What Is A Red Herring?

What is a red herring? Believe it or not, a red herring does not only mean a soft, red bony fish. It’s a document submitted by a company as part of an IPO. It has as much to do with the stock market as it does with fish. For today, we’re going to talk about the importance of red herrings and what you will and won’t find in the red herring prospectus. So what is a red herring?

What Does It Mean When Someone Says It’s a Red Herring?

What Is a Red Herring

What is a red herring? A red herring prospectus is a document submitted by a company (issuer) as part of an initial public offering of securities.

These securities are either stocks or bonds. Which is something we all either trade or invest in.

More often or not, it’s associated with an initial public offering (IPO). Like the Form S-1 registration, the red herring prospectus must be filed with the securities and exchange commission (SEC).

A lot of people get excited about IPOs too.

What Is A Draft Red Herring Perspective (DRHP)

Before any company goes for an IPO to raise money and hits the primary market, it issues a draft red herring perspective. For startups, established companies or funds wanting to raise money through a formal offering, certain rules must be followed. Securities regulators worldwide, as well as investors in a private offering, require the company (Issuer), to submit a professional preliminary red herring prospectus.

This document is filed with a market regulator and is also known as an offer document or preliminary registration document. In short, the draft red herring prospectus serves as a crucial communication link between the company, its investors and shareholders. 

Within the draft red herring prospectus are the reasons for the IPO, the risks involved, and how the capital raised will be spent. The information also protects the issuing company (Issuer) against any lawsuits from investors. In some cases, investors t claim pertinent information was not fully detailed before the investor put money into a security.

Risks are typically disclosed early in the prospectus and described in more detail later. 

Information Contained Within The Draft Red Herring Prospectus

What Is a Red Herring

What is a red herring? And what information can we find in it? Quite a lot actually. Let’s look and see what it tells us.

-balance sheet

-earning statement

-net proceeds

-legal opinion of the listings and

-a copy of the underwriting documents

A Red Herring Prospectus: An Incomplete Picture

 A red herring prospectus is incomplete, and that’s ok. Below is what potential investors won’t see:

-the number of securities to be issued or, 

– the details of the price 

The Disclaimer

 The front page of the prospectus contains a bone draft disclaimer explaining the information in the prospectus:

– is not complete;

– can be changed, and;

– the securities may not be sold until the registration statement filed with the market regulator is effective. 

Expressions Of Interest

Potential investors are prohibited from placing buy orders based solely on the information contained within the pulmonary prospectus. However, if potential investors get a copy of the red herring atleast 48 hours prior to the public sale, they can express an indication of interest.

Once the registration statement is effective, and the stock is offered to the public, these indications of interest can be converted to purchase orders. At this point, the final prospectus must be promptly delivered to the buyer. 

Contents Of A Red Herring Prospectus

Within the red herring prospectus, you’ll find:

  1.  Purpose of the issue;
  2.  Disclosure of any option agreement; 
  3. Underwriters commissions and discounts;
  4. Promotion expenses;
  5.  Net proceeds to the issuing company (issuer); 
  6. Balance sheet;
  7. Earnings statements for the last three years, if available;
  8. Names and addresses of all officers, directors, underwriters and stockholders owning 10% or more of the currently outstanding stock;
  9.  Copy of the underwriting agreement;
  10.  Legal opinion on the issue;
  11.  Copies of the issuers’ articles of incorporation.

Why Do We Need A Red Herring Prospectus?

Since the SCC form S1 registration statement is complex and long, the Securities Act of 1933 requires the preparation of a shorter document. This shorter document is known as a prospectus and is used for investors to read.

When Is The Red Herring Prospectus Distributed?

Before the registration statement has become effective with the SEC, or the “quiet” period, the preliminary documentary or red herring prospectus is distributed. 

When Is The Final Prospectus Prepared?

Once the registration is effective, the final prospectus is prepared and distributed. Within the final prospectus, you’ll see the final public offering price and the number of shares issued. Only then can one consider the public offering of shares complete. 

Where Does The Term Red Herring Come From?

The name red herring refers to the red letter disclaimer displayed on the front page of each preliminary prospectus. That disclaimer contains statements similar to the following:

 -A registration statement relating to insecurities has been filed with the SEC but has not yet become effective.

-Information contained here is subject to completion or amendment.

-These securities may not be sold or made offers to buy be accepted before the time the registration statement becomes effective. 

As you can imagine, the wording within each individual filing can be slightly different. 

The Cooling Off Period

Twenty days, that’s the minimum amount of time between registration filing and its effective date. We also refer to this as the “cooling-off period.” During this time, the SCC can deem that registration deficient, in which case registration does not become effective until the deficiencies are corrected.

Did You Know?

 The SCC does not approve the securities registered with it, does not pass on the investment merits, nor guarantees the accuracy of the statements within the registration statement or prospectus. Instead, the SCC merely attempts to ensure that all pertinent information’s disclosed.

All information about companies listed on stock exchanges is public domain for everyone to see. But what about companies that are not yet public? These are companies that are gearing up to go public. 

Making Informed Decisions

By allowing potential investors access to the firm’s financials, business objectives, business operations, holding market valuation, and other important information, investors can make informed decisions. 

A Real-Life Example Of A Red Herring 

On February 1, 2012, Facebook filed red herring with a bold “red disclaimer .”As you already know, this is basically a Form S-1 with a disclosure. It read as follows:

“The information in this prospectus is not complete and may be changed. Neither we nor the selling stockholders may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and neither we nor the selling stockholders are soliciting offers to buy these securities in any state where the offer or sale is not permitted.”

Final Thoughts

As you know, fortunes are made getting in on the ground floor of new ventures. The allure of startups attracts many with extra cash hanging around. If you’re lucky enough to get in as an angel investor in a company that goes parabolic, you can see return’s in the millions. 

 As we always say at Bullish Bears, take your time and do your due diligence. Before you throw your money into some new fancy, start-up, take the time to read the red herring prospectus. 

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