Have you read the "Risk Factors" section of an IPO prospectus?

In the ‘CFO Bridge Insights’ April issue, we discussed the need for MSMEs to adopt an ERM framework. Here is a link to our April newsletter -  "Do you embrace Enterprise Risk Management (ERM) in MSME context?  

In continuation of the ERM framework, in the current issue, we will discuss the meaning and importance of the "Risk Factors" covered in section II of an IPO (initial public offering) prospectus filed by Indian companies planning to go public.

The following three steps will help SME finance leaders and founders draft the ‘Risk Factors,’ get SEBI’s approval, and generate public interest in their IPO.

1: Get Guidance from Past Prospectus Filings

The main objective of this exercise is for SME leaders to familiarize themselves with the process of planning an IPO to raise funds from the general public. Studying the past prospectuses filed with SEBI or Indian Stock Exchanges by companies operating in similar industries and geographies, understanding the associated risks, and seeing how they can be highlighted proactively to keep investors informed can help SME leaders plan their prospectus document.

2: Cover Internal and External Risks in The Prospectus

Although there are no specific guidelines on what to include in this section, SEBI expects companies to include all possible, known, and unknown risks that can affect their business operations so that investors are aware of them before investing.

A business plan usually outlines the SWOT analysis, financial projections, and business risks. It can also be elaborated further to prepare the prospectus.

 It is good to study the recent prospectus filed by a company that is your business's closest representative and use it as a reference to draft the risk factors for your business.

 SEBI requires a detailed listing of a company's internal and external risks.

SEBI reviews and questions these risk factors as part of the draft prospectus approval process to identify any gaps in the communication of risks.

While your merchant bankers and advisors would help, you must familiarize yourself with what must be done proactively.

3: Prepare for SEBI Review, Analyst Calls, and Road Shows

What is surprising is that while the risks are elaborately covered in the prospectus, the probability of these risks or the steps planned by the company to mitigate them are not mentioned.

Hence, the ‘Risk Factors’ section in the IPO prospectus only conveys a message of gloom, with no points to state that mitigating actions or processes are implemented to control the risk factors.

Currently, this is not being done since the prospectus does not advocate the same; maybe SEBI can contemplate giving guidelines to companies to share the mitigating actions or opportunities the company can foresee.

The companies are usually questioned in the analysts' calls or road shows on the listed risks to seek clarity on the probability of their occurrence as a process of valuation assessment.

So, the finance leaders need to prepare for the SEBI review and analysts’ calls and keep their risk mitigation strategies ready.

Have you read the Risk Factors section of an IPO Prospectus? Here Are Sample Extracts.

To get guidance from past prospectuses, we have extracted relevant samples of how companies introduce and draft their internal and external risks.

This is only indicative; you will need to study your business risks and draft accordingly.

This section has three sub-sections:

A.     How the Risk Factor section is introduced in the prospectus

B.      Disclosure of Internal Risks in the prospectus

C.      Disclosure of External Risks in the prospectus

Let us take a look at some examples.

A. How the Risk Factor section is introduced in the prospectus:

Below is an extracted disclosure of a recent filing by an IT company. By going through this section, one can understand how the context is set for the investor before the company starts highlighting the risks impacting their business:

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“An investment in Equity Shares involves a high degree of risk. Before making a decision to invest in our Equity Shares, prospective investors and purchasers should carefully consider all the information contained in this prospectus, including the risks and uncertainties described below and the sections titled "Our Business, "Management's Discussion and Analysis of Financial Conditions and Results of Operations," "Industry Overview," and "Financial Information",. of this Prospectus as well as other financial information contained in the prospectus.”

“The risks described in this section are those that we consider the most significant to our business, as well as the results of operations and financial condition as of the date of this prospectus.” “In addition, the risks described below may not be exhaustive and are not the only ones relevant to us or our Equity Shares, the industry and segments in which we currently operate, or the countries or regions in which we conduct business, particularly India. Additional risks and uncertainties not presently known to us or that we deem immaterial may also impair our businesses, results of operations, financial condition, and cash flows.

Any potential investors in, and purchasers of, the Equity Shares should also pay particular attention to the fact that we are governed in India by a legal and regulatory environment that, in some material respects, may be different from that which prevails in the United States, the European Union, and other countries.

If any of the following risks, or other risks that are not currently known or are currently deemed immaterial, actually occur, our business, results of operations, financial condition, and prospects could be adversely affected, and the market price of our Equity Shares and the value of your investment in our Equity Shares could decline.

