by John Rolfe
In preparation for the first day of drafting, company counsel usually puts together a rough draft of the prospectus. The rough draft provides a reference point from which to begin working. It’s easier than beginning work with a blank sheet of paper, but this rough draft is really rough, like that institutional toilet paper that feels like a sheet of sandpaper in your ass. The rough cut normally just includes a brief description of the company up front, and then a bunch of section titles in the back as placeholders. It costs the company a few thousand dollars, and by the time the final draft rolls around not a single word from the original will remain.
When it comes to drafting, there’s no such thing as pride of authorship. The normal rules of literary law and etiquette do not apply. This is probably because the rules of literary law that address plagiarism only apply to prose worth stealing, and there’s never been any text in a prospectus worth stealing. Bankers aren’t known for their vivid imaginations, so the chances of them breaking any new ground in their descriptions of a company’s business are slim. Furthermore, whatever mildly compelling prose any banker has managed to create to describe a company’s business has inevitably gotten watered down by paranoid lawyers. There’s no prime rib in the process; hamburger goes in, horsemeat comes out.
The various sections of any given prospectus are dictated both by tradition and regulatory mandate. The sections may differ slightly, depending on the nature of a given deal, but there are certain sections that are included in nearly all prospectuses. What follows here is our guide to prospectuses. For the uninitiated it will hopefully serve as a road map if you ever decide, against your better judgment, to actually sit down and read one.
Prospectus Summary—This is always the first section. It’s what the drafting team spends 75 percent of their time working on, and it’s often the only thing that prospective investors ever read. It’s supposed to give the reader all the key information in two to three pages. It’s supposed to tell the reader why the company doing the offering is the best, most successful competitor in its industry, why they’re the ass kickers who take no prisoners. It’s supposed to tell the reader how the company is going to take over its industry, and then its country, and then the world, so that an investment in the company will eventually represent pro-rata ownership in world domination. This section usually contains more bullshit than any other section.
Reversion to the mean dictates that most companies have to be average. There can only be a few standouts in any given industry. This principle works against the goal of presenting every company engaged in an offering as the industry leader. Since, therefore, it is impossible to present facts that actually support most companies’ claim to be the standout in their industry, the prospectus summary generally tries to confuse the readers through obfuscation. Those drafting the prospectus believe that if they can layer in enough nonsensical prose, readers will become so confused that they’ll be unable to realize how mediocre the company actually is.
Risk Factors—This section is a lawyer’s wet dream. It describes all of the things that could go wrong with the company. Years ago, the bankers, the lawyers, and the company all used to spend a lot of time fighting about what went into this section. The bankers and the company didn’t want to put too much in here, because they thought that people might get scared and not buy into the offering. The lawyers, though, were scared shitless and just wanted to cover their asses. The fights raged on and on. Then, one day, folklore has it, a brilliant young lawyer came up with a most Machiavellian strategy. He decided that if he overloaded this section with a bunch of irrelevant drivel, people would give up in frustration and neglect to read any of it or, at the very least, stand a good chance of missing the really important points. The strategy was pure genius. Today, there are maybe one or two risk factors that are relevant, really relevant, for any given deal. The rest is window dressing, but there’s so much of this extraneous window dressing that the relevant risk factors get ignored. The lawyer, the one who invented the strategy, has been immortalized as a charter member of the Prospectus Drafting Hall of Fame.
Use of Proceeds—Not too many people pay attention to this section, but they should. A careful reading of this section will tell you where the hell all the money from the offering is going. If it’s not going into the company coffers to help grow the company, but instead is going to pay out existing owners and management, then stay away. If owners are cashing out, there’s no reason for you to be cashing in.
Selected Financial Data—This section is also known to insiders as “Creative Presentation of the Company’s Financial Performance.” In it, the bankers and accountants put all their efforts into figuring out a way to make the company look like a real money machine. If a company’s got good cash flow but no earnings, you’ll see a cash flow line presented in a fat, bold font. If a company’s got neither cash flow nor earnings, but it’s growing like a weed, then you can bet that there’s going to be a bold line at the bottom showing year-over-year revenue growth or unit growth or employee growth. The only situation that’s difficult for even the most talented bankers and accountants to contend with is one where there’s no revenue at all. Even Houdini can’t mask the vacuum that a revenue line equal to zero creates. In this situation, the company is effectively fraternizing with the professional beggars on New York’s subway lines—“Please, I need money right away. It’s not for crack, I swear. Just soup and a sandwich.”
Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)—MD&A is the place where dreams are made, and mistakes justified. While the tables in the Selected Financial Data section can be spun and recrafted to focus attention on and present results in the best possible light, a good huckster needs a real soapbox to get out the vote. This is where MD&A comes in. In MD&A management gets the opportunity to justify its mistakes and take credit for its successes. In a painstaking narrative the management team explains just how things got to be the way they are. Revenues have dropped by 20 percent. Here’s why. Costs are spiraling out of control? There’s a valid explanation, and here it is.
