Why mustn’t you skip IPO prospectus?

IPO is an excellent way to invest early in a company for long-term growth. Over the last few years, the Indian IPO market (primary market) has seen a significant boost in the number of IPO launches, with several offers receiving oversubscription. Given the scenario, one feels motivated to apply in IPOs. However, making an informed decision is critical for any investment, including IPOs.

Every IPO is associated with a prospectus. IPO prospectus is a document that contains necessary details regarding the issuing company and the offer, which help investors evaluate risk-return prospects. It is quite a bulky document, but there are five broad areas which you mustn’t miss.

What is an IPO prospectus?

An IPO prospectus, also called the Red Herrings Prospectus (RHP), is the most important document associated with an initial public offering (IPO). It is the critical marketing and legal document issued by the company to inform investors.

A new IPO prospectus includes all material information related to the offer, including company background, details related to offer size, price, dates, risks, regulatory landscape, and financial condition prevailing at the time of the offer.

Every company desirous about launching an IPO offer needs to file an IPO prospectus with the SEBI. It is an authentic document since published by the company and approved by the market regulator.

There are five critical sections in the prospectus which investors must never overlook while selecting potential IPOs for investment.

It Tells Everything About The Company

It is the starting point of understanding the IPO.

Behind every IPO offer, there is a business. And, the IPO prospectus gives you a glimpse of that. It tells about the industry in which the company operates, its position against peers, unique strengths, and advantages. It also discusses the challenges of changing business landscape, which can impact the return on your investment. For instance, a traditional firm may face challenges from emerging new businesses.

A prospectus discloses challenges and the company’s ability to withstand those to create unique value for its investors.

The prospectus also lays out details on the company’s promoters and senior management, allowing investors to decide the team’s capability to manage the business for long-term profitability.

Company financials and valuations

When a company discloses its financials, it allows investors to calculate long-term profitability and risks before they invest.

A new IPO prospectus contains details on profit/loss, debt, income, and revenue.

What you must check through the financial details is whether the financials are steady or there are disruptions. Essentially investors also look into pre-IPO and post-IPO company valuations. Since companies ending up with a large capital base tend to lose out on valuation traction.

Similarly, investors would avoid companies with large debts. Companies with a tendency to accumulate costly debt would lower the value of an investment.

Several companies use IPO proceeds to reduce their debt burden, but they must also ensure a low debt ratio in the future.

Lastly, company financials disclose P/E and P/BV ratios, which tend to give a glimpse of the stock’s future valuation.

Use of IPO proceeds

If investors need to know where the company will use the capital, they need to look into the prospect.

Since it is critical to gauge the merit of an IPO, regulators have mandated that companies divulge the purpose of the offer in IPO prospectus.

Companies issue IPO to meet various capital requirements. The most common causes including funding business expansion, setting up new plants and buy machinery, repay debts, and raise the capital base.

When businesses say they are raising capital to fund expansions, investors use ROE to assess the value of the IPO

If the company plans to use the fund to reduce the debt burden, then one needs to affirm what steps the business is taking to keep debt low in the future before subscribing to the offer

Thirdly, be wary of companies trying to raise funds to leverage working capital base because it can lead to asset-liability mismanagement

Fourthly, avoid offers where companies float IPO to invest in real estate and offices. These are the least productive assets

As you understand where the company is going to use the capital, you can make an informed decision.

Understanding Parties Associated With The Offer

A new IPO prospectus packs critical information like the company’s plans and warning signs, especially when company promoters are drastically trying to reduce their stakes in the business or anchor investors exiting permanently. These are indications that trouble is brewing somewhere, and one is better off avoiding these offers.

Similarly, before investing, check the pedigree of the Book Running Lead Managers. Investor’s perception depends on the merchant bankers’ credibility and track record.

Understanding Associated Risks

Companies disclose risks associated with the offer in the prospectus, and It is perhaps the most critical section, which you shouldn’t miss if you want to make a sound decision. While most of the risk factors are routine, they can still divulge critical information, like legal proceedings against promoters, contingent liabilities for the company, and more.

IPO prospectus is a critical document. It contains a wealth of information, but the record shows that only 0.1 percent of investors actually read IPO prospectus.

IPO prospectus helps you make smarter decisions regarding IPO offers. But what about false disclosures in the prospectus?

Making false disclosures or omitting critical information in the prospectus can lead to SEBI imposing penalties on the issuer. Like recently, it penalised DLF of 85 crores for not disclosing certain material information on their prospectus.