In making an investment decision, prospective investors must rely on their examination of our business and the terms of the Offer, including the merits and risks involved. Prospective investors should consult their tax, financial, and legal advisors about the particular consequences of an investment in our Equity Shares.

This prospectus also contains forward-looking statements that involve risks, assumptions, estimates, uncertainties, and other factors, many of which are beyond our control. Certain factors, including but not limited to the considerations described below and elsewhere in this prospectus, could cause our actual results to differ materially from those anticipated in these forward-looking statements.

Unless specified or quantified in the relevant risk factors, we are not in a position to quantify the financial or other implications of any of the risks described in this section. (Disclosure)

The above-extracted disclosure clearly establishes that the company is making all efforts to disclose the risk factors and tries to quantify them where feasible, and the investors are investing on their own and making a considered decision.

B. Disclosure of Internal Risks in the prospectus:

The primary focus of the risk factors would cover: 

• Business-related: Operations, production, customers, employees, etc.
• Statutory compliances, legal, and regulatory matters

The potential risks of running the business and any failure or potential of a failure and how it can impact the business are elaborately explained in the section.

There are bulleted headings or topics on which the risk is explained, followed by a detailed narrative supported by facts and figures. This would give investors a fair understanding to take a considered call.

Get Ready to Prepare the “Risk Factors” Section of the Prospectus:Representative sample extracts from the prospectus of companies that filed for IPO recently in the manufacturing and IT services space (not an exhaustive list):

Risks Related to Business and Operations:

• We operate out of a single Manufacturing Facility located at xxxx; any localized social unrest, natural disaster, breakdown of services, or any other natural disaster in and around xxxx, or any disruption in production at, or shutdown of, our manufacturing unit, could have a material adverse effect on our business and financial condition.
• We are expanding our operations and establishing a network of distributors and customers in regions where we do not have a significant presence or prior experience. Failure to expand into these new regions could adversely affect our sales, financial condition, results of operations, and cash flows.
• We are dependent on a few customers for a significant part of our revenues. Further, we do not enter into long-term arrangements with our customers, and any failure to continue our existing arrangements could adversely affect our business and the results of our operations.
• We are required to obtain, renew, or maintain certain statutory and regulatory permits and approvals to operate our business. If we fail to do so in a timely manner or at all, our business, financial conditions, results of operations, and cash flows may be adversely affected.
• Underutilization of our manufacturing capacities and an inability to effectively utilize our expanded manufacturing capacities could have an adverse effect on our business, future prospects, and future financial performance.
• We do not have long-term agreements with our suppliers for raw materials, and an inability to procure the desired quality and quantity of our raw materials in a timely manner and at reasonable costs, or at all, may negatively impact our business, results of operations, financial condition, and cash flows.
• We have a large workforce, and employee benefit expense is one of the larger components of our fixed operating costs. An increase in employee benefit expense could reduce our profitability. Further, our operations could be adversely affected by work stoppages, increased wage demands by our employees, or any other kind of dispute with our employees.
• We conduct our business in various jurisdictions globally. We may be unsuccessful in operating and expanding into new markets and face numerous legal and regulatory requirements while doing so, and violation of these regulations could harm our business.
• We may also be subject to client and/or third-party claims of intellectual property infringement and unsuccessful in protecting our intellectual property rights. Unauthorized use of our intellectual property may result in the development of technology, products, or services that compete with our services.
• For our products business, we rely on vendors and partners for software, many of which are single-source or limited-source suppliers. Such reliance or adverse change in our relationships could harm our business by adversely affecting availability, delivery, reliability, and cost.
• We conduct our business in various jurisdictions globally. We may be unsuccessful in operating and expanding into new markets and face numerous legal and regulatory requirements while doing so, and violation of these regulations could harm our business.
• Failure to comply with standards required by our clients under our service agreements, which may include industry and country-specific laws and regulations, could harm our reputation, result in liability claims and significant costs to us, and impair our ability to enter into future contracts regarding our services and solutions and serve our existing clients.
• If we are unable to collect our dues and receivables from, or invoice our unbilled services to, our clients, our results of operations and cash flows could be adversely affected. Our success also depends on our ability to innovate, and our business could be adversely affected if we fail to upgrade and adapt our services and solutions to evolving clients' requirements or if we fail to change our pricing model to keep up with clients' expectations.
• Challenges relating to immigration laws, rules, and policies, requiring us to hire locals instead of using our existing workforce, may affect our ability to compete for and provide services to clients in the United States and some European countries, among others. This could result in lower profit margins and delays in, or losses of, client engagements and expose us to penalties in relation to employment visa violations in the future.

