Latent Impact of Corporate Governance Reforms on Technology and other Private Companies

Private companies are beginning to experience lessons that the public company sector learned six months ago. The reach of corporate governance reforms in the wake of Enron, WorldCom, and other corporate scandals -- while focused on public companies and capital markets -- extends long and deep.

The reforms have significant implications for private companies, especially those who seek investments from venture capital funds and other institutional investors. Beyond the lingering skittishness of investors occasioned by the technology bubble burst, the continued death of venture capital financing also reflects concern about the impact of corporate governance reforms on the ability of portfolio companies to operate and perform at levels that are attractive to venture capital investors in this new era.

The principal reform initiatives target public companies, whose securities are widely held by large numbers of investors, for several obvious reasons. Such investors have limited (if any) effective ability to assess the quality of their investments other than through reliance on the transparency and integrity of disclosures made by management. And, they have no control over day-to-day behavior by the managers of their companies, other than through effective governance protocols that prohibit certain conduct, limit others, and require conspicuous disclosures as a deterrent to some actions that might not reflect a proper regard for the interests of the public owners.

The keystone of these initiatives -- the Sarbanes-Oxley Act of 2002 and the SEC rules that have been or are being promulgated in its wake -- reflect that focus. They regulate the actors (e.g., auditors, audit committees, and management), processes (e.g., the SEC’s "disclosure controls and procedures" requirement), as well as certain substantive matters (e.g., the restricted use of certain non-GAAP financial information) that feature prominently in the chain of preparing and furnishing financial and other material information to the public. The reform initiatives of other organizations, such as the NYSE, Nasdaq, and Institutional Shareholder Services, derive from a similar focus on public companies and their investors and on a general concern for restoring investor confidence in the public capital markets.

The focus on public companies masks the impact of these reforms on private companies. But, the latent impact is real, and it is multi-faceted and potentially substantial. Here are four examples of fairly broad impact.

First, many of the protocols that emerge from these initiatives are likely to become standards for "best practices" for private as well as public companies. In particular, institutional investors such as venture capital firms may require private companies to comply with certain provisions of the Sarbanes-Oxley Act and related SEC rules, even though such compliance is not legally required by private companies (just as they do now for many other SEC rules). Likely candidates include the composition and qualification requirements for audit committees, limitations on certain services by the companies’ auditors, prohibitions on personal loans to executives, and implementation of codes of conduct.

The initiative by Institutional Shareholder Services -- which provides research and shareholder proposal recommendations to its institutional clients -- to rate the corporate governance practices of public companies could have a major impact on public company shareholder votes beginning this spring. If institutional shareholders decide to vote against management proposals specifically because of a company’s low corporate governance rating, companies may be pressured to implement reforms that are in the mainstream, or at least comparable to those of its competitors. These would likely become industry norms or best practices that also affect emerging private companies in those industries.

Second, even the most clearly public company-targeted of the requirements -- such as Sarbanes-Oxley’s mandate that public company CEOs and CFOs make certain certifications as to their companies’ financial statements -- can reach private companies. For example, under federal securities laws, a public company that acquires a private firm may be required to file certain historical financial statements of the private company as part of the public company’s SEC reports and other public disclosures. In such a case, the public company CEO and CFO could be required to certify as to those financial statements, either on their own