Darwin Magazine , April 2003
By Robert A. Adelson
Are you the founder, CEO or COO of a growing early stage company? Are you thinking down the road toward exit strategy? Is your goal an acquisition or IPO?
If so, beware. New corporate governance rules have changed the culture for emerging companies.
Currently, the new rules, collectively known as the Sarbanes-Oxley Act, are biding on public companies only. These rules, however, represent “best practices” that can impact your private company as you position for future exit strategy and compete for capital, talent and commercial opportunities in difficult times.
Most important, these rules will influence your need for building a strong board of directors.
The Sarbanes-Oxley Act
Over the past year, numerous corporate scandals have exploded on the marketplace stunning investors and the general public alike. Enron, Worldcom, Qwest Communications and Global Crossing were just a few of the corporations to come under SEC investigation during 2002.
Such an unprecedented number of corporate follies sparked a public cry for corporate reform legislation that was answered by the enactment of the Sarbanes-Oxley Act on July 30, 2002. Addressing the need for a more accurate admission of public company’s financial records, Sarbanes-Oxley tightens regulation through five main areas of corporate governance: disclosure, board of directors, auditors, ethics and compensation.
Taken one by one, they are:
- Disclosure: Company management is now required to evaluate and report on the effectiveness of its “internal control structure and procedures” concerning financial disclosure. While the new rules increase disclosure and decrease filing time for former 10-K, they also enhance the difficulty and costs of private companies to get audits completed in a timely fashion and sent to investors.
- Board of Directors: NASDAQ and NYSE have proposed rules to the SEC requiring the board of directors to have at least a majority of “independent” directors. Under the new rules of the Sarbanes-Oxley Act, independent is narrowly defined as being truly autonomous from the business.
- Auditors: All auditing members must be completely independent and not entangled within the business. A higher standard is set for financial expertise, with a director who will act as the “audit committee financial expert.” Sarbanes-Oxley requires that the lead audit partner and lead review partner rotate every 5 years, even if the company was private for the firs 4 ½ years.
- Ethics: The new rules require audit firm independence. An audit firm will not be considered independent if the company’s CEO, CFO, CAO or controller was a former employee of an audit firm that worked on the company’s audit during the past year, even if the company was private during the previous year.
- Compensation: Sarbanes-Oxley prohibits public companies from extending credit in the form of personal loans to executive officer and directors. However, loans made before July 30, 2002, are grandfathered.
Impact on Private Companies
The Sarbanes-Oxley Act applies to public companies. However, private companies with exit strategies need to plan for events that would “trigger” application of this law. The private company will become subject to Sarbanes-Oxley when it files a registration statement or when it is acquired by a public company.
Thus, in due diligence leading up to an acquisition or IPO, a private company may need to show Sarbanes-Oxley “readiness.” If it cannot, such a failure may affect price or even imperil the deal.
Building a board of independent directors, retaining independent auditors, initiating methods to assure corporate transparency and rooting out fraud are procedures that take time to implement. However, early adoption of these “best practices” will well position the early-stage and emerging business for exit strategies. Just as important, these practices will make the company attractive to venture capitalists, angel investors, strategic partners and top executive talent that the company seeks to recruit.
Building a Strong Board
A strong board with independent directors is the key element to corporate governance compliance.
To guide your emerging company toward compliance with the new corporate governance rules, remember that the independent board members you seek should be independent of the CEO and management. As a group, the board members should enhance the value of your company with comprehensive industry knowledge and a wide network of contacts. Additionally, they should have extensive skills in management, marketing, finance and operations. Most important though, the members you seek should have sufficient time and interest in serving and aiding the company.
In order to recruit and fully tap into the strengths and visions such a board can bring to management and to the company overall, consider the following:
- Incentive Pay: Provide cash for meetings and special assignments that recognize the commitment involved. Also consider deferred stock or options designed for long term support of company.
- Meeting Preparation: Meeting packages should be prepared and distributed in advance, as well as full and timely disclosure of information.
- Central Role & Recognition: Schedule regular board meetings with carefully kept board minutes. Consult between meetings, keep the board well-informed of developing events and demonstrate consideration of board advice.
- Independent Actions: There should be a meeting of independent directors and hiring of an independent chairman or board leader.
Asset of Good Governance
For some companies, the new laws arising from the recent scandals will be a costly nuisance. Furthermore, companies simply going through the motions may find the process to still be costly and not achieve the true independence needed to unveil potential frauds.
Yet, emerging companies that embrace these new laws are able to use them as a means to strengthen the board by developing independence form management and governance procedures. It will be discovered then that the board and the procedures that materialize from the process can themselves become assets for growth.
An emerging private company is best advised to adapt to change and make change work for the company. Striving for a goal of ready adaptation early will produce gains in the best interests of the company.
© 2003 Robert A. Adelson
Robert A. Adelson, Esq. is a partner at Engel & Schultz LLP in Boston, Mass.
He specializes in startup and early stage corporations, trademark and trade
identification and executive employment negotiation. He can be reached at
firstname.lastname@example.org or at (617) 951-9980 ext 205.