The SarbOx Bind

The new rules trap small companies, too

In July of 2002, Congress passed the Sarbanes-Oxley Act, also known as SarbOx, in hopes that the new regulations would help curb financial abuses at large public companies. The act demands that public companies enhance their accounting oversight and adopt stringent internal controls. It isn't supposed to have any effect on private companies. So why did privately held ProfitLine, which analyzes and manages telephone bills for large clients, spend hundreds of hours and about $200,000 last year to comply with Sarbanes-Oxley?

In a classic case of trickle down, some companies such as ProfitLine are complying because their big-company clients are asking them to. Others are seeking outside investors, who increasingly require SarbOx-style controls. Meanwhile, a few states are considering imposing SarbOx-like regulations on private companies. All this is happening as audits are becoming more expensive. Already, nearly 60% of companies with revenues of less than $25 million are either complying or planning to comply with some aspect of Sarbanes-Oxley, according to a 2004 survey by Baruch College in New York and Financial Executives International, an association of financial officers.

That's enough to make the Securities & Exchange Commission take notice. In April the SEC convened a special advisory committee to examine the law's impact on small public companies. No immediate changes are expected, but the review could spur a "Sarbanes-Oxley lite" for smaller public companies. That, in turn, might provide a less onerous standard for private companies that nonetheless feel compelled to comply.

Even if the law is simplified, the move toward more rigorous accounting for private companies is here to stay. Like the $20 million, 100-employee ProfitLine, many are bolstering their accounting procedures so their large company customers can comply with the act. Sarbanes-Oxley requires public companies to improve their corporate reporting and oversight and to increase operational transparency, accountability, and truthfulness. That includes knowing what's going on at their suppliers. ProfitLine hired a Big Four accounting firm and diverted two employees to work full-time on a SarbOx-style internal audit. Compliance "costs a lot of money, and has a big impact on our ability to get the rest of our work done," says CEO Richard Valencia.


Financiers are pushing for the changes, too. Some venture capitalists and mezzanine investors are making documented audits and oversight committees -- both Sarbanes-Oxley requirements -- conditions of dealmaking. Some banks even make loans contingent on such measures. "Market pressures will continue to hold small companies to a higher standard, regardless of whether the law will allow something less," says Mark Jensen, national director of venture capital services at Deloitte & Touche in New York and a member of the SEC committee.

Last year privately-held Layton Belling & Associates, a 60-employee real estate investment company in Irvine, Calif., budgeted about $50,000 to hire a small accounting firm to set up internal financial controls and perform internal audits like those mandated by Sarbanes-Oxley. "There is an expectation among our investors that we have an institutional approach to our accounting and reporting," says Tom Rutherford, CFO of the $20 million company. He hopes the internal audit will make it possible for Ernst & Young, the accounting firm that does Layton's annual external audit, to sign off more quickly and slash its annual $300,000 bill.

Sarbanes-Oxley is also making it tougher and more expensive for small companies to go public. "The venture capital investment landscape is changing, and there is now more of an emphasis on having an independent board and more corporate-governance procedures," says Richard Busis, partner at law firm Cozen O'Connor in Philadelphia. Plus, Big Four accounting firms are so overextended that they're less likely to take on small clients. Thanks to heavy demand, external audits run about $35,000 for startups, up from $15,000 in pre-Sarbanes-Oxley days, says E. Rogers Novak Jr., co-founder of Novak Biddle Venture Partners in Bethesda, Md. Established companies pay much more. All of which makes finding a merger partner, rather than a public offering, increasingly appealing.

New York and California are considering asking private companies to comply with SarbOx-type regulations. In January, California began requiring nonprofits with more than $2 million in annual gross receipts to complete audits and upgrade their accounting. Colleen Cunningham, CEO of Financial Executives International, says compliance is not a matter of if, but when. "Private companies have the advantage of doing it right now at their own pace," says Cunningham. However painful that may be.

By Jeremy Quittner

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