Risks Related to Legal, Compliance, Regulatory, and other matters:

• We have availed unsecured loans, which may be recalled by our lenders at any time. We may also convert unsecured loans into Equity Shares, which may dilute your shareholding.
• In the past, our company has delayed the payment of statutory dues.
• We have incurred significant indebtedness and carry substantial debt-servicing obligations. Further, we have a high debt-equity ratio and a low debt-service coverage ratio. If we do not generate sufficient cash flows from operations, our liquidity and our ability to service our indebtedness could be adversely affected.
• We do not enter into hedging transactions with regarding to foreign currency exposure and are subject to risks resulting from foreign exchange rate fluctuations. Any losses, on account of foreign currency exchange rate fluctuations, may adversely affect our business, results of operations, and financial condition.
• We claim deductions under special tax holidays for units set up in special economic zones in India. If these tax holidays, other taxation laws, or their interpretation change within India and in the other jurisdictions in which we operate, such changes may significantly affect our business, results of operations, cash flows, financial condition, and prospects.
• Our insurance coverage may not be adequate to protect us against all potential losses,   which may have a material adverse effect on our business, financial condition, and results of operations.
• If we fail to maintain an effective system of internal controls, we may not be able to successfully manage or accurately report our financial risk. Employee misconduct or such failure of our internal processes or procedures could harm us by impairing our ability to attract and retain clients and subject us to significant legal liability and reputational harm.
• We may engage in acquisitions that may not be successful or meet our expectations. If we are unable to obtain indemnification protection or other contractual protections or relief for any material liabilities associated with our acquisitions or investments, our business, financial condition and results of operations could be adversely affected.
• We have certain contingent liabilities that have not been provided for in our financial statements, which, if they materialize, may adversely affect our financial condition.
• Our failure to comply with anti-money laundering, anti-terrorist financing rules, and regulations thereunder and applicable Indian Securities Laws and related circulars and guidelines issued by various regulatory and government authorities could result in criminal and regulatory fines and severe reputational damage.

 C. Disclosure of External Risks in the Prospectus

Like internal risk factors, many external risk factors may impact the company, and these are specifically mentioned.

A few sample extracts for external risks are listed below:

• Political, economic, and social developments, natural or man-made disasters and hostilities, terrorist attacks, civil unrest, and other acts of violence in India and globally could adversely affect our results of operations, cash flows, and financial condition.
• A slowdown in economic growth in India could adversely affect our company's business.
• Financial instability in other countries may cause increased volatility in Indian financial markets.
• Changing regulations in India could lead to new compliance requirements that are uncertain.
• Inflation in India could adversely affect our profitability and, if significant, our financial condition.
• Any adverse change in India's credit rating by an international rating agency could materially adversely affect our business and profitability.

In addition to internal and external risks, the company also needs to cover risks associated with public issues, but we are not dwelling on that topic in this newsletter.

 Summing up

• To sum up, any investor needs to review the potential risk factors the company identifies in its prospectus and be informed before making any investment decision.
•   Finance heads and business leaders who are contemplating an IPO listing soon should know how the risks are communicated to prospective investors in their prospectus to be filed as part of the IPO listing.
• Please understand that SEBI and other agencies will review this before they give approval to proceed with the IPO listing.
• The key is to ensure that the risk factors are as exhaustive as possible and that efforts are made to list all the risks associated with the business.
•  The called-out risk would also be discussed in the analyst call or investor roadshow, so company leadership must be better prepared with answers.

We hope you found this newsletter topic useful. Do share your feedback. Thanks

Sources used:

We have taken the sample extracts from the ‘Risk Factors’ section II of the prospectus of the following three companies:

a. Tata Technologies. : https://www.sebi.gov.in/filings/public-issues/mar-2023/tata-technologies-limited_68881.html

b. Jyoti CNC: https://www.sebi.gov.in/filings/public-issues/jan-2024/jyoti-cnc-automation-limited-prospectus_80603.html

c. Platinum Industries. https://www.sebi.gov.in/filings/public-issues/feb-2024/platinum-industries-limited-rhp_81623.html