The term “red herring” usually refers to a misleading clue or statement, but it has a different meaning on Wall Street. For investors, a red herring is a preliminary prospectus filed by a company that’s planning an initial public offering (IPO).
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.
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.
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, which allows corporations to raise money through the sale of company stock.
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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.
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.
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.
A traditional prospectus would normally include the IPO share price and the number of shares made available to investors when the IPO commences. 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.
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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 IPO 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 US securities law. Once the company gets through that hurdle they can continue moving through the IPO process.
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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.
• 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.
• 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.
The red herring IPO is the first version of a new IPO company prospectus and may be the first detailed impression the investing public gets of a new IPO 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 IPO can introduce an investor to a new stock, which can provide much of the information necessary for investors to decide whether they’re interested in the company.
If you’re interested in IPO investing, a great way to start is through the Sofi Invest brokerage platform. The new IPO Investing feature allows members to access IPO shares before they’re listed on the public stock market.
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