Business—This section is an exact replication of the prospectus summary, but with twice as many meaningless adjectives and even more excruciating detail. If it wasn’t boring enough the first time around, it’ll become so in the Business section.
Management—This section presents biographies of both the management team and the board of directors. Members of management and/or the board of directors generally get only two to three sentences each to make themselves seem important, so they maximize the balderdash per sentence. The Management section also presents the reader with an opportunity to assess just how inbred the board of directors is. A good way to figure out how likely it is that the directors are sucking money out of a company is to draw a chart with each director’s name in a box. Read through the Management section, and each time that you identify a professional or personal connection between two directors, connect their boxes with a line. If you also happen to know about other relationships between directors, for instance one director is married to another director’s daughter, or one director is an old college buddy of another director, you can draw a line in there as well. If, upon completion, the chart looks like a spider web, then hold on to your wallet.
Principal and Selling Stockholders—This section describes who owns big pieces of the company and, if it’s an equity offering, whether any of them are selling their stock. If there are relatively few stockholders, each of whom owns a large piece of the company, that’s good because they’re probably going to be just as pissed off as the minority shareholders if the value of their holdings starts going down the toilet. It’s good to have a group of people channeling their fear, frustration, and greed to maximize the value of your investment.
If any of the large holders are selling their shares in the offering, stay away. As junior bankers, when institutional buyers would ask us why insiders were selling their stock in the offering, we’d volunteer numerous g
lib responses:
“Oh, it’s a liquidity issue.”
“Estate planning, nothing more.”
“Diversification, they don’t want to have all their eggs in one basket.”
In general, if the people who know the most about the business are taking their money out, it’s a safe bet that you shouldn’t be putting yours in.
Underwriting—This section will indicate which banks or brokerage houses are getting allocated a portion of the offering to parcel out to their preferred accounts. Effectively, the relatively small number of investment banks that underwrite the deal (the managers) sell the entire deal to a much larger group of brokerage houses (the syndicate), which in turn sell the deal to investment institutions and individuals. Now it’s much more lucrative to be a manager of a deal than it is to merely be a member of the syndicate, but a crummy free lunch is better than no free lunch at all. The syndicate is like the Treehouse Club—only the really bad boys don’t get to be members. The investment banks all fight tooth and nail up front to be given the mandate to manage a deal, but there’s an unspoken understanding among all the players that even those who lose out on the management mandate will get to be a part of the syndicate at selling time. Participation in the syndicate is the ever present booby prize of the public offering world.
Financial Statements—This is the real meat and potatoes of the prospectus. This is the section that should be up front. The problem is that this is the section with the least room for creative input, since disclosure in the financial statements is dictated by a well-defined set of independent accounting principles. The bankers don’t get a vote here; it’s the timid little bean counters who make the final decisions on what makes it into Financial Statements. In fact, it’s not so much the fact that the bankers don’t get to make the decisions on what goes into this section that drives them mad. It’s that the guys who do get to make those decisions are the accountants. If a big hitter like a CFO were responsible for the decisions it would be one thing, but it’s the frigging accountants. Call it the accountant’s revenge, and chalk one up for truth and justice.
For the investor, the financial statements are the only unadulterated statement of historical fact that can be used as a justification for taking on risk. The prospectus should be read like a Chinese newspaper, start at the back and work your way forward.
The entire drafting process can take anywhere from five to ten full working days. With a working group of twenty to thirty people, that translates to somewhere between one hundred and three hundred equivalent work days. That’s about a year’s worth of work for the creation of a document that hardly anybody reads. If one were to add up all the man-hours that go into the drafting of prospectuses in a given year there might be enough to develop a cure for cancer. The cure probably wouldn’t pay as well as writing prospectuses does, though.
As associates, our responsibilities at the drafting sessions were a function of the senior banker on the deal. Some senior bankers didn’t want us to do anything but sit quietly. We were just there to provide a presence, and as long as we didn’t fall asleep or wet ourselves we were doing our job. Other senior bankers gave us marginally more responsibility. They would stand up to leave the room and announce, “I have to go make a few phone calls. My associate here will lead the drafting while I’m gone.” That meant that if the group spent more than ten minutes arguing about how a single sentence should be worded, it would be our responsibility to state loudly, “OK, let’s keep things moving here.” It was an impressive skill to be developing.
The associate’s other responsibility once the document begins taking shape is to conform it to the bank’s formatting style. Every investment bank has a style manual. It’s a book that details every element of prospectus formatting—what size fonts to use in which locations, where headings should be placed, which lines in the financial tables should be underlined. This is important stuff, and being on style duty at the drafting sessions was exactly the sort of intellectually challenging work Rolfe and I had always dreamed that we’d be doing one day as investment bankers. We were determined to become the best damned style managers Wharton and Harvard had to offer.
