How to Read an IPO Prospectus
The IPO market is red-hot these days, but before you invest in an IPO, you need to read the prospectus. Here's what to look for and where to find it.
IPOs are back — and so is the hype. SpaceX (SPCX) launched its record-breaking initial public offering in June, and artificial-intelligence heavyweights Anthropic and OpenAI have also filed to go public, although there's talk that the latter, the developer of ChatGPT, may delay its upcoming IPO until 2027.
With Wall Street bringing its brightest, shiniest objects to market, investors thinking about owning a piece of these freshly minted public companies can't buy blindly. It's due diligence time. Homework time. And that means it's time to study the IPO prospectus. This legal document, known as the S-1, is akin to a company confessional, as it lays out the investment thesis, spills financial secrets and flags every risk imaginable.
"The prospectus is the first time a significant light is shined on a private company," says Kaush Amin, head of private market investing at U.S. Bank Asset Management.
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A prospectus can be dry, technical and feel like hundreds of pages of fine print — because it often is. It's still a must-read. Just as a home buyer shouldn't purchase a house without reviewing the inspection report, no serious investor should risk buying shares of a newly public stock without reading the prospectus.
"That’s where the real story is," says Robert Edwards, chief investment officer at Edwards Asset Management.
Another consideration for investors is the health of the IPO market itself. With the bull market still on solid ground and investor sentiment upbeat, investment bankers want to take advantage of the open window to get deals done and take previously private companies public.
This year is shaping up to be the best year for IPOs since the 2021 boom, according to research firm PEInvest. Wall Street tends to roll out its star IPOs first. And as investor excitement builds, Wall Street rushes out more speculative, lesser-known unicorns, which can carry greater risks.
An IPO that's good for Wall Street bankers may not be good for Main Street investors. "The later stages [of an IPO cycle] is when people get caught investing in bad stories," Edwards warns.
You don't need a PhD in finance or an accounting degree to translate a prospectus's thicket-like prose into plain English. The key is to know what to look for and where to find it so you can digest the needed information to make an informed investment decision.
"The prospectus is really the only place that you're going to get an accurate picture of the company's health," says Erin Kolo, a portfolio manager at money management firm Baird.
Because a stock prospectus isn't as fun, well written or easy to read as a James Patterson whodunit, you might be relieved to learn it's not necessary for you to read it from cover to cover.
You can glean the key highlights, such as what the company does, who's running it, how it makes money, whether it's profitable and, most critical, what the risks are, by reading just a few key sections.
We'll point you to the parts that are necessary to review and the most important disclosures to search for. Think of the information below as a plain-English, CliffsNotes-type guide to a prospectus.
Among them:
The prospectus summary
Your first stop should be the summary. This provides you with a high-level overview of the company's mission and ambitions; its business model, along with key growth drivers and risks; its current sales and earnings (if it makes money); and future revenue and profit estimates.
It may also include financial details such as the total addressable market (TAM) that management is projecting (SpaceX's S-1, for example, cited a TAM of $28.5 trillion). Your job is to try to figure out whether a company's lofty expectations are truly within reach.
"Do some homework, ask some questions and challenge the assumptions in the prospectus," says Amin.
Risk factors
This is where the company fesses up to everything that can go wrong. It’s full of red flags. It's akin to "Caution" signs you see driving down the freeway: The purpose is to warn of potential trouble you might have to navigate. "You want to fully understand how your investment might not pan out," says Kolo.
Think of this section as a risk checklist. There are countless things that could get in the way of a promising investment. Examples of risks to look out for include: Intense competition. Regulatory hurdles. Legal challenges. Too high a reliance on a single customer. Negative cash flow.
Reliance on unproven technologies (or technologies that don't yet exist). Or growth projections that are too aggressive and may never come to fruition. "The risks are all there; they're all listed," says Edwards.
Use of proceeds
The goal of an IPO is to raise money, so it's important to know how the company will use the money it raises. What you want to see is the company earmarking the bulk of the proceeds to fuel growth.
For example, funding research and development, recruiting top talent and developing new products are better uses of the cash than, say, paying off debt.
Management discussion and analysis
This part of the prospectus is where management gets to present its side of the story to prospective investors. It provides color on the company's financial condition, recent business trends and future strategy. It includes all the relevant numbers on net income, revenues, cash flow, earnings and debt.
Make sure to inspect the balance sheet, income statement and other key data points.
More importantly, management explains why the numbers are what they are. Company execs explain, for example, why sales plunged or skyrocketed, why there's no cash flow yet, why they're betting big on a new product or market, or why it might take longer to meet their growth targets and post a profit than originally planned.
"The analysis tells you what's happening with the company and why," says Edwards.
Management
If you're going to invest money in a company, it's important to learn about who's running it and their track record. You wouldn't invest in a company that's seeking to make money by flying to Mars or the moon, as SpaceX is, if the top executive made his or her mark in the fashion business. The management section of a prospectus is an executive bio page on steroids.
"I go to the management-team section first," says Steven Conners, founder and president of Conners Wealth Management. "If they can't execute the business plan well, it doesn't matter how good their product is."
Conners looks for executives with a record of success — preferably graduates from leading universities who have work experience at the world’s top companies. "That adds credibility," says Conners.
Other things to look for include any special stand-alone sections at the end of the prospectus, such as the "Index to Financial Statements" included in the SpaceX S-1. Do a deeper dive here. These can add additional insights into the company's financial condition.
Finally, make sure to read about the timing of share lockups (the date insiders and other investors can sell IPO shares for the first time). This information can be found in sections with names such as "Shares Eligible for Future Sale," "Plan of Distribution" or "Underwriting," or by searching the prospectus using key words or phrases such as "lockup" or "restricted period."
Most lockups permit selling 90 or 180 days after the IPO although SpaceX is using a novel staggered structure. "Circle the [lockup] date on your calendar," says Edwards. "That's when you’re going to find out what the smart money really thinks of the IPO."
If you're tempted to skip the prospectus before buying an IPO, think again, says U.S. Bank's Amin. Without it, "you're just making a bet based on hype and hope."
An exciting IPO can be tempting, but it should be just one part of a well-diversified investment strategy.
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Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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