Sarbanes-Oxley For Start-Up's: Does it Matter?

Joseph W. Bartlett, Founder of VC

This is the first of a three-part series on Sarbanes-Oxley and its practical implications on private equity firms, and more importantly, their portfolio companies.

Just when you thought you had plumbed the depths of Sarbanes-Oxley, the parade of horribles which counsel are serving up to the management and directors of public companies along comes a point of view, expressed by Carter Beese of Riggs Capital Partners in an opening speech at the NASBIC annual meeting at Palm Beach last month, to the effect that Sarbanes-Oxley will be applied, ceteri paribis, to private companies. Excerpting from Mr. Beese's presentation, Sarbanes-Oxley has, among others, the following results:

"A dramatically changed atmosphere for corporate fiduciaries of all companies, public or private:

  • You must be fully aware of the new regulatory/legal burdens

  • Stricter corporate governance will be mandatory for all companies, public or private

  • It is inevitable that the standards of public company governance will be increasingly applied to private companies.

Particularly effects private company governance in several key situations:

  • Board composition, Audit Committee responsibility

  • Companies in financial distress: the "zone of insolvency"

  • Companies considering M&A opportunities, particularly with a public company

  • Companies considering an S-1 registration statement for IPO

But has equally profound indirect effects [on]:

  • D&O coverage and costs

  • Private equity fund transparency

Beese forecast that, for both public and private companies (the issue for public companies is beyond argument), the net effects will include: increased costs, increased time spent on these issues, increased liability and increased complexity, coupled with challenges if and as the company achieves a liquidity event in the form of an IPO or a trade sale.

And, he is certainly right that there are overflow effects of Sarbanes-Oxley of concern for private firms. The statute of limitations, for example, extended for shareholder lawsuits against directors in both public and private companies . if not because of Sarbanes-Oxley, then as voted by state legislatures and judges reacting to the forces which gave rise to Sarbanes-Oxley, i.e., the more or less universal revulsion at highly visible examples of corporate misconduct. Sarbanes-Oxley does in fact amend the Bankruptcy Code to eliminate a discharge in bankruptcy for securities law liability, which is a danger to both public and private companies; and D&O costs will go up across the board (they already have for both public and private issuers). However, I do not believe that the Act particularly the certification requirements, are likely to "trickle down" to private companies even in, as Beese puts it they are unsolved, 'trade sales to a public company.' The question of representations and warranties in private trade sales (which is another way of looking at the certification requirements) is, of course, always on the table.

However, if the issuer is being acquired in toto from its shareholders who stands behind the representations and warranties post-closing? It is rarely, and I think it will continue to be rarely, the responsibility of the target board of directors to back up representations and warranties. I don't think the CEO and the CFO, by signing the closing certificates, are executing the same with the equivalent impact of a Sarbanes-Oxley certification and I do not believe that personal liability for those certificates will be the next big thing. See the Buzz of the Week on "Sleeper Clauses" (October 1, 2002).

Also, I do not believe that there will be a general prohibition on loans by private companies to officers and directors. Beese thinks such loans "are clearly bad corporate policy for any corporation now." That is not a statement which can be supported by logic and principle in private equity; there are any number of reasons for companies to make loans to management in the private equity context, the great majority of which were legitimate.

Moreover, if we are talking about venture-backed companies, the independence of the board is a given. The VCs are usually in control and they certainly control the key committees. Since most of these companies are losing money and indifferent (at least until they approach the IPO penumbra) to reported earnings (cash flow is king in private equity), I do not see major roles for audit committees. The board, as a committee of the whole dominated by VCs, usually has a pretty good line, independent of any management shenanigans, on how the numbers are being presented.

I also do not agree with Beese's criticism of "membership by investors on multiple boards, particularly where two portfolio companies may compete." The essence of venture capital is multiple board seats for the managers of the private equity fund concerned; and it may be, from time to time, that the companies compete. But it is rare that the opportunity for predatory conduct is thereby enhanced. Total "independence" of board members in venture-backed companies is a fine-sounding concept; but, the pursuit of value added board members is vital to the venture process and the fact that one or more may be less than entirely pure is not the major consideration; the trick is to get board members capable of adding value in the first instance.

Nice questions about independence are not usually of material importance in entrepreneurial finance. In other words (if it has not become apparent) I understand where Mr. Beese is coming from; but I do not forecast that hundreds of thousands of private companies are going to be able to afford, or indeed induced to shadow, most of the provisions of Sarbanes-Oxley. Of course directors are going to be on their toes across the board in private and public companies; and, litigation is becoming more and more a way of life in the United States. However, one must remember that professional plaintiffs' counsel are not usually attracted to private companies. The shareholder census is limited; the major shareholders are usually represented on the board; the company may have gone broke, which creates damages by definition, but the likelihood of securities fraud, assuming all investors are accredited and have been given an opportunity to perform due diligence (or are following the due diligence of the lead member of the syndicate), is usually remote.

I do not purport to diminish the points made Beese's presentation, many of which are spot-on. His remarks on the necessity of directors generally (whether the company is public or private) reviewing the D&O coverage is compelling. For example, if the D&O policy covers not only the directors and officers but also the corporation itself, in bankruptcy the creditors can take the view that the coverage is an asset of the company and, therefore, the proceeds of the policy unavailable to the directors and officers. Moreover, influenced by pressures arising in the public arena, fewer directors may be viewed as "truly disinterested" for purposes of validating inside trades of one kind or another under Del. GCL. õ 144. And, heightened exposure under Sarbanes-Oxley will influence the question whether to sell the company or go public (a point I have made before, see Buzz, "The Public or Private Question," October 8, 2002, because the registration process necessarily implies that the registrant is full compliant with Sarbanes-Oxley.)

In other words, Beese is correct that the pendulum, fueled by public anger and animosity is swinging in favor of minority shareholders and plaintiffs in general including particularly the plutocrats who make a living as plaintiffs' counsel. But, I do not think the typical start-up with a limited number of shareholders (consisting of friends and family, the founder the occasional angel and the VCs) needs to get overly excited about collateral damage arising out of Sarbanes-Oxley and its siblings. Many early stage companies elect not to pay for audited statements and, therefore, the functions of an audit committee are generally irrelevant. There is little or no secondary trading and rescission actions, based on flawed placement memoranda, are not usually based on the allegation that the losses of the company had been understated. My prediction, in short, is somewhat different than Beese's . i.e., that an increasing number of public companies will seek to retreat to private status with one, but only one, of the driving forces being the exposure to shareholder litigation which is multiplying itself in the current climate.