Drafting sessions are utterly forgettable. They are slow, painful, and excruciatingly boring. Usually, the most difficult aspect of the drafting sessions is striking a reasonable balance between the amount of coffee one has to drink to stay awake and the number of trips one takes to the bathroom to mitigate the diuretic effects of the caffeine. Mealtime provides the only break in the insufferable monotony. I once asked Rolfe whether he’d ever enjoyed himself at a drafting session. He thought long. He thought hard. I began to worry that his brain might crack. After much reflection, he said no, he’d never actually enjoyed himself.
Rolfe and I had been to drafting sessions in Dallas, Los Angeles, Washington, D.C., Montreal, and New York. We could have had drafting sessions on the beach at Maui, or while flying in a hot air balloon high over the Amazon. It wouldn’t have made a difference. They still wouldn’t have been memorable.
The associate never knows for how many weeks the drafting sessions are going to drag on. Each drafting session ends with the scheduling of the next session. The associate understands that drafting is a lot like chemotherapy. There are no guarantees that the drafting will eventually lead to a completed deal, but without it there’s no chance for success. Each session is a necessary step in an evil, painful process. At the end of each session, the associate yearns for some indication that the process is drawing to a close. One day, he gets it.
The senior banker on a deal is the one who pulls the trigger and decides when the drafting sessions are done. This determination is not an objective process. The members of the drafting team don’t dot the last “i,” cross the last “t,” look around at each other, and exclaim “by God, we’re done!” It’s much more subjective than that. The lead banker uses an internal productivity gauge, developed over years of experience with both human nature and the tendency of attorneys to generate as many billable hours as possible. The lead banker assesses each drafting session’s accomplishments. When the number of accomplishments per dollar of billable legal time for a given drafting session falls below some minimum threshold the lead banker pulls the trigger. The banker decides that the time has arrived to light a fire under everybody’s ass. The time has arrived to start making it really expensive to continue wasting time. The lead banker decides to crank up the momentum, and take the drafting team to a place where dillydallying is not allowed. The lead banker speaks the words:
“It’s time to go to the printer.”
Push the Button
It is a riddle wrapped in a mystery inside an enigma.
—Winston Churchill
From the time fledgling bankers first begin their descent from on high, they hear about going to the printer. Until they get the chance to go, it’s one of banking’s biggest mysteries. They don’t know what actually happens at the printer. They don’t know what they’re supposed to do at the printer. They just know that a trip to the printer is important, really important, so important in fact that any of the other deals they might be working on take a backseat. They know that if a vice president or a managing director calls them up and says, “I need you to be at this pitch with me tomorrow,” they can tell him, “Fuck you, I’m gonna be at the printer.” The printer always takes priority, even over the calls of senior bankers.
Going to the printer is a classic investment banking clusterfuck. Young bankers who haven’t ever been to the printer don’t know what they’re supposed to do there—they’re expecting the associates in the know to give them some guidance. The problem is that the associates who have been can’t remember anything of substance they’ve ever done there, so they’ve got nothing to tell the associates who haven’t been. Nobody knows anything, nobody wants to look like an idiot, and nobody will admit their ignorance. It’s a self-perpetuating cycle of stupidity spiraling into a black hole.
When we first started workin
g at DLJ I cornered Troob one afternoon to find out what went on at the printer. He’d worked in banking before, so I knew that he’d been to the printer. I figured that he’d have the answers.
“Troobie, man, I’ve got a question for you.”
“Yeah, what is it?”
“The printer, I want to know about the printer. Everybody’s always going there. What do they do there?”
Troob was quiet for a minute. “You know. They go to the printer. They print up the prospectuses there. Why are you asking me?”
“I’m asking you because everybody’s always talking about the printer. I want to know what happens there. What do you mean, they print up prospectuses? Why don’t the lawyers just print them out at their office and get the copy center to make copies?”
“Because they need the copies to look really good. They want to have a professional print them out. You know, so that they can print it on that really thin paper, the stuff that’s like toilet paper. That way the investors can at least use it to wipe their ass since they’re not gonna read it. You have to be able to have some glossy color pictures up front. The copy center can’t do those copies on the glossy paper. You know how shitty their color copies always look. That stuff is important. How can you sell a deal with shitty color copies?”
“OK, I’m with you, but what do we do there? I mean the bankers. Do we go to the printer, put on work aprons, and turn a big steel crank to help print the prospectuses? I just don’t get it. Are we like those old Chinese guys with big racks of steel alphabet characters? Do we help load them into the printing presses? Why do we have to go?”