What It Is:
A prospectus is a legal document issued by companies that are offering securities for sale. Mutual funds also provide a prospectus to potential clients, which includes a description of the fund's strategies, the manager's background, the fund's fee structure and a fund's financials statements.
How It Works/Example:
To get an idea of the role of the prospectus, let's assume Company XYZ is pursuing an IPO. Before launching the IPO, Company XYZ must first file a registration statement, which discloses all material information about the company, with the SEC. Part of the registration statement is the prospectus, which must be provided to all purchasers of the new issue.
After Company XYZ files the registration statement with the SEC for review, a cooling-off period begins. During this 20-day period, securities brokers can discuss the new IPO with clients, but the only information that can be distributed is the preliminary prospectus.
When the registration statement becomes effective, Company XYZ will amend the preliminary prospectus to add such important information as the offering price and the underwriting spread. This final prospectus must contain:
Description of the offering
History of the business
Description of management
Use of proceeds
Description of the underwriting
Risks to buyers
Legal opinion regarding the formation of the company
When the final prospectus is released, brokers can take orders from those clients who indicated an interest during the cooling-off period. A copy of the final prospectus must precede or accompany all sales confirmations.
Why It Matters:
The role of the prospectus is the make investors aware of the risks of an investment. Without this information, they would essentially have to make investments "sight unseen." This disclosure also protects the company from claims that it did not fully disclose enough information about itself or the securities in question.