The Impact of Sarbanes-Oxley on Private Companies

The Sarbanes-Oxley Act has ushered in sweeping changes to corporate governance, putting compliance issues at the forefront for U.S. public companies. When SOX was adopted in 2002, the congressional record indicated that it was not intended to apply to any organization other than public companies. What initially seemed only to affect public companies is now also having far researching implication on corporate America as a whole.

According to a PricewaterhouseCoopers’ report, CEOs from 30 percent of the nation’s fastest-growing private companies say that the Sarbanes-Oxley Act has had an impact on them and their business over the past 12-24 months, or will in the near future. The management teams and Boards of Directors of many private companies are embracing various aspects of SOX as introducing a new platform of “best practices.” Also, familiarity with these new rules will help private companies avoid pitfalls that could interfere with important future milestones such as strategic partnerships with a public company, an acquisition by a public company, or an IPO. It is understood that these new rules will contribute to the foundation of a company culture of fiscal and corporate responsibility.

In light of SOX, CEOs and business executives leading fast-growing private companies need to ask these questions:

·   What is the SOX Act, and how does it affect our company?

·   How will adopting the SOX principles make us a better company and create value?

·   Do the benefits of SOX compliance now outweigh the costs?

·   What are the responsibilities for our management team?

·   How do we get started with our roadmap to SOX compliance?

Private companies should view this as an opportunity to implement best practices and adopt a company culture that is less susceptible to the problems that prompted the enactment of these new rules. Sound business practices mean a well-controlled environment, better financial information, and better financial planning. This leads to better business planning, improved tactical operations, and improved company valuation. Since the management team holds majority of the stock in most privately owned companies, all of which should translate into a better return for all stakeholders!

Do you have a strategic alliance with a public company?

Chances are great that your company is selling a product, providing a service, or has a strategic relationship or an outsourcing agreement, with a public company. To increase their protection the public companies are pressuring their private strategic partners to improve their Internal Controls (following SOX Section 404 compliance regulations) or similar governance processes, as a condition of working together in the future. This is especially true if a private company partner receives favorable credit terms, or long-term contracts, in a heavily regulated industry, or has any controls over significant payments, receipts, or business activities.

Are you working with lender to get a loan, or a line of credit?

Traditional lenders such as banks, leasing companies, and insurance companies, increasingly have begun to focus on whether their clients have effective Internal Controls and corporate governance policies. Lenders are beginning to require compliance with some of the SOX requirements before providing financing. Lenders are particularly interested in accurate financial reports and may require officers to certify the accuracy of such reports similar to certification requirements imposed on public officers under SOX.  Also, private companies with public debt must comply with the SEC’s reporting requirements. This may include the executive certification and Internal Control reporting requirements, providing financial statements, and associated auditor’s reports in the fiscal year the registration statements for such debt are declared effective.

Are you going to raise money from venture capitalists?

Increasingly, venture capital firms are finding it necessary to bolster their governance of investee companies, in light of the SOX, with clear implications for the way that they conduct business. A venture capital firm’s ultimate goal is to maximize investments for its limited partners by providing a return on investment through various exit strategies, including initial public offering, the issuance of public debt, the sale of assets, a private sale, or a combination of all of the above. The requirements of SOX take on an even more important role when the exit strategy for the venture capital firm involves an IPO or public transaction. After the transaction, under the SOX, there will have to be reports on Internal Controls over financial reporting and an assessment of management’s process for evaluating and reporting on the control environment. The portfolio companies must also have a robust oversight program in place in order to maximize the return on investment. Venture capitalists are now reviewing business plans, compliance programs, and internal and external audit scopes of their current portfolio companies. The expected payoff in the future will be less oversight time for acquisitions and exit strategies and enhanced valuations for all.

Do have plans to be acquired by a public company?

Private companies that may be acquisition targets will benefit from SOX compliance. The industry data clearly points to a fundamental reality that private entrepreneurial companies are more likely to experience a liquidity event through an M&A transaction than through an IPO in today’s market. It is not difficult to see that SOX can have significant implications for private companies that ultimately may be acquired by a public company or even by another private company seeking to go public or be acquired by a public company. SOX may result in increased scrutiny of a private company being considered for acquisition by a public company, because of the likelihood that public company suitors would have a higher comfort level with a private company that followed similar standards. Any potential public company acquirer will likely want to conduct significant due diligence on the private company’s controls and procedures and will insist on representations in the acquisition agreement covering the Internal Controls and procedures. This will be necessary to help ensure that the acquirer is in a position to make the required statements and certifications in its SEC filings with respect to its own Internal Controls and procedures. Because following the acquisition the SEC filings will resume and depend in part upon the Internal Controls and procedures of the private company. So, in certain cases, buyers might be willing to pay a premium for companies that have brought their system of Internal Controls into line with standards in the Act’s Section 404 before the transaction.

Do you have plans for an IPO?

Private companies that are on the IPO Journey must be prepared to meet Section 404 and 302 requirements and should have a good grasp of what is required of public companies. Because a private company will become subject to the SOX Act upon filing an IPO registration statement with the SEC. There are certain key matters to be addressed by IPO candidates in the 12 to 18 months before an IPO. They should have a level of Internal Controls and procedures in place that will enable it to comply with SOX and take similar steps toward compliance so they can meet requirements as soon as necessary. This includes planning for the costs of compliance, recruiting and compensating independent directors, acquiring director and officer liability insurance (D&O) and expanding staff, either on an in-house or outsourced basis, to manage the SOX requirements and needs. The underwriters and investment bankers of a company’s IPO will almost certainly scrutinize the company’s Internal Controls and procedures as part of their due diligence process. Their initial determination of a material weakness or significant deficiency could prevent the company from going public. Therefore compliance beforehand may save substantial time and expense.

Business executives and board members of private companies must ask themselves: is SOX worth the time and effort? As with any significant organizational decision, the benefits of adopting certain provisions of SOX must be evaluated in light of the related costs and their relationship to a company’s overall strategies, objectives, and goals. And even in an indirect sense, SOX will affect a private company’s relationship with its accountants. For example, private companies may experience difficulty getting their accountants’ attention to complete an audit any time between January and the end of March given the Form 10-K filing deadlines for public companies with calendar fiscal year ends.

Private companies may find that the wisest approach, and certainly the most proactive one, is to voluntarily incorporate key SOX requirements, rather than waiting for the requirements to catch up to them. Being prepared, well in advance, is sound advice. Companies that view the SOX compliance process as a starting point are in a stronger competitive position to navigate the fast-changing regulatory environment. Becoming familiar with the new corporate governance and disclosure rules applicable to public companies will help a private company prepare for an acquisition by a public company or an IPO. SOX compliance should be looked as the starting point for greatness, increasing value, and ultimate success.