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How Sarbanes-Oxley makes electronic startups less competitive

The legislation may have prevented accounting debacles, but it's also had a chilling and unintended consequence: reducing or eliminating the attractiveness of an IPO as a growth strategy for small electronics firms.

By Geoffrey James -- Electronic Business, 9/25/2007

It's been five years since congress passed the Sarbanes-Oxley Act, and vice chairman of the Nasdaq stock exchange Michael Oxley (who as a congressman co-authored the Act) has been quick to insist that it's made U.S. firms more competitive.

"Other countries have stepped up and understood how important it is to have these kinds of standards, and I would expect that this will continue apace and continue to pay great rewards," he said recently.

However, while Sarbanes-Oxley may have prevented accounting debacles like those that plagued Enron, Tyco and WorldCom, it's also had a chilling and unintended consequence: reducing (and even eliminating) the attractiveness of an IPO as a growth strategy for small electronics firms. "Hardly a week goes by that I don't hear the CEO from a startup say that they can't go public because they can't afford to hassle with government regulations," says Doug Brockway, managing director at Innovation Advisors, a banking firm that caters to small and mid-market technology firms.

The reason? Expense. Sarbanes-Oxley compliance can be pricey in a large firm; National Semiconductor, for example, spent $7 million and consumed 68,000 worker hours, according to CNET. But while compliance costs less for a smaller firm, there's a base minimum that a company must spend, and for a startup that amount is far from chump change. "It can cost anywhere from half a million to a million dollars to get up to speed, and that's the kind of cash that most startups simply don't have lying around," says Brockway.

To make matters worse, smaller firms often lack the existing infrastructure that might make compliance less expensive, according to Gartner analyst Dale Hagemeyer. "When you're growing a company, you typically don't have the management bandwidth to worry about hiring professional 'watchers,' much less watchers to watch your watchers," he says. And the extra expense isn't just a matter of a one-time bite of the proverbial bullet. "While the overall expense of Sarbanes-Oxley compliance for the second year is typical lower than the first, auditor's fees are only 25% less, and remain steady in subsequent years," says John Bace, who covers corporate governance issues for Gartner.

"Because they have less capital on hand, the financial burden of Sarbanes-Oxley falls disproportionately on the shoulders of smaller firms," according to John Greenagel, communications director at the Semiconductor Industry Association (SIA), an industry trade group. He cites the example of the SIA itself, which was forced to change accounting firms—and pay a hefty bump-up in its accounting fees—simply to get in line with government regulations. "It's not at all clear to me that we got all that much value from the experience," he says wryly.

This is not to say that electronics startups can't extract some value from the process of working Sarbanes-Oxley issues. "I've come across companies that used the Act as an excuse to implement controls that were long overdue," Bace says. In fact, he recommends that companies struggling with Sarbanes-Oxley view it as a way to create a competitive advantage rather than just a task on the corporate to-do list. However, the potential for better internal controls is scant consolation if the expense of compliance makes it impossible to execute an IPO, Brockway says.

Tough road to IPO

Companies that plan to go public definitely face significant hurdles, according to Andrew Yang, CEO of the EDA vendor Apache Design Solutions, which is preparing for its own public offering. "We estimate that it's costing us upwards of $1.5 million to get ready," he says. Somewhat surprisingly, though, Yang sees Sarbanes-Oxley as a positive rather than a negative influence on the electronics industry. "If you're profitable and growing rapidly, and you've built a company that's well run, the additional expense to becoming compliant with Sarbanes-Oxley shouldn't be significant," he explains.

Yang believes that the extra expense winnows out companies that have no business going public in the first place. He points out that "going public simply for the sake of going public" was responsible for some of the "irrational exuberance" (to quote Alan Greenspan) that led to the passage of the Act in the first place.

However, creating roadblocks to an IPO makes electronics startups inherently less attractive to venture capitalists, according to Brockway. "It isn't fair to ask smaller firms to pay a penalty, in terms of their business strategy, as the result of fraudulent practices inside giant companies that were in completely unrelated sectors," he complains.

What's worse, Sarbanes Oxley sometimes encourages smaller firms to focus on relatively unimportant elements of their control infrastructure, according to Douglas Hubbard, president of Hubbard Decision Research, a company that helps technology firms assess the economic impact of their information technology. "It's not unusual to see firms struggling to achieve a complete inventory of every device connected to their network while simultaneously neglecting controls that might prevent data theft," he warns.

Greenagel likens the situation to the recent accounting changes relative to declaring stock options on financial statements. "The intent was to hold large firms accountable for massive stock options granted to top executives, but the net effect has been to make it far more difficult for smaller firms to attract and retain engineering talent," he explains.

The problem, of course, is that government regulation that unintentionally favors large companies makes it easier for giant firms to remain dominant in their respective markets. "My immediate reaction is that larger companies are using Sarbanes-Oxley to their advantage by dissuading successful private companies to go public," Yang says. While he remains bullish on Sarbanes-Oxley, he admits that most his colleagues view the Act with disdain.

Brockway, by contrast, sees Sarbanes-Oxley as a very real impediment to entrepreneurialism in the electronics business. "Startups used to have three strategic options: remain private, go public, or get acquired," he says. "But with an IPO slipping outside the reach of many startups, there's fewer ways to grow a company and thus less chance that a startup's disruptive technology will displace the market position of established vendors."