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. So, it has as much to do with the stock market as with fish. Today, we will discuss the importance of red herrings and what you will and won’t find in the red herring prospectus. So, what is a red herring?
Table of Contents
- Red Herring Prospectus Explained
- Contents Of A Red Herring Prospectus
- Red Herring History
- Frequently Asked Questions
Red Herring Prospectus Explained
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). Meanwhile, 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.
Red Herring Perspective (DRHP) Draft
Before any company goes for an IPO to raise money and hits the primary market, it issues a draft red herring perspective. Certain rules must be followed for startups, established companies, or funds wanting to raise money through a formal offering. Securities regulators worldwide and 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 is 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 investor lawsuits. 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 on Draft of Red Herring Prospectus
What is a red herring? And what information can we find in it? Quite a lot. Let’s look and see what it tells us.
- balance sheet
- earning statement
- net proceeds
- the legal opinion of the listings and
- a copy of the underwriting documents
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 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, potential investors can indicate interest if they get a copy of the red herring at least 48 hours before the public sale.
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.
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Contents Of A Red Herring Prospectus
Within the red herring prospectus, you’ll find:
- Purpose of the issue;
- Disclosure of any option agreement;
- Underwriters commissions and discounts;
- Promotion expenses;
- Net proceeds to the issuing company (issuer);
- Balance sheet;
- Earnings statements for the last three years, if available;
- Names and addresses of all officers, directors, underwriters, and stockholders owning 10% or more of the currently outstanding stock;
- Copy of the underwriting agreement;
- Legal opinion on the issue;
- 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 for investors to read.
Before the registration statement has become effective with the SEC, or the “quiet” period, the preliminary documentary or red herring prospectus is distributed.
Once the registration is effective, the final prospectus is prepared and distributed. The final prospectus shows the final public offering price and the number of shares issued. Only then can one consider the public offering of shares complete.
Red Herring History
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 registration statement becomes effective.
As you can imagine, the wording within each filing can be slightly different.
The Cooling Off Period
Twenty days is the minimum 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 becomes ineffective until the deficiencies are corrected.
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 attempts to ensure that all pertinent information is disclosed.
All information about companies listed on stock exchanges is public for everyone to see. But what about companies that are not yet public? These are companies that are gearing up to go public.
Investors can make informed decisions by allowing potential investors access to the firm’s financials, business objectives, business operations, holding market valuation, and other important information.
Real-Life Example Of A Red Herring
On February 1, 2012, Facebook filed a red herring with a bold “red disclaimer .”As you already know, this is 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.”
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 returns in the millions.
Frequently Asked Questions
A red herring example would be a misdirection. Where you want one thing, but something else is promoted to keep you from realizing what you want won't be happening.
A strawman misconstrues the opposing argument to win. A red herring distracts from the main point and gets you to focus on something lesser.