Introduction
When a company decides to go public, it must introduce itself to the market through a detailed disclosure document known as the Draft Red Herring Prospectus (DRHP). This document is prepared under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, often referred to as the ICDR Regulations.
The DRHP does not only highlight the company’s strengths and opportunities. It also presents the challenges that may affect its business in the future. These challenges are set out in the “Risk Factors” section. This is where a company lists the uncertainties, vulnerabilities, and possible adverse situations that could affect its operations, financial performance, or long-term prospects.
The law requires that these risks are stated clearly and are specific to the company. Generic or vague statements are not acceptable. The aim is to help investors make a fully informed decision based on both the potential and the risks of the offer.
A. Why Risk Factor Disclosures Matter
The risk factors section serves two main purposes:
First, it is a matter of compliance. The company must disclose all material risks to meet the requirements of the ICDR Regulations. Omitting important information or making false statements can lead to regulatory action under the Companies Act, 2013, and the SEBI Act.
Second, it is an important tool for investor protection. It gives potential shareholders a clear view of the issues that could impact the company’s future. Investors can weigh these risks before deciding to subscribe to the offer.
For companies, this section also has another benefit. A well-drafted set of risk factors creates a record that the company informed investors of possible hurdles. If those hurdles appear later, the company can point to this record to show that it acted transparently at the time of the offer.
Example of how risk factor is disclosed in DRHP: Snapshot from DRHP of LG Electronics India Limited
- Benefits for the Company
- Meeting Regulatory Obligations and Avoiding Penalties
A complete and accurate risk factors section ensures the company complies with DRHP disclosure rules. This reduces the chance of penalties for non-disclosure or misstatement. It also limits exposure under the Companies Act, which treats misstatements in a prospectus very seriously.
- Defence in Litigation and Investor Disputes
If risks are disclosed in clear and specific terms, the company can use them as evidence that investors were properly informed before investing. This can help defend against shareholder complaints, regulatory investigations, or claims that material facts were hidden.
- Setting and Managing Market Expectations
By explaining potential challenges upfront, the company sets realistic expectations for the market. This can reduce negative reactions when those challenges arise after listing and protect the company’s credibility.
- Enhancing Transparency and Governance Reputation
Specific and relevant disclosures show that management understands its responsibilities. This builds trust with institutional investors, market analysts, and regulators, and supports a stronger reputation for governance.
- Improving Internal Risk Awareness
Drafting the risk factors section forces management to identify and evaluate operational, legal, financial, and market-related vulnerabilities. This process can highlight areas that need better controls, contingency planning, or new policies.
- What Makes a Good Risk Factor Disclosure
A useful risk factor statement is specific. It explains the exact nature of the risk, why it is relevant to the company, and how it could impact operations or financial results.
An effective disclosure usually:
- Names the risk clearly.
- Gives background on why the company is exposed to it.
- Adds numbers or data where possible, such as revenue dependence or cost exposure.
- Uses plain language instead of technical jargon, so any investor can understand it.
Generic statements like “Our business may be affected by market conditions” do not help investors and do not protect the company in the same way a detailed, tailored disclosure can.
- Investor Perspective
For investors, the “Risk Factors” section should be one of the first parts of the DRHP they read. It often contains information that is more candid than other sections of the document.
Investors should check whether:
- The risks are described specifically rather than vaguely.
For example:
Vague disclosure: “Our business may be affected by changes in government policy.”
Specific disclosure: “Our business depends on government defence contracts, which contributed 70% of our revenue in the last fiscal year. Any reduction in defence spending or delay in tender awards could significantly impact our revenues.”
The second version tells you what policy, which revenue stream, and how it could hurt the company.
- The company provides facts and figures to support the statement.
For Example:
Without numbers: “A large portion of our raw materials is imported and subject to price volatility.”
With numbers: “We import 60% of our raw materials from Southeast Asia. A 10% increase in international commodity prices in the last fiscal year increased our costs by ₹35 crore, which materially impacted margins.”
Numbers give investors a measurable sense of scale, rather than leaving the risk abstract.
- There is a clear connection between the risk and the company’s business model.
For Example:
Generic statement: “We may be adversely affected by competition.”
Linked to operations: “Two large multinational competitors have recently entered our product segment with significantly lower pricing. If we are unable to match their pricing, our market share in Tier I cities may decline.”
Investors can now see how competition plays out in the company’s market, instead of just being told “competition exists.”
- The company explains any steps it is taking to address the risk.
For Example:
No mitigation shown: “Our revenues are dependent on a few large customers.”
With mitigation shown: “Our top five customers contributed 40% of our revenues in FY 2023. To reduce this dependence, we are expanding into new sectors such as automotive and consumer electronics, where no single customer accounts for more than 10% of projected revenue.”
A disclosure that combines the risk with a mitigation plan gives confidence that management is not only aware but also proactive.
When these elements are present, the section becomes a valuable guide to understanding both the potential and the limits of the business.
Conclusion
The “Risk Factors” section is more than a legal requirement. It is a communication tool that, when done well, serves both investors and the company.
For investors, it offers transparency and a realistic picture of what could go wrong. For companies, it helps meet regulatory obligations, manage expectations, strengthen governance standards, and build a defence against future disputes.
Writing this section with care is good compliance practice. It is also good business. It signals to the market that the company is honest about its challenges and confident in its ability to address them. In the fast-moving and unpredictable world of capital markets, that combination of honesty and preparedness can be as valuable as the business opportunity itself.