Sarbanes-Oxley squeezes startups – Private companies face new hoops to jump through.

The Sarbanes-Oxley Act – passed in the wake of the questionable accounting practices by such capsizing corporate giants as Enron, WorldCom and Global Crossing – was designed to increase transparency in financial disclosure and instill good governance in publicly traded companies. Backed with the threat of stiff legal punishments for boardroom scofflaws, the corporate-reform legislation would bring confidence back to investors.

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What lawmakers did not count on was the havoc that the increased internal controls and ethics codes would wreak among private startups – many of them in the technology sector.

While few would argue with the law’s lofty goals, Congress may have thrown a wrench into the exit strategies of many promising young companies.

Private companies are not covered by Sarbanes-Oxley, but in order to prepare for exit strategies, startups face strong pressure from investors to comply with the law’s provisions. These mandates include the approval of corporate financial statements by CEOs and CFOs; a limitation on “sweetheart deals” with companies linked by board members; the end of the widespread perk of company-backed loans for top executives; and a much more rigorous definition of oversight and fiduciary responsibility for corporate directors.

Sarbanes-Oxley adds legal, accounting, and recruitment costs to the startup equation far earlier than previously required. Dotting all of those bureaucratic i’s can distract management from other pressing tasks. And finding independent board members as required by the law in a clubby place like Silicon Valley can be a formidable task.

"Corporate governance rules make it much more difficult to go public," says Mark Medearis, a partner at Heller Ehrman White & McAuliffe, and a founder of Venture Law Group, which recently merged with Heller Ehrman. "It increases the costs and time spent with accountants and lawyers. It fundamentally makes the exit strategy harder.”

Brooke Seawell, a general partner at Technology Crossover Ventures, stresses the additional time now needed for companies to prepare to go public. "It used to be you would call a meeting, round up the lawyers and the management team, and say, ‘It’s time to go public.’ But if you do that today and you are not Sarbanes-Oxley compliant, you have got a lot of catching up to do," he says. "You have to think about the topic from the beginning."

Ernst & Young’s recent report, “2002: Year in Perspective,” shows that companies heading toward an IPO must now make major mid-course infrastructure changes. Sarbanes-Oxley may extend the time from seed financing to public offering an average of a year or two. Companies that wait till the last minute to plan for the law’s requirements risk even longer delays. Most startups are only beginning to grapple with provisions of the law.

One stipulation that will impact all IPO-bound companies is the requirement of a completely independent audit committee on a board of directors. Young VC-backed companies, which typically have hand-picked boards designed to strengthen them, will need to scramble in the months before an IPO to find independent directors.

Another provision no company can escape is Section 404. It requires management to document and evaluate internal controls and procedures for financial reporting – forcing a great deal of detail work onto private companies previously spared until now. A new industry, in fact, has grown up supplying software and services to assist in the process.

Sarbanes-Oxley also targets a tool used by startups for a variety of reasons: loans to senior executives In cities like San Francisco and New York, where housing prices are extremely high, companies have relied on executive loans to lure managerial talent. That weapon is now banned from the arsenal. But an even thornier problem is keeping top executives committed to the companies they join. The ban on loaning money to purchase shares in pre-IPO companies could give executives a freelance mentality – loyal only to themselves.

Even startups with acquisition exit strategies may be affected by the law. Public companies that are complying with Sarbanes-Oxley may begin looking for the same compliance from their acquisition targets.

The private companies hardest hit by the requirements of Sarbanes-Oxley will be those that have been waiting for the IPO market to open up. Many have been planning exit strategies for several years, and retooling their plans again is one more cruel twist of fate. For newer startups that are only beginning to contemplate their exit plans, the headaches will be less painful if only because they have more time to adapt. But a headache is a weak reason to forego a public offering.

"Some CEOs at startups are a bit put out – they are already overwhelmed with so many priorities. This just adds one more to the stack," says Todd Chaffee, a managing partner at Institutional Venture Partners. "But look,” he adds, “Sarbanes-Oxley is also about good housekeeping and good management. A lot of the buttoned-down VCs and CEOs were doing this anyway. It has just gone from something you want to do, to something you have to do."

Some in the VC and merger-and-acquisition fields argue that applying Sarbanes-Oxley to small startups is like using a sledgehammer to drive in a nail. Wade Meyercord, a compensation consultant and board chairman of the once fraud-plagued California Micro Devices, argues that the new laws distract board attention away from business strategy and building shareholder value, and toward defensive measures and legal compliance. Speaking at a conference in August, he expressed doubts that the law will actually prevent corporate fraud. Recalling his experiences at California Micro, he believes that the company “could have caught [the fraud] sooner. But prevent it? I don’t think so.”

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