The term “red herring” usually refers to a misleading clue or statement, but when it comes to initial public offerings (IPOs) a red herring is a preliminary prospectus filed by a company that’s planning the IPO.
A red herring provides information on an IPO company, including coverage of its operations, total estimated IPO amount, management and competitive market standing. But it does not delve into the company’s financial information or reveal the share price or number of shares to be issued.
A red herring IPO stock has both investment and regulatory implications for newly minted IPO companies, and any investors who may be interested in steering some portfolio cash into these companies.
Key Points
• A red herring in an IPO is a preliminary prospectus filed by a company that provides information on operations, estimated IPO amount, management, and market standing, but doesn’t include financial information.
• A red herring combines both an IPO and an investment prospectus, and is a preliminary prospectus filed for review with the SEC.
• The SEC reviews the red herring prospectus to make sure that all information is accurate before allowing the company to transition to the final investment prospectus phase.
• Red herrings typically offer more pros than cons, but investors should understand the risks associated with trading IPO shares.
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What Is an IPO Red Herring?
To better understand a red herring in IPOs, investors need to understand both the IPO and accompanying investment prospectus.
IPOs, Explained
An initial public offering is the process through which a private company goes public, with shares of the company’s stock available to the investing public. The term “initial public offering” simply refers to a new stock issuance on a public exchange, which allows corporations to raise money through the sale of company stock.
💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.
Investment Prospectus, Explained
When a company transitions from a private company to public stock issuance, they must file a prospectus, a formal document sharing their financial picture with the Securities and Exchange Commission (SEC). That prospectus helps potential investors make good investment decisions based on the information included in the prospectus. A prospectus doesn’t just cover stocks — it’s also required for bonds and mutual funds.
Recommended: A Guide to Tech IPOs
Red Herring, Explained
A red herring combines both an IPO and an investment prospectus. A red herring in a preliminary prospectus filed before the actual prospectus is completed (it’s the first prospectus investors see). Companies file their red herring prospectus for review with the SEC.
As noted above, a red herring provides essential information on the company that’s about to debut in the public marketplace, including its operations, total estimated IPO amount, management and competitive market standing. Typically the red herring doesn’t get into the company’s financial information.
A traditional prospectus would normally include a stock’s share price and the number of shares made available to investors when the IPO commences, but a red herring prospectus does not. Still, the red herring prospectus contains a lot of the information that investors would want to know if they’re thinking about purchasing an IPO stock.
The more information that investors can collect about a stock, the better understanding they’ll have about whether it fits with their portfolio strategy and what type of investment risk they might need to consider. While all stocks include some degree of risk, IPO shares are particularly high-risk investments. Despite the media hype around many IPOs, which often focuses on big wins, the history of IPOs shows plenty of losses as well.
This is one reason why investors are typically asked to meet certain requirements in order to trade IPO shares through a brokerage.
How a Red Herring Works
Prospectuses are dynamic and change regularly, as new information comes forth. So, an investment prospectus will likely have multiple drafts before a final draft is released after SEC review.
In a red herring document, the prospectus is incomplete and noted as such, with the word “Red Herring” included on the prospectus cover. That disclaimer lets readers know not only that the prospectus is incomplete, but also that the company has filed for an upcoming IPO. The term “red herring” refers to both the initial prospectus and the subsequent drafts.
Additionally, a stock cannot complete its IPO until it fulfills the registration statement process, which is a primary reason why a red herring prospectus doesn’t include a stock price or the number of shares traded.
The SEC will review a red herring prospectus prior to its release to ensure that all information is accurate and that the document does not include any intentional discrepancies, falsehoods or misleading information.
Once regulators clear the registration statement, the company can go ahead and transition out of the red herring IPO phase and enter into the final investment prospectus phase. The time between the approval of the registration process and the time that it reaches its “effective date” (which clears the stock for public trading) is 15 days.
In clearing the IPO for stock market trading, the SEC does not hold any position on the stock, it simply confirms the necessary information is included in the final prospectus and that the information is accurate and compliant, based on U.S. securities law. Once the company gets through that hurdle they can continue moving through the IPO process.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
Red Herring Pros and Cons
Red herring IPO prospectuses typically offer more “pros” than “cons,” but any investor looking to invest in an IPO stock should understand the benefits and investment risks when it comes to red herrings and in investing in IPOs.
Advantages
• Useful overall information on the company. While investors won’t find any information on pricing or share amounts, they can review company history, operational strategies, management team, potential IPO amount, and market performance, among other company particulars.
• Some financial data points. Red herring IPOs may provide valuable information about how a company plans to use proceeds from an IPO stock offering. Knowing, for example, that a company plans to use stock proceeds to grow the company or to pay down debts gives investors a better indication of company direction, which they can use to make more informed investment decisions.
• Risk factors. Under a section known as “Risk Factors”, a soon-to-be publicly-traded company lists any potential risk factors that could curb performance and growth. Legal or compliance problems, abundant market competition, and frequent management turnover are just some of the potential risks included in a red herring IPO prospectus – and investors should factor those risks into any potential investment decision.
Disadvantages
• No pricing data. The biggest drawback of red herring IPO prospectus is the fact that the documents don’t provide any guidance on IPO stock pricing or number of shares available. These are obviously critical components of any investment decision, but investors must wait until the registration statement process is fully complete before that data is available.
• Shifting information. IPO company information can and does change from document version to version. Investors need to be diligent and stay apprised of all information on red herring prospectuses, from version to version, if they’re interested in an IPO stock.
• Uncertainty. If government regulators cite deficiencies in a red herring prospectus they may half the IPO process until they’re addressed.
Recommended: SPAC IPO vs Traditional IPO: Pros and Cons of Investing in Each
The Takeaway
The red herring prospectus is the first version of a new IPO company prospectus, and may be the first detailed impression the investing public gets of an initial public offering.
By providing all the necessary information on a new publicly traded company (minus the opening share price and the number of shares available), a red herring prospectus can introduce investors to a new stock, which can provide much of the information necessary for investors to decide whether they’re interested in the company, and willing to assume the risks involved in trading IPO shares (if eligible).
Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.
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Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.
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