What is a Prospectus - Working, Types and Use in Mutual Funds (2024)

A prospectus is a legal document disclosing information regarding a public company seeking to raise capital from investors and market participants using an invitation to offer for the purchase or subscription of securities. Distributing the document to the public is mandatory and should be filed under local regulatory bodies. A prospectus of a company updates prospective investors about the business before they make financial commitments to a securities offering.

Dive into the article if you want to learn more about the multiple aspects of a prospectus, its different types, merits and uses.

What is a Prospectus?

According to the Companies Act (2013), a prospectus is a legal disclosure document made available to the general public before a company makes a new security offering like a stock, bond, or mutual fund. The document can be in the format of a notice, circular, advertisem*nt, or any document that serves as an invitation to the public offering of a company’s securities. There are different types of prospectus, namely the red herring prospectus, shelf prospectus, abridged prospectus, and deemed prospectus.

The legal document should contain all the relevant information regarding the public company and its securities offering to ensure that market participants can make an informed investment decision. The company should file the prospectus with the regulatory body where the public offering is being made.

In India, the national regulatory body is the Securities and Exchange Body of India (SEBI). The document includes financial performance, management, material facts regarding the securities offering, risks, future forecasts, and any further information potential investors may find relevant.

How Does a Prospectus Work?

As per the Companies Act, 2013, any public company that wants to invite offers from the public for the purchase or subscription of its securities (stocks, bonds, or mutual funds) has to issue a prospectus. The first step in the process involves an application form, which is only made available to the company when an abridged prospectus accompanies it.

The prospectus must contain all the mandatory information required to be declared by a public company under Section 26 of the Companies Act 2013. The content includes general information about the company, its capital structure, terms, particulars about the issue, the management structure and details, specifics regarding its projects, and reports on financial information.

A copy of the prospectus is filed with the registrar upon delivery, containing the signatures of all the named directors, proposed directors, or assigned attorneys mentioned in the prospectus. It is then registered by the registrar if it meets all the conditions of Section 26 of the Companies Act 2013. It includes the consent of all the parties mentioned in the company’s prospectus.

After registration, the company must issue the prospectus within 90 days (starting from the day of delivery to the registrar) to be considered valid. Moreover, the contravention of Section 26 of the Companies Act 2013 in issuing the prospectus is punishable by law and leads to criminal liability.

Importance of Prospectus

A prospectus is a reliable source of information for the public regarding a public company and its invitation to offer for purchase or subscription of securities. It provides vital information to prospective buyers, allowing them to make an informed decision regarding their investment and gauge the probable monetary results. Additionally, it maintains a written record of the terms and conditions of the issue. It also allows public companies to raise funds through market investors and increases visibility.

Types of Prospectus

A company can issue four types of prospectus under the Companies Act, 2013. They are as follows:

1. Red Herring Prospectus

It is filed with the Registrar at least three days before the opening of the subscription list and the offer. It is an offer document comprising the details of the securities submission without containing the securities’ price or the issue’s size.

The company should mention any variations between the red herring prospectus and the prospectus in the issued prospectus.

2. Shelf Prospectus

A shelf prospectus is issued by any public financial institution, bank, or company for one or more securities issues or a class of securities. It eliminates the need for a separate prospectus for each offering by the public company for a given period, not exceeding one year.

3. Abridged Prospectus

The abridged prospectus contains the salient features or a summary of the prospectus and is filed before the Registrar. It should accompany any form issued for the purchase of securities of a company. It provides all the relevant information to the general public succinctly.

4. Deemed Prospectus

If a company agrees to allot or offer securities to the public, the document is a deemed prospectus. It means that all the provisions regarding the content and liabilities of a prospectus will apply to it.

Requirements for a Prospectus to Be Issued

A company should comply with the following requirements to be issued a prospectus:

The prospectus of a company should be filed with the local regulatory bodies and agencies like SEBI and stock exchanges.
It must be dated and duly signed.
It should contain all the necessary information outlined in the Companies Act 2013.
It should not contravene the Companies Act 2013 or provide misleading information.

An Example of a Prospectus

The initial public offering (IPO) of Life Insurance Corporation (LIC) was the largest public offering in the history of the Indian stock market. An IPO refers to the process of a corporation’s new stock issuance to the public for investment. The best way for prospective investors to decide if they should invest in an IPO is to begin by reading the Draft Red Herring Prospectus (DRHP).

It can help investors decide whether the company’s stocks are worth the capital risk or not and the company’s potential. It contains information such as the company’s financials, operations, the utility of the funds raised through the IPO, risk factors, management, and business overview.

LIC filed its 652-page Draft Red Herring Prospectus on 13th February 2022 with SEBI for its IPO. The behemoth sought to sell a 5% stake to raise an estimated Rs.63,000 crore by issuing an offer to sell 31.6 crore shares to the public.

Apart from the details regarding the IPO, the DRHP contained vital information such as the company’s embedded value of Rs.5.38 trillion as of 31st September 2021; its assets under management (AUM) valued at Rs.39.55 trillion; the number of individual agents in commission and the commission paid to them; its deteriorating cash flow and rising operating expenses; its market share and dividend payouts.

The corporation filed an updated Draft Red Herring Prospectus in April. This draft revised the percentage of stake sold to the public from 5% to 3.5% for a valuation of Rs.21,000 crore. The Red Herring Prospectus was filed on 26th May 2022 with SEBI along with an Abridged Prospectus containing the salient features of the former.

What’s in the Prospectus of Mutual Funds and ETFs?

The prospectus of mutual funds or ETFs provides relevant information to potential investors. It details the investment objectives and strategies of a fund or group of funds, past financial performance, associated risks, distribution policy, executive team, fees and expenses and investment strategies.

They are directly available from the issuing companies through email, mail, phone or company websites. It is a legally binding contract between the issuer of the prospectus and investors.

How is a Prospectus Useful for Investors?

A prospectus is extremely useful for investors who want to make a knowledgeable decision rather than dive headlong into investing in a company. The prospectus provides all the necessary details regarding the invitation to the offer of sale of securities.

It ensures accountability on the part of the public company that is seeking to raise capital from the market by legally documenting the terms and conditions of the sale. More importantly, the prospectus is valuable as it states the risks associated with the investment opportunity.

Final Word

A prospectus is an essential legal document that bridges the gap between a public company and possible investors through an invitation to an offer of sale of securities. The information consists of details regarding the company, the securities offering, management structure, financial information, and other information outlined in the Companies Act, 2013.

Studying this document can help an investor determine whether it is a sound investment or not. Instead of relying on guesswork, investors can make a well-thought-out decision based on the information made known directly by the issuer in the form of legal disclosure.

Filing the prospectus under the supervision of local regulatory bodies lends an additional layer of security to the process. So, if you are a prospective investor seeking to make a profitable investment, it is wise to look at the prospectus of a company before committing capital.

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FAQs

Q1. What is a prospectus in a company?

Ans: A prospectus is a legal document issued by a public company to invite the public and investors to subscribe to the securities.

Q2. Can a private company issue a prospectus?

Ans: No. A private company can not issue a prospectus, while a public company can issue the prospectus to offer its shares and debentures to the public.

Q3. Is it compulsory to issue a prospectus?

Ans: No. It is not mandatory for every company to file a prospectus. A company can file a statement in lieu of the prospectus with the Registrar of Companies instead of Articles of Association.

Q4. When should a prospectus be issued?