Prospectus - What Is It and How to Read It

Securities and Investment Fraud and Misrepresentation Litigation and FINRA Arbitration Lawyer, Russell L. Forkey, Esq.

The term “prospectus” is a fairly common word that one runs across in investment circles. The Encarta Dictionary defines prospectus as a document that provides official advance information about something that is going to happen in the future. One such area relates to the issuance securities. The purpose of this post is to provide some basic information relative to what a securities prospectus is and what it should contain. Please keep in mind that this information is being provided for educational purposes only. Thus, it is not designed to be complete in all material respects. Therefore, it should not be relied upon as legal or investment advice. If you have any questions, you should consult a qualified professional.

What is a Prospectus?

A prospectus is a document that should disclose all the important facts about a company that is selling securities. It can be an important sales tool for both the company and the brokerage firms that market the securities for the company.

A prospectus is also a legal document. If the stock does not do as well as you expect and you end up in a dispute, the company and the brokerage firms may use the prospectus as evidence that you were given all the important facts about the company and its securities offering.

State and federal law require that you be given a prospectus before you buy securities in a public offering. If you buy securities after the public offering, you may find the kind of information generally found in a prospectus in the annual report, and in reports that companies are required to file with the Securities and Exchange Commission (SEC).

In an effort to make the prospectus easier to understand, the SEC has recently passed a rule requiring that the cover page, summary and risk factors sections of the prospectus be written in “plain English.” This means that companies should use active voice, short sentences, and no legal jargon or highly technical business terms in these sections. However, a prospectus is often prepared by lawyers. Other sections may contain legal jargon. You should make sure that you understand the information in the prospectus. Make sure that any explanations you receive are consistent with the information contained in the prospectus.

You should take whatever time is necessary to understand the information. First, become familiar with the basic parts of the prospectus. Then, consider the information in each part so you can make an informed investment decision.

Parts of a Prospectus and Factors to Consider Cover Page

The Cover Page identifies the company offering the securities, the cost per share, the total amount of money to be raised by the company from the sale of the securities, and the name of the brokerage firms selling the securities. The front page will indicate if it is a preliminary prospectus. A preliminary prospectus is in the process of being reviewed by the SEC and the states where the offering is being registered. Information may be added or changed at a later date. Typically, a preliminary prospectus does not include the purchase price or the number of shares that will be offered for sale.

As indicated on the cover page, neither the SEC nor any state securities division will recommend or offer an opinion concerning the securities offered by the prospectus. Regulators review the prospectus to ensure that it contains the type of information that you need so that you have an understanding of the offering and the risks involved. None of the agencies can attest to the accuracy of that information.

Prospectus Summary

The Prospectus Summary briefly describes the company and its location, the kind of product it sells or the service it provides, its goals for the future, and its plans for achieving those goals.

Read the summary to determine if this is the type of company you are interested in, and if its goals seem to be achievable.

Risk Factors

The Risk Factors section lists and briefly explains the risks relating to the operation of the company, sale of its products or services in the marketplace, and other factors that may affect the ability of the company to succeed. Often, a risk factor will refer you to another part of the prospectus that contains a more detailed discussion of that particular risk.

As you read through the rest of the prospectus, consider whether these risk factors are acceptable to you. Risks may be common to the industry (e.g., the price or availability of a raw material, a highly competitive market), or unique to the company (e.g., a very high debt ratio, dependence on key personnel). Look for risks that may affect the company after you have invested in it (e.g., the risk that the company’s product may become obsolete).

Prospectus relating to initial public offerings many time contain phrases such as “you should only invest if you can afford to lose your entitle investment.” Consider this type of disclosed risk factor carefully.

Use of Proceeds

The Use of Proceeds section explains how the company plans to spend the money raised in the offering.

Examine the intended use of funds received from the offering. If a substantial percentage of the proceeds is to be used for “working capital,” management has broad discretion to use these funds, including using money for purposes not discussed in the prospectus.

