Definition

Red Herring

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What is Red Herring?

Red herring prospectus is often associated with an initial public offering (IPO), it is a first or preliminary introductory leaflet or offer document filed by the issuer company as part of a public offering of securities (such as shares or bonds) with the Securities and Exchange Commission (SEC) to raise money from the public. The Red herring document contains most of the information related to the issuer company’s operations, promoters, financials, prospects, and its objective for raising funds by filing an IPO.

Further, it also explains how the issuer company aims to use the raised money and the possible risk in investing, which help investors to identify if the company has potential or not and if it is right company to invest in.

The red herring does not include key details of price or number of shares being offered or the amount of issue, which means if the price is not disclosed, the number of shares and the upper and lower price bands are disclosed. On the other hand, the company can give details on the number of shares and the issue size that are determined later. As the prices can’t be determined until the bidding process is completed.

Understanding Red Herring

Red herring prospectus may be referred as the first document filed with the Securities and Exchange Commission (SEC) with various other following drafts created prior to obtaining approval for public release. To get the approval, the SEC thoroughly review the red herring document provided by the company to ensure that all the information provided does not include any incidental falsehoods or intentional or statements that violates the rules & regulations and laws.

The cover page of the red herring displays a bold red disclaimer, stating the information in the preliminary document is not complete and may be changed as and the securities may be sold until the registration statement being offered has been filed with the SEC but has not yet become effective.

Once the registration statement become effective the issuer company circulates a final prospectus with details regarding the final IPO price and issue size. Then the investors may express an “indication of interest” in the offering to convert to orders for the issue at the buyer’s option.  The minimum time between the registration statement filing and its operational date is 15 days.

The Securities and Exchange Commission (SEC) does not approve the securities but ensure that the information in the preliminary document are relevant and according to regulations and laws.

Contents in Red herring

The red hearing statement contains:

  • Prospectus summary
  • Purpose of the issue
  • Underwriter’s commissions and discounts
  • Disclosure of any option agreement
  • Net proceeds to the issuing company (issuer)
  • selected consolidated financial and other data
  • copy of the underwriting agreement
  • earning statements for last 3 years, if available
  • names and address of all officers, directors, underwriters, and stockholders owning 10% or more of the current outstanding stock
  • Copies of the articles of incorporation of the issuer and legal option on the issue.
  • Promotion expenses
  • Dividend policy
  • Risk factors
  • Legal and other information

Where can an investor find red herring prospectus?

  • The Issuer company’s website
  • The website of the merchant banker
  • The website of the Securities and Exchange Commission (SEC): sec.gov

How do companies prepare a Red Herring Prospectus

The issuer company going public approaches a merchant banker to prepare the preliminary document. The merchant banker ensures that the potential investors are aware and keeps in the loop of the public issue and it also takes care of all the legal compliance issues.

Things to look out for in a Red Herring Prospectus

  1. Industry and Business overview

The industry overview segment in the red herring provides a macroeconomic view that includes GDP growth and consumption patterns of the country’s economy.   The industry overview segment provide information’s about demographics, opportunities, risk, growth drivers and macro & micro level analysis of the industry and its sub-segments

  1. Strengths

The preliminary document lists the internal and external strengths of the company, which differentiate the company with its competitors. The strength of the company can help investor in understanding its future growth potential.

  1. Strategies

This section gives a brief detail about the strategies of the company to establish and expand its business. It can help investors in understanding the company’s approach to generate profits.

  1. Operations

The operation segment provides brief information about the processes and systems followed by the company to offer its products and services to make investors understand the way the company goes about its business.

  1. Financial information

It is one of the most important segment which contains financial statements and audit reports. The investor may get an idea of profit and growth potential of the company and can gauge the profitability and risk factor of the future investment growth based on the financial statement. 

  1. Risk Factor

The company list out all the potential risk factors that could impact their operation, business and investors investment growth potential. As investors you need to read carefully between the lines to identify the real risks that may affect business future growth.

  1. Management

The management is responsible for planning strategies and many take many other important decisions for the company. So it’s really important to know who are running the business. This section has details such as name, designation, qualification and other important information about the board of directors of the company.

  1. Use of Proceeds

This section gives detail about the reason behind the capital raised through the IPO. And what are the plans of the company to utilize the capital collected.  It can be to reduce debt, purchase of new assets or working capital needs. 

  1. Capital Structure

This section gives brief information about the company’s capital structure that is the ratio between the debt and equity used by the company to finance its overall operations.

  1. Dividend Policy

However, it is not compulsory for the company to declare dividends, but some company has dividend policy that is declared in this section.