A company’s risk factors form an essential part of the reports filed by public companies and companies seeking to go public. Risk factor disclosures are cautionary statements that companies include in their disclosure documents about the key risks a company faces. They highlight risks that could have a material adverse impact on its business prospects, financial condition, or results of operation.
Companies usually spend an extensive amount of time drafting their description of material risk factors. Investors scrutinize that section of public filings to better understand the company’s value proposition. A disclosure can reveal red flags about the investment outlook for a particular company.
Although private companies need not file periodic reports, such as 10-Ks, with the Securities and Exchange Commission (SEC), they nonetheless may opt to highlight key risk factors affecting the company’s outlook within their annual or quarterly reports. Companies typically post these reports on their websites for investors and potential investors to review.
From the company’s perspective, adding more risk factor disclosures can be like an insurance policy. It can help mitigate or prevent litigation or other liability actions down the road. Exposing some of the challenges a company faces or will face in the near term puts investors on notice. Thus, if those risks materialize, the company can argue that investors had some advance notice.
Companies have some discretion with respect to drafting their disclosures. But they must satisfy certain requirements in Item 105 of Regulation S-K. Regulation S-K is a SEC regulation that lays out reporting requirements for public companies.
Under Item 105 of Regulation S-K, risk factors must be organized logically, generally in order of the relative risk magnitude for the company. Item 105 of Regulation S-K also requires the grouping of risks under relevant headings. If the risk factors section exceeds 15 pages, the company must include a concise, bullet point summary of the main factors at the beginning of the section.
Aside from Item 105 of Regulation S-K, the SEC has outlined key plain English principles for drafting risk factors. These key principles are highlighted in Rule 421 under the Securities Act of 1933 and include:
- Short sentences
- Active voice
- Avoiding legal jargon to the extent possible
- Use bullet point lists to make complex concepts more reader-friendly
To protect companies, the Private Securities Litigation Reform Act of 1995 (PSLRA) establishes a safe harbor from liability. The PSLRA provides that certain forward-looking statements can be exempt from liability if they are meaningfully qualified by cautionary language. Forward-looking statements consist of disclosure that references a company’s future plans or performance. This includes financial projections and statements regarding expectations about the company’s economic performance.
Material Risks: Deciding What to Disclose
In drafting risk factors, companies must grapple with the scope and level of detail they want to present. The disclosure should include adequately-tailored factors. The order in which the company presents risk factors offers insight into management perspective. It helps investors understand how they view different risks and the extent to which the company’s leadership teams view those risks as material.
Types of Risk Factors
The biggest risk factor category is related to a company’s operations. This is unique to the company. While companies operating within a particular industry face many overlapping risks, the business risk factors also cast a spotlight on characteristics that distinguish a particular company from others within the same industry. Some examples of company risk factors include:
- Risks related to acquisitions
- Risks related to competition
- Lack of operating history
- Dependence on key employees
- Risks relating to key suppliers or key customers
- Current material litigation
Industry risk factors cover challenges posed to the company and its peers by virtue of the industry in which they operate. Some examples of industry risk factors include:
- Labor shortages
- Risks of increased costs of raw materials
- New regulatory regimes
- General economic conditions
- Seasonality of the business
Investment or Securities Risk Factors
The investment or securities risk factors relate to the risks of ownership of the company’s securities. This section should distinguish between the risks affecting the company’s debt securities and risks affecting its equity securities. For example, in the case of debt securities, a key risk is the covenant structure. These covenants might place restrictions on the company’s ability to incur additional debt in the future or to pay dividends.