Sarbanes-Oxley Compliance: Impact on Private Companies

The Sarbanes-Oxley Act of 2002 and the related rulemaking by the SEC and the stock exchanges has profoundly impacted the corporate governance and financial reporting processes at public companies. Many private companies have also felt pressure to comply with certain provisions of these regulations and may realize benefits from improving their processes. Investment bankers advising private companies on financing transactions and M&A deals should advise their clients on how the new reforms will affect private companies.

Financing Transactions

Private companies that are seeking financing should expect investors to request additional information and possibly request specific corporate governance covenants. Many venture capitalists serve on boards of directors for other companies, some of which may be public companies and some of which may be preparing for an IPO. Investors want to know that the portfolio company is well-suited for a liquidity event, such as an IPO, and that if the company goes public, it will be able to succeed as a public company. As a result, the venture capitalists have been learning about the world of corporate governance and are becoming increasingly aware of issues related to director liability. In order to protect themselves and their portfolio companies, investors are promoting steps to evaluate and improve the company's corporate governance and financial reporting processes.

Companies seeking private financing should expect the following:

• Investors will expect increased disclosure even in private financings; PPMs usually include similar information as would be required in registration statements. This may include more discussion about the company's financial results (similar to MD&A).
• Investors may request additional representations from the company about related party transactions and potential conflicts of interest. Investors may also request that the company establish audit and compensation committees, with detailed charters.
• Investors will ask additional questions about the company's financial reporting process and corporate governance practices. Investors may ask the company to provide copies of any corporate governance guidelines, business ethics policies and key committee charters that the company has adopted.
• Investors will still request and expect to have seats on the company's board of directors. However, when negotiating board composition, the company should consider the appropriate number of truly independent, outside directors and make sure that the investors' rights to have their representatives serve on the company's key board committees (audit, compensation and nominating/governance) terminate at the time of the IPO.
• Underwriters and investors will want to see that a company headed toward an IPO has experience operating under its governance principles.
• The public offering process is very demanding — implementing appropriate governance practices in advance will ease the process.

Mergers and Acquisitions

Another possible liquidity strategy for a private company may be merging with, or being acquired by, a public company. When a public company acquires a private company, the private company's financial results are usually consolidated with the acquirers' financial results. Also, the public company usually takes on the liabilities of the private company. For these reasons, public company acquirers are increasingly taking steps in their due diligence to determine whether the private company has implemented good corporate governance practices and sound financial reporting processes. The primary reasons why public company acquirers may spend more time inquiring about the private company's practices in these areas include:

• Public companies that acquire private targets will take comfort knowing that the business they are acquiring is less likely to face shareholder litigation or discover hidden fraud or other abuses.
• The acquirer will appreciate relying on the target's sound internal financial processes, especially as those results get consolidated with the acquirers' results.

Other Benefits

Even if the company is not considering a liquidity event in the near future, there are many other parties that will expect to see an increased level of compliance. For example:

• Banks and other lenders may increase their inquiries about the company's financial reporting processes.
• Insurance companies are more concerned about corporate governance practices, particularly when writing D&O policies.
• Prospective board member candidates may demand enhanced governance practices before accepting a nomination.
• Prospective senior management team members will also ask more questions about a company's practices before accepting a position of leadership and responsibility.
• Customers, joint venture partners and other business partners that are public companies will expect their business partners to follow the same practices
• Auditors will apply many of their additional procedures required in connection with public company audits to all of their audit clients.
• Judges and courts hearing matters regarding shareholder lawsuits or other corporate wrongdoing are interpreting and applying fiduciary duty standards with an expectation that companies are implementing additional corporate governance procedures.

Best Practices

Complying with the SEC and stock exchange rules can be time-intensive and expensive. Private companies should decide carefully which steps to take to improve the company's corporate governance while maintaining the flexibility that emerging companies need and balancing the costs of compliance. For all of the reasons described above, compliance can also save costs and minimize risks and even add value to the company. Following are a few suggestions on best practices that private companies should consider:

• Identify at least a couple truly independent directors to serve on the board.
• Establish key board committees, such as an audit committee and a compensation committee, and elect truly independent directors to represent at least a majority of the committee members. Consider adopting charters for these key committees and hold regular meetings.
• The audit committee should meet each quarter and should meet separately with the independent auditor.
• The compensation committee should meet at least twice a year and should be responsible for setting, approving and evaluating compensation for the senior executives.
• Confirm that the company's independent auditor is appropriately suited to the company's needs and is independent of management. Use a firm other than the company's independent audit firm to provide non-audit services that may impair the independent auditor's independence.
• Adopt policies and practices to avoid conflicts of interest. Prohibit, or carefully monitor, any transactions between the company and an insider. A board committee with independent directors should approve all related party transactions.
• Provide means for employees to submit concerns about the company's accounting or auditing practices or other non-compliance on an anonymous basis. Establish a procedure for promptly investigating and handling any claims that are submitted.
• Consider whether the company adequately documents the company's processes for financial reporting, internal controls, determination of executive compensation arrangements and enforcement of ethics policies. Discuss with advisors the appropriate level of documentation — enough to show the company followed good processes, but not too much to create a paper trail that could be used against the company.

Sarbanes-Oxley, and the related regulations and exchange requirements, have significantly "elevated the bar" for many areas of corporate governance and financial compliance for public companies. Many private companies can expect that several of these requirements will also, directly or indirectly, be extended to them. By taking action now to comply voluntarily with many of these requirements, larger private companies (or those companies with aspirations of achieving significant growth, going public or being acquired) can reap rewards associated with third party approvals and improved internal controls and governance, while at the same time reducing their litigation exposure. In addition, investors and acquirers may be willing to pay a premium to invest in or buy companies with sound corporate governance practices. The administrative cost — in time and dollars — associated with undertaking such actions will in most cases be outweighed by these benefits.