Virus-Vetted Thoughts on Risk Factor Disclosures

A key piece of good disclosure in offering documents used to raise investment capital is the “risk factors” section.  This section is used to highlight important risk factors a prospective investor should consider in making an investment decision.  Its tone is the opposite of good salesmanship—here are all the reasons not to make this investment!  Companies often want to use “boiler-plate” disclosure language or fail to give careful thought to the true risk factors their business can face.  They simply do not want to discuss the potential downside to investing in their business.

The COVID-19 crisis provides a gut-punch reality check on giving careful thought to risk factor disclosures.  The picture posted nearby shows the parking lot I can see from my office window.  The picture is taken mid-morning on what would otherwise be a typical business day, and ordinarily nearly every slot would be filled with other cars circling to find a scarce empty space.  Who was thinking last week about the implications of a two-week or longer near total shut down of business activities across the entire economy?  We are now discovering in real time how staggering the risk factors were.  As the picture shows, what looked sunny and hopeful just last week, today looks dark and overcast.

Risk factors need not predict the future.  Yet they really must identify the key risks currently embedded in the business.  The metric for evaluating what risk factors need to be disclosed is, “what would a reasonably prudent investor want to know in making an informed investment decision.”

If risks factors were being written this week instead of last week, I daresay they might be addressing issues such as:

• Is our supply chain secure or at risk for disruption, and does it have built in redundancies.
• How stable or sustainable is our customer base.
• How is our business affected in the event of significant stock market variations, or dramatic fluctuations in interest rates.
• Is our existing technology robust enough to facilitate significant numbers of employees working remotely.
• Do we have established succession planning and redundancy for key employees.
• Are we adequately capitalized to weather significant short-term disruptions in cash flow.

The list of these issues is limited only by our imagination.  While some risk factors are systemic, others are distinctive or unique to a specific business plan.  An investor is entitled to know them, and the company has a responsibility to make them known prior to taking the investor’s money.