VCs Wrestle With Sarbanes-Oxley: As business takes off,investors are finding howthe Act –

When the Sarbanes-Oxley Act was passed two years ago in the wake of the Enron and WorldCom scandals, lawmakers touted it as a prescription that could restore confidence in the public financial markets and stem the tide of corporate corruption that seemed to have flooded American businesses.

Most observers would agree that Sarbanes-Oxley is the single most important piece of legislation affecting corporate governance, financial disclosure and the practice of public accounting since the U.S. securities laws of the early 1930s.

As the bill’s provisions went into effect, it was public corporations shouldering the rising costs for compliance, while private companies and venture capitalists watched from the sidelines.

As the economy slowly improves, however, and the IPO becomes en vogue again, it’s venture capitalists who find they must grapple with the effects of Sarbanes-Oxley, as well as its increased costs. In short, the act is changing the way investors prepare to exit their companies.

“The IPO market was virtually nonexistent for a while, so venture capitalists had other things to worry about,” says Audrey Roth, the head of the private equity and emerging companies group at Sullivan & Worcester in Boston.

Now, she says, many VCs have to focus on Sarbanes-Oxley because the market is coming back. And now, no matter if an investor is looking at an IPO or an M&A transaction with a public company, the deal likely requires compliance with Sarbanes-Oxley.

“IPOs are not looking as enticing as they did before Sarbanes-Oxley was passed,” she adds.

The problem, Roth says, is that VCs have to spend more time doing due diligence on their investments and concentrate more on building bigger companies with more robust infrastructures.

“As a result, we’re seeing a bunch of roll-ups to make the VC-backed companies stronger so they can go public and absorb the extra costs or be acquired at a greater cost in an M&A,” Roth says.

Costly Changes

The cost of complying with the new rules includes higher accounting fees, legal fees, insurance costs and training costs. And companies have to pay directors more to take a seat on the board.

For example, Netegrity, a security software provider from Waltham, Mass., which reported more than $78 million in revenue in last year, doubled its cash retainer paid to non-employee board members from $6,000 in 2002 to $15,000 in 2003. Plus, the chairman of the its audit committee will receive an additional $15,000 a year and the other members of the audit committee will receive an additional $5,000 a year – added costs that did not exist before Sarbanes-Oxley was enacted.

Among other things, Sarbanes-Oxley creates protections for whistleblowers and imposes new criminal penalties relating to fraud, conspiracy, and interfering with investigations. As a result, directors face exposure to increased legal liability under the new law. So while Sarbanes-Oxley was never intended to raise compensation for board members, it’s a result nonetheless.

Why would anyone want these jobs if they weren’t getting paid for them?” wonders Tom Murphy, the head of securities and corporate governance at McDermott, Will & Emery in Chicago.

Neil Aronson, the head of corporate transactions at Mintz Levin Cohn Ferris Glovsky in Boston, has seen audit costs for public companies double in the last two years.

Aronson points out that since the legislation requires increased independence and financial expertise in the make-up of a board of directors, companies have found it difficult to find good people to fill seats.

“Where you used to have three founders and two venture investors, now you have one founder, two venture investors and two outsiders that are acceptable to everyone,” he says.

In addition, companies are required to institute a number of new internal controls to monitor the quality of financial processes and reporting. Thus, investors need to obtain independent assistance on appraisals of assets and valuations of all kinds because internal auditors are barred from doing it themselves.

“It was hard before, but it’s harder now,” says Murphy about all the new red tape. “There’s only so much time in a day. If an executive spends a lot of time trying to figure out how to file a certification, that’s time they can’t spend reading the report and determining how accurate it is.”

The end result is that companies need to be bigger and more prepared when they launch an IPO than they were before. Not only do they need deeper pockets to cover the costs of increased regulation, they also need to be large enough to attract the attention of analysts in order to garner a following once they start trading on an exchange. Under Sarbanes-Oxley, this is much more difficult for a smaller company now that analysts at investment banks have become less prevalent.

However, Stephan Mallenbaum, a partner in the capital markets group at Jones Day in New York, says that Sarbanes-Oxley presents a new opportunity for the buyout community.

“VCs are approaching the big LBO funds out there to see which can grow a portfolio company to the next level,” he says. “A lot of capital has flowed to private equity funds as people have pulled back from VC funds lately, so they should have the means to do it.”

While most industry sources agree that Sarbanes-Oxley has been effective in making companies invest more in their corporate governance standards, some are not sure that the benefits gained were worth the cost.

“It was an overreaction in some ways,” says Roth. “The costs are actually too much for the benefits. I think there are other ways to fix the system that wouldn’t be so onerous and draining on the companies themselves.”

Still, studies have shown that good corporate governance at a company usually makes for better operating results. Aronson points out that venture capital funds are dealing with their own conflicts of interest when it comes to disclosing portfolio results to limited partners.

“Whether it’s mutual fund industry or venture capital industry or the corporate world, everyone’s looking at what we can do to make sure we have appropriate controls on the people that are managing our company or our assets,” he says.