296 ENTREPRENEURSHIP
- Initial Registration Statement: Three major elements comprise the paperwork required
by the regulating authorities (the SEC). The first, the registration statement, contains so
much detail that a significant number of appendixes are usually attached.
The second component, the prospectus, is used to sell the new company stock. In some
respects it conforms to regulatory standards, but in other respects it is very much like the
business plan. It describes the business, its product/market/technology configuration, along
with the competition and operations, and it includes full audited financial statements. It is
governed by the rule of full disclosure and must reveal all information known to the com-
pany that might materially affect the decision of an investor. From a practical standpoint,
then, the company must reveal all risks, all conflicts of interest (real and potential), and all
transactions conducted by the top managers that might be construed as self-interest. This
provides the firm some legal protection against claims of fraud.
The third component is supplemental data, essentially a huge appendix containing such
items as copies of leases, employment contracts of the top managers, sales and distribution
contracts, and loan agreements. These can run to several hundred pages. - SEC Review and Comment: The package is sent to the SEC for review and comment. In
its review, the SEC staff looks for internal consistency of business plans and use of proceeds.
It reviews the description of the issuer’s unique risks, looking for more than simple boiler-
plate disclaimers.
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The SEC is interested in areas in which the investor might be misled—
for example, overly optimistic descriptions of new-product development, overstatement of
the actual size of the firm, exaggerated reports of signed contracts for work in hand, and
understatement of projected expenses for the use of proceeds. The SEC does not comment
on whether the business will succeed; instead it seeks to protect investors against malfea-
sance and fraud. - Preparation of the Revised Statement: No IPO review is approved on the first submis-
sion. An SEC review letter will request revisions and resubmission. Amendments are added
to the application statement, deficiencies are corrected, and language is modified. - Preliminary Prospectus: Once the approval letter is issued, the preliminary prospectus,
which has been in preparation during this period, can be published and then circulated. This
prospectus is sometimes called a red herring because the cover page has a red border and
because of the speculative nature of IPOs in general. Neither number of shares to be issued
nor price per share is included in this document. The purpose of the preliminary prospec-
tus is to give the new issue visibility within the investment community. Now the underwrit-
ing group or syndicate—a group of investment houses that will sell the issue and spread the
risk—can be organized by the lead underwriter. - Due Diligence: The underwriter performs due diligence to ensure that the stock is a legit-
imate investment. If the underwriter were to sell stock without completing a full investiga-
tion, it might also be liable for fraud and damages (both from investors who lost money
and from other brokers who lost money and reputation). Independent accountants review
the company’s financial picture, policies, and prospects and issue a letter to the underwrit-
ers detailing what they find. All the lawyers also write letters to each other describing the
company’s legal situation (current lawsuits as well as potential liability). All this investiga-
tive diligence is designed to weed out legal problems before they occur and to protect the
underwriters, lawyers, and accountants from liability if they are deceived by the top man-
agers.