscure regional broker-dealer. In either case, the investor should want to know the underwriter's track record. For example, how many offerings have they underwritten? How have those offerings fared? Brokers sometimes tout their success by telling potential investors that their firm's previous underwritings increased in value significantly immediately after the offering. That, however, is only a small part of the picture. An investor should want to know how the stock (and the company) performed over a longer period of time – three months, six months, two years. Did shares skyrocket immediately after the offering, only to plummet earthward once the brokerage firm's best customers had taken their profits? Or did the company's shares build value over time? If you're a speculator you may not care. But if you're a long-term investor you will certainly take note of this factor.Information about underwriters is available through the SEC's Edgar Online site (www.sec.gov), while stock performance can be found through NASDAQ (www.nasdr.com), the OTC Bulletin Board (www.otcbb.com), or a variety of informational databases (such as Yahoo and AOL).
The underwriter's reputation and disciplinary history are other factors that investors would be well advised to consider. Some prospectuses will indicate whether the underwriter has run afoul of the regulators or is involved in any disciplinary proceedings brought by the SEC or the NASD. Sometimes, however, the prospectus will remain silent on these issues because the individuals drafting the prospectus (the Company, the underwriter, and teams of attorneys representing each) don't consider this information "material" to investors. So check for yourself. The NASD provides disciplinary information about all licensed brokers and brokerage firms (www.nasdr.com). You certainly will want to know whether the underwriter has been charged with engaging in questionable sales practices in the past. For example, have brokers working for the underwriter misrepresented the business or prospects of a company to prospective investors? Take advantage of your ability to access those details.
Risk Factors
To put it simply, a prospectus is drafted for two primary purposes: to inform the public and to protect the company. Which goal is paramount? Critics may differ, but they can agree on one essential point: the prospectus must, under the law, include "material" information about the company, warts and all. What's "material?" Generally speaking, information is material if it is likely to affect your decision to invest. On a case by case basis, however, the determination of materiality is often a judgement call for the people running the underwriter and the company, and their respective attorneys.While most of the prospectus focuses upon the Company's past successes and future plans, it will also include a section entitled "Risk Factors" which is supposed to present various risks for investors to consider. The Risk Factors are the equivalent of a caution sign. If a disgruntled investor complains at some later date, the company can point to the Risk Factors and simply say, "We told you so!"
Every investment bears risks. Question is, are they bearable? For you? Here are a few things to ponder as you review the Risk Factors:
Does the company warn investors of the need for future financing? If so, does it have other plans – concrete ones – for raising funds? Financial concerns are always a red flag. If the company has repeatedly gone to the well for new financing, you can fairly predict that it will need funding again in the future.
Even if more funding is not an immediate consideration, is the Company financially sound? Check and see whether the Company's auditors are concerned that it may not be able to continue in business as a "going concern." Auditors issue a "going concern" opinion when they question a Company's ability to survive. That fact alone makes for a risky and speculative investment. The prospectus should tell you if the auditors have expressed these reservations, and why. Try to determine whether the Company can cure these problems. And what will be their long-term effect? For example, default on bank loans or a line of credit might affect the company's ability to continue as a going concern and, perhaps just as importantly, make it more difficult to get credit in the future.
Debts can become an albatross around the neck of a business. As an investor, you will want to know whether the Company owes money and, if so, how much and to whom? Is the Company in default on any loans, and what is likely to happen as a result of that default? Will the company be using any of the proceeds from the IPO to pay off this debt, and if so, what will be left over? Some companies can't get off of this treadmill – raising new money and incurring new obligations just to pay off old debt.
A start-up company is almost always a risky investment. But a new line of business for an existing company can be just as risky. Do the Risk Factors warn that the Company is engaged in something new and untested? If so, who are its competitors and what is their experience? If other players in the field are already established and well-funded the Company's prospects for success may be doubtful.
It is important to find out whether the Company has sufficient resources to develop its business. The Risk Factors should provide a clue. Will the Company have to depend upon suppliers, manufacturers, technicians, inventors? Does it have agreements with these people and companies and, if so, what are their terms? If the Company is forced to look for replacements for any of these business partners will they be easy to find, and at what cost? Each of these questions relates to the same central issue – does the Company have the money, personnel, technology and resources to carry out its business plan?
Does the Company's business require technical expertise, patents or trademarks? If the Company is manufacturing, distributing or selling a product does it own the rights to that product or does it license them from another party? What are the terms of any licenses and how would their termination affect the Company's ability to stay in business? It is particularly important to find out whether a license will expire or can be cancelled. A Company's future is indeed precarious if it relies on such a slender reed.
Is the Company's business subject to any governmental regulations (such as those promulgated by the Food and Drug Administration or the Federal Trade Commission)? Are there pending laws and regulations that could adversely affect the Company's plans? Consider what could happen to the Company's business if unfavorable regulations were to be enacted.
Is the Company dependent upon any "key" employees? How unique are their skills? Do they have employment agreements? If so, check out the terms of those agreements. Do salaries seem reasonable in light of the Company's income and history of profits or losses? More importantly, can this Company afford to pay the agreed upon compensation? If a Company appears to be too dependent upon one (or more) employees it may be cause for concern. Can they be replaced if necessary?
Is the Company being sued by anyone? Litigation is expensive – the cost of defending may be steep and the potential liability is often prohibitive. Review the nature of any outstanding lawsuits against the Company. Are the claims covered by insurance? What does the Company (and you as an investor) stand to lose? For example, if a disgruntled ex-employee is claiming that he or she owns the rights to all of the company's patents, the potential consequences to the company could be devastating.
Will the stock be traded on a national stock exchange like the New York Stock Exchange or NASDAQ, on the OTC Bulletin Board or through the "Pink Sheets?" Almost without exception, companies don't list their stock on the OTC Bulletin Board or in the Pink Sheets because they want to -- they do it because thy have to. A Company that lists on the OTC Bulletin Board probably has been unable to meet NASDAQ's more stringent listing standards. Consequently, the Bulletin Board company will generally be less established, lack a history of profits and have fewer assets. The Pink Sheet company may be in even more precarious condition – but you may never be able to find out the details because Pink Sheet companies aren't required to file financial statements (otherwise they would qualify for the OTC Bulletin Board (See, BUYER BE WARY – IN THE PINK). Bulletin Board and Pink Sheet stocks are almost always risky! Be wary of anyone who tries to tell you otherwise.
Read each Risk Factor carefully, no matter how tedious the process may seem. Remember, while specific Risk Factors will differ from offering to offering, each represents a warning to investors – and a protection for the company. Take those warnings seriously.
Catch your breath. In our next installment we will conclude our look at the minefield commonly known as a prospectus.
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