Dividend Policy

The Dividend Policy section explains whether the company plans to pay a portion of its profits to investors, or whether all the profits will be kept by the company to finance its growth.

If receiving income is important to you, you may not want to invest in a company that does not pay dividends.


The Capitalization section identifies the amount of money owed to creditors, received from shareholders, and generated from operations, both before and after the offering.

Check to see whether the company’s cash flow appears to be adequate to pay its debts. To obtain details of the company’s long-term debt, refer to the Notes to the Financial Statements.


The Dilution section compares the book value per share (i.e., assets minus liabilities divided by number of shares of common stock outstanding) with the price you are paying per share.

If the book value per share is substantially less than the price you are paying per share, you may be paying too much for your shares.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The Management’s Discussion and Analysis of Financial Condition and Results of Operations section provides management’s explanation of how the company has performed in each of its most recent quarters and years.

This section gives you an idea of positive and negative trends in earnings and expenses. Read it carefully to see if you agree with management’s estimations of the company’s financial condition.


The Business section presents a detailed description of the company’s history, business plan, method of operation and competition.

Look at the age and track record of the company, as well as the market for the company’s products or services. Consider whether the market for the company’s products or services seems to be growing. Note if the company is dependent on a few key clients or key suppliers. Understand who or what constitutes competition for the company.


The Management section identifies the officers and directors who run the company, describing their education and work experience. It also identifies the officers who receive more than $100,000 a year in compensation.

Consider how much experience in a similar type of business the management brings to the company, and how much time each member of management will devote to the company. Also, check to see if management consists of one or two key individuals and how dependent the company seems to be on these individuals (this may also be discussed in the Risk Factors section). In the subsection on compensation, note any special option plans, stock appreciation rights or other “unusual” compensation arrangements. For example, consider whether you want to invest in a company whose management is only part-time and receiving huge salaries and benefits or stock options.

Certain Transactions

The Certain Transactions section identifies transactions between the company, its officers and directors, and other parties related to the company or to management. This discussion highlights possible areas that could lead to conflicts of interest, or special, favorable treatment being given to insiders or other related parties.

Look for loans to officers and directors, or for leases of equipment or space from members of management. Some of these transactions may not be competitive, or in the best interest of the company.

Principal Shareholders

The Principal Shareholders section discloses how much of the company is owned by management, and identifies executive officers, directors and individuals who own more than 5 percent of the company.

If you look at the table of shareholders, you can tell whose ownership is changing because of the offering. If a number of the original investors are selling out, they may know something about the company that you do not.


The Underwriting section lists the brokerage firms responsible for the sale of the securities, and describes how they are compensated for selling the securities.

Check to see if the offering is “firmly underwritten” or offered on a “best efforts” basis. In a “best efforts” underwriting, the brokerage firm does not guarantee that all the shares offered will be sold, and only promises to use its “best efforts” to make the offering a success. Firm underwriting means that the brokerage firm has committed to buy all the securities offered. Thus, in a firm underwriting, the company is virtually assured that it will receive all the money it hopes to raise in the offering.

Financial Statements and Notes

The Financial Statements and Notes section describes the financial condition and performance of the company, including whether the company made a profit or sustained a loss during its most recent year of operation.

Check the auditor’s letter to see if the auditor expresses a concern about the ability of the company to remain in business. Take the time to read through the notes, which will provide insights into the business operations of the company.

In Conclusion

Although these considerations will help you make an informed investment decision, they are not comprehensive. You need to do your own homework, and use your own judgment.

Before making any investment, be certain that you know what you are investing in and what risks you are taking. Make sure that you are given a copy of the prospectus, and read it before you invest. If you don’t understand a part of the prospectus, don’t hesitate to ask your stockbroker or other financial professional for assistance. Even if, with the additional assistance, you don’t understand the investment or your gut tells you that there is something about it that you just don’t like, don’t invest. Why take a chance?

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