Prospectus in Investment Banking - Part 1

The job of an investment banker includes enabling the flow of information between the company and its investors. When a company is going public for the first time, investors do not have any information about the company. As such, they do not have a strong basis for making a well-informed decision. Hence, it is the job of the investment banker to ensure that all the information is communicated to the prospective shareholders and to the public at large.

Investment bankers have traditionally prepared a document called a prospectus to share all this information with prospective investors. The prospectus is a huge document that often runs into hundreds of pages and provides detailed information that has the potential to enable decision making.

In this article, we will have a closer look at some of the information which is typically contained in a prospectus document.

Summary

As mentioned above, the prospectus document contains hundreds (even thousands) of pages of detailed financial information. Most of the investors do not have the know-how or the time to go through this detailed information. This is the reason why investment bankers usually include a summary of the entire deal at the beginning of the prospectus. This summary often contains a lot of information in a tabulated form. However, investors are most interested in looking at the number of shares which the company is looking to sell as well as the price band in which the sale will be made. Another important piece of information that the investors are generally interested in knowing is why the company is trying to sell shares. This helps them understand the company's value proposition, its target market, as well as how the company plans to serve its target market.

Risk Factors

The prospectus is a legal document using which investment bankers and the company are soliciting money from the investors. Hence, it is the job of the investment bankers to ensure that investors are aware of all the possible risk factors involved. This is a part of the legal requirement that investment bankers are supposed to fulfill. The risk factors include a broad range of risks that the company faces. This includes market risks, financial risks, and all other risks. The law mandates that investment bankers must make this document as comprehensive as possible. Educated investors use this information to understand the risk and the cost of capital that the company faces. The purpose of this section is to prevent the company and investment bankers from lawsuits in case the stock investments do not work out as intended.

How the Proceeds will be Used?

The public markets are powerful took of capitalism. They allow companies to raise several hundred millions of dollars almost instantaneously. Hence, the rules to access the capital markets have been framed in such a way that the misuse of capital markets is avoided. When companies and their investment bankers access public markets, they are supposed to explain exactly how the proceeds from the sale of shares are going to be used.

The most common use of the proceeds is to fund the expansion of the company in the same market or in different markets. However, there are several other purposes commonly used. Sometimes, the proceeds are used to pay off large portions of debt, which may be weighing down the profitability of the company in the short run. Many times, companies also sell stock to fund an acquisition or even to allow employees to cash in their stock options. The purpose mentioned here is legally binding, and the company cannot divert the funds to a different purpose unless it has approved by the shareholders' body.

Industry and Competitive Structure

The industry in which the investors' are putting their money obviously has a huge bearing on the returns which the shareholders can expect. For instance, investors can expect a high margin when they invest in the technology industry. On the other hand, they can expect a lower return when they invest in utilities or grocery stores. The competitive structure also has a large bearing on the returns which the investor can expect. If the company has access to some sort of proprietary technology that makes them better than their competitors, then they are likely to capture a higher market share and earn more money.

Management Discussion and Analysis

This is the section wherein the investment bankers and the management can discuss their analysis of the current scenario. This section provides them with the opportunity to make a compelling case about why their company will make significant profits in the future. In this section, investment bankers generally provide a line by line detail of the expected financial statement. The statements provided in this section show projections over a number of years. This allows investors to estimate cash flows in the future and create a discounted cash flow analysis.

The bottom line is that the prospectus is a detailed document that provides a lot of information. Only some sections of the prospectus have been explained here. There is more information contained in the prospectus, which will be explained in the next article.