Adequate research is, without a doubt, the most effective way to identify and stay away from the IPO disasters waiting to happen. The prospectus, which contains nearly all aspects of a company’s business and game plan, is the first place any investor interested in purchasing a new issue should look.
Finding an online prospectus is a snap
Getting a prospectus is easy. If you’re reading this online, you should be able to electronically download a prospectus without any problem. Prospectuses for all US companies are available for free from the Securities and Exchange Commission’s Web site, FreeEDGAR.com, or on a delayed basis from EDGAR Online.
If you don’t have access to a computer — or your access is too slow for downloading a prospectus (which is an extremely long document) — you can also obtain a prospectus by calling the investment banks that are involved in selling the shares of an IPO. Calling the company will also work.
The fine print: A confusing read
Warning: A prospectus is not an easy read. Written mostly by lawyers, they are laden with confusing jargon.
In addition, the tone of these documents is decidedly negative. Companies have to be completely honest about all of their warts in order to avoid future lawsuits. Thus, bullish statements are often followed by cautionary disclaimers, and there’s an entire section titled “Risk Factors” dedicated to what may go wrong at the company.
Before you get scared off from investing in an IPO, however, you should realize that many of these risk factors and disclaimers are included in every prospectus. Then again, just because they’re boilerplate doesn’t mean you shouldn’t pay attention.
Following is a list of some warning signs that prospective IPO investors should pay close attention to. In general, they’re listed in order of where one would find them in the prospectus, from the front of the document to the end.
Again, this is only a partial list, and in the final analysis, what’s most important is that an investor feels comfortable with a company, its business, its market position, its growth strategy, and its management.
Second-tier investment banks — Investment banks hired by a company to handle an IPO must do a fair amount of due diligence, so it’s always comforting when the names on the front of a prospectus are well-known and well-regarded. Of course, even the best banks take out some turkeys. Plus, a number of small regional banks have solid reputations. Just be a little more careful if the name of the investment bank doesn’t ring a bell. Found on bottom of front page.
Recent developments — This section, usually added to amended filings, updates any recent notable events, often how a company performed in its most recent quarter. Make sure this section is mainly good news. Usually found in “Recent Developments” (not always there).
Selling stockholders — It’s usually a bad sign when a large number of shares in an IPO come from selling stockholders, meaning pre-offering investors who are cashing out. Not only does it mean that the company won’t receive the money from the sale of those shares, but it also should make one wonder why investors would want to sell their shares so quickly if a company’s prospects are strong. In fact, investors usually prefer that management retain a sizable stake in the firm after the offering is completed. The number of selling stockholders is found in a section called “The Offering,” while management’s total stake can be found in “Principal and Selling Stockholders.”
Use of proceeds — If a company is st majority of the money to pay off debt or dole out a huge dividend to pre-IPO investors, watch out. That means people buying shares in the IPO are in essence paying for the company’s past, not its future. Also be careful when a company says it’s allocating most of the money for general corporate purposes. It’s comforting if a company has more specific ideas about where your money will be invested — acquisitions, advertising, capital formation, research and development, etc. Found in “Use of Proceeds.”
Declining revenue — If revenue for a company’s most recent fiscal year is down from the year-ago period, it may be time to run as far away as possible. Revenue for companies looking to go public should be growing rather significantly. Even slowing revenue growth is a warning sign. At the very least, read a company’s explanation for the revenue slowdown, found later in the prospectus. Revenue totals can be found in “Summary Consolidated Financial Data” or “Selected Consolidated Financial Data.” The explanation behind the results is found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Declining margins — Along the same lines as declining revenue, declining operating margins are not a good sign. It means the company is becoming less and less profitable. However, if a company is in a fast-changing, highly competitive industry, it may need to sacrifice profitability for market share and brand equity. Again, read the explanation behind the shrinking margins. Margin totals found in “Summary Consolidated Financial Data” or “Selected Consolidated Financial Data.” Explanation behind results can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Working capital deficit — This is when a company’s liabilities, or debts, are greater than its assets. This is not uncommon for a new issue, but it should be explained and should disappear on an “as adjusted” basis after the completion of the offering. Details can be found in “Summary Consolidated Financial Data” and an explanation is in “Liquidity and Capital Resources.”
Other financial red flags — A number of other problems can be found on a company’s balance sheet or income statement. Things such as inventories or accounts receivable rising more rapidly than revenue, high interest expenses, or extraordinary charges should be explained. Found in “Selected Consolidated Financial Data” with more detail in the “Index to Consolidated Financial Statements.”
Over-reliance on one customer — A clear danger sign. Several IPOs have imploded after the companies announced they were losing one of their major customers. Of course, like all of these warning signs, there are exceptions. Found in “Risk Factors.”
Supplier reliance — A company can be too reliant on its suppliers as well as its customers. Make sure a firm can switch from one supplier to another rather easily. Suppliers that double as competitors are another danger. Found in “Risk Factors.”
Competition — Given that monopolies are illegal, competition will always be there, but you better watch out if some well-run, well-capitalized firms are on the list. One name that jumps quickly to mind: Microsoft. Found in “Risk Factors” and “Business.”
Other risk factors — Patent disputes, heavy indebtedness, and litigation are just some of the other more dangerous risks. Read the entire “Risk Factor” section carefully, but don’t get overly discouraged.
Too-small pie — No matter how effective a company is at selling widgets, there needs to be enough people willing to buy those widgets at high-enough prices. A company’s target market should be large and rapidly growing. This information can be found in the “Business” section.
Decliningvaluation — Pre-offerint an IPO be priced so they get a huge return on their initial investment, often as much as 10 times. You can find out what those original investors paid on average for their shares in the section entitled “Dilution.” Compare that to the offering price. If the two prices are close, then you can bet pre-IPO investors at one point were too optimistic about the valuation for the company. While it may seem like a good deal to buy a company for about the same price as earlier investors, there’s a reason for the lower valuation. On very rare occasions, IPO investors can actually pay less on average than the company’s pre-offering backers.
Overvaluation — A lot of factors go into determining an IPO’s offering price and not all of them have to do with the price-to-sales or price-to-cash flow multiples that determine the value of most other stocks. Unfortunately, professional investors are at an advantage since they can often find out a company’s sales and earnings projections. As a regular retail investor, you won’t get any future estimates until analysts start covering the new issue about 25 days after the stock starts trading. Still, you can compare how companies are valued to past results. Just take the number of shares outstanding after the offering, multiply it by the expected offering price (take the midpoint of the listed pricing range), and find out what the market value of the company will be. Then, divide that figure by the firm’s revenue and profit for the past four quarters. Hopefully, these multiples, although rough calculations, will be comparable to similar publicly traded companies. Number of shares outstanding is found in “The Offering,” expected offering price range is usually found on the front page (but it is not always there), and quarterly sales results are usually found in “Selected Consolidated Financial Data” (if quarterly results are not available, use results from the most recent fiscal year).
Overcompensated or overmatched management — You usually don’t want members of the management team in a newly public firm to be making hundreds of thousands of dollars in base salary. Rewards are fine, but make sure most of them are in the form of stock options. That way, management will only be rewarded if the shareholders are. Also, look for a management team that has extensive experience in the industry and/or with other public companies. A chief financial officer with little experience running a public company could be overwhelmed by the duties. In addition, watch out for an executive team or board of directors filled with relatives. Nepotism rarely makes for solid management. Found in “Management” and “Executive Compensation.”
“Going concern” statement — If a company’s accountant says that the firm’s business results raise “substantial doubt about the firm’s ability to continue as a going concern,” watch out. It usually means that a company needs the IPO pretty badly to continue paying off its obligations. Many companies avoid getting plagued with this scarlet letter by raising money immediately prior to the IPO. Found in “Report of Independent Auditors.”