What Is a Red Herring?
A red herring is a preliminary prospectus filed by a company that’s planning an initial public offering, or IPO. While a red herring prospectus includes coverage of the company’s operations, total estimated IPO amount, management and competitive market standing, it doesn’t reveal the share price or number of shares to be issued.
The SEC reviews the red herring prospectus, and all subsequent iterations, to make sure that all information is accurate before allowing the company to transition to the final investment prospectus phase.
A red herring prospectus has both investment and regulatory implications for companies heading toward an IPO, and any investors who may be interested in obtaining IPO stock.
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.
• A red herring is not final, and investors must take into considerations that the filing doesn’t include the share price for the IPO or the number of shares to be issued.
• The SEC reviews a 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 offer investors some insight into the pros and cons potentially associated with trading IPO shares of the company in question.
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.
Red Herring Prospectus
When a company transitions from a private company to public stock issuance, they must file a prospectus, a formal document sharing the new company’s structure, the purpose of the issue, underwriting, board of directors, and other relevant details with the Securities and Exchange Commission (SEC).
That prospectus, while not final, may help potential investors make 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.
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, owing to the volatility of these shares.
The risks associated with IPO stock is a significant reason why investors are typically asked to meet certain requirements in order to trade IPO shares through a brokerage.
💡 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.
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How a Red Herring Works
Prospectuses are dynamic and change regularly, as new information about a company 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 S-1 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.
Recommended: A Guide to Tech IPOs
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 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: 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.
Red Herring Pros and Cons
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.
Red Herring 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.
Red Herring 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
Red Herring Example
A red herring prospectus when filed with the SEC may have the words “Red Herring” stamped on the document as a reminder to prospective investors that the information in the document is subject to change, and that the securities (i.e. shares of stock, or bonds) are not available for sale until the SEC has approved the final prospectus.
The statement typically included in a new company’s prospectus may say:
The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.
The Takeaway
The red herring prospectus is the first version of a new IPO company S-1 prospectus, and may be the first detailed impression that institutional investors and 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.
FAQ
How does a red herring document differ from the final prospectus?
The red herring document is usually shorter than the final filing with the SEC. In addition the final document contains the number of shares in the IPO, as well as the IPO price.
Are there any legal or regulatory requirements associated with red herring documents?
Yes. The SEC must validate all claims and data included in the red herring to ensure that it does not include any false information, or anything that might violate existing laws and regulations. Once the red herring passes muster,
Can investors rely on the information provided in a red herring document when making investment decisions?
Investors may use the red herring document to inform their basic understanding of the company that is seeking an IPO, but it may not be enough to guide an actual decision to buy shares.
Are there any risks or limitations associated with red herring documents that investors should be aware of?
Red herring documents are an important part of a new company’s IPO process, and as such they contain key information about the company, but investors need to be aware that the details are not finalized, and the terms may change before the final prospectus is filed.
Photo credit: iStock/Riska
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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.
New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
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