Sarbanes-Oxley flexibility: Too little too late

By Geoffrey James, Contributing Editor -- 10/9/2007

You know a government regulation is seriously out-of-whack when even the SEC begins to backpedal. That's the case with Sarbanes Oxley, the corporate governance act that's placed an extraordinary financial burden on small-to-medium electronics firms thinking of going public.

The SEC recently issued a new auditing standard for Sarbanes Oxley intended to "reduce unnecessary costs, especially for smaller public companies," according to SEC Chairman Chris Cox. Unfortunately, experts who work closely with electronics startups see the standard as more of a band-aid than a panacea, when it comes to encouraging industrywide innovation.

The new standard aims to encourage companies and auditors alike to move away from the checklist approach to Sarbanes-Oxley audits, a methodology that drives auditors to delve into each financial element in fine detail. Cox himself admits that the checklist approach forces small companies to overcome the same hurdles as multibillion-dollar enterprises, resulting in "disproportionately higher costs." With the new standard, the SEC is recommending a "risk-based approach that will encourage executives, auditors, directors, and audit committee members to focus on the material risks that investors care about," according to SEC materials.

This "risk-based approach" attempts to transfer some of the responsibility for auditing corporate governance to a firm's own management and internal auditing teams, counting on them to determine and check what's really important. "Management and audit committees now can engage in a more meaningful dialogue with their auditors to ensure that auditors are focused on what matters—risk and materiality—and not on rote compliance with a rulebook," says Cox. However, while the new standards would appear to be good news for electronics firms, experts agree the new standards aren't likely to make it any easier for smaller firms who would benefit from an infusion of capital resulting from a public offering.

Part of the problem is that a risk-based approach runs counter to the interests of the public accounting firms tasked with confirming compliance. First, most external auditors use billable hours to charge fees, an approach that makes the checklist approach more lucrative than any approach that involves more participation of internal resources. External auditors are goaled on finding things that the internal auditors missed and public accounting firms have corporate cultures that make them alternatively suspicious and dismissive of the internal auditing process.

Even without the financial incentives, external auditors have a major incentive to be overly thorough—the survival of their entire company hinges on not making a big mistake. "One of the byproducts of the Enron debacle was Sarbanes Oxley, but the other was the demise of Enron's auditor [Arthur Andersen]," says Doug Brockway, managing director at Innovation Advisors, a investment banking firm with many high tech clients. "Under the circumstances, it's no surprise that public accounting firms don't want to get too cozy, or too credulous, when it comes to the management of the companies that they're auditing."

In addition to touting the new standards, Cox has made much of the fact that "over 6,000 public companies" still aren't required to provide the audited disclosures required by Sarbanes Oxley, because they have more than $75 million in public equity. However, that threshold creates a "donut hole" of companies that, if they went public, would be too big to qualify for exemption but too small to afford the expense of compliance. "A rule of thumb is [don't] consider going public if you cannot generate immediate market capitalization of over $200 million and…unless post-IPO market capitalization is at least $500 million," explains Thomas Martin, co-chair of the venture capital and emerging companies practice at Dorsey & Whitney, a law firm that focuses on venture-capital firms.

And for that to happen, there will need to be a shift in public opinion about the reliability of business owners, according to Martin. "These cycles of severity and flexibility of regulation have occurred in the past and will occur in the future, just as public opinion of the business community has been cyclical," Martin explains, predicting that it may be some time before the cycle moves far enough to allow true regulatory relief. "When public opinion was outraged with the shenanigans of the 1990s that became apparent with the 2001 market collapse, congress reacted with Sarbanes Oxley [and] the SEC further reacted with very strict implementation," he explains.

For Martin, the real importance of the new guidelines lies in the fact that they reflect the beginnings of such a shift in public opinion. "The SEC is a politically appointed body that is as sensitive to public opinion as any other politically appointed body, so now that the impact of strict interpretation and implementation is becoming more clear, the SEC is reacting with more flexibility," says Martin. And while the situation is clearly not ideal, the new flexibility does lighten the burden somewhat, according to Sumant Mandal, managing director at Clearstone Venture Partners, a venture-capital firm that specializes in optical and wireless-networking startups. "Sarbanes Oxley has been a real pain in the backside, but now that accounting firms have a better idea of what's really necessary, expectations are becoming a bit more realistic."

However, neither the new guidelines nor the small-company exemption are thus likely to provide much relief to electronics firms hoping to go public, according to Mike Schiavo, chief financial officer for Kodiak Venture Partners, a venture-capital firm that's helped launch more than a dozen semiconductor and electronics-equipment firms. "Regardless of industry sector, what's actually needed is changes to the law that allow accounting firms to treat smaller firms differently from their larger brethren because smaller firms simply don't need the same level of internal controls," he says.

Unfortunately, even with the new "flexibility," Sarbanes Oxley is closing off the strategic business options that have been instrumental in fueling innovation in the electronics business. "Many 'micro-cap' publicly held companies are currently considering means of ending their public-company status, in large part because of the expense imposed by Sarbanes Oxley," says Martin. Even worse, companies in markets, such as EDA, where the traditional exit strategy involves being acquired, are now unable to command the same purchase price without taking into account Sarbanes Oxley. "Acquiring firms are demanding basic compliance inside the companies that they acquire, if only because the acquired operations will need to pass an external audit during the first year after the merger," says Schiavo.

The consensus appears to be that, unless the law is substantially changed, the burden of Sarbanes Oxley will continue to be a major factor in strategic business decisions within small-to-medium sized electronics firms.
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