What Should I Look for in an IPO Prospectus?

An Initial Public Offering (IPO) prospectus is the report prepared by a corporation when it is seeking to raise capital from investors by selling company shares of stock to the public. The IPO prospectus details the reasons for the IPO, how the company plans to use the capital raised, and the risk factors involved in the business. Careful evaluation of the IPO prospectus can help a potential investor steer clear of a company that is seeking money to bail itself out of a difficult financial situation or allow some shareholders to sell their ownership in the company.

An IPO prospectus is a lengthy and wordy document that can be confusing to someone unfamiliar with the format or the terminology. It contains many details about the company and its business environment and considers many possible risks. A potential investor should focus on learning about the company's recent performance and the reasons for the IPO.

In general, an investor should look for a company that is a "going concern," i.e., an entity that is profitable and growing with well-managed operations, no excessive indebtedness, and no recent major problems. In the section of the IPO prospectus called "Summary Consolidated Financial Data," the company's most recent financial results will be presented; in the section titled "Management Discussion and Analysis," company executives provide an analysis of the balance sheet. Revenue for the current year that is less than the prior year or a profit margin for the current year that is lower than the prior year can be a warning sign unless these issues are adequately explained by the management analysis. If the accounting firm expresses any reservations about the company's financial procedures or its ability to remain in business in the "Report of Independent Auditors," this too is a major warning sign.

In the section titled "Use of Proceeds," the reader will find the company's declaration of how it intends to use the capital raised by the IPO. If the capital will be used to pay off debts or to purchase shares from earlier investors, this might indicate that the company is having problems maintaining cash flow or that the earlier investors are uncomfortable retaining their investment in the company. A more positive option would be the intended use of capital to expand or upgrade facilities for anticipated growth. If the company wants to modernize processing equipment or computer systems, these are also forward-looking uses of capital that might be detailed in the IPO prospectus.

Another consideration of the IPO prospectus is the environment in which the company operates. If it produces only one product with a limited potential market, this will affect its ultimate success. Companies that rely on only one or few principal customers might also be in serious trouble if those customers take their business elsewhere. Potential regulatory changes or pending litigation might also have an impact on future growth. All these potential problems should be laid out in the section called "Risk Factors."

A person reviewing an IPO prospectus should do enough study and investigation to be comfortable with the company and its operating environment. Additional analyses provided by investment banks and underwriters can assist the potential investor because these analyses are prepared by financial professionals who are in the business of evaluating the financial health of companies. If the investor still has concerns, addressing questions to the company directly or to the investment bank representing the IPO can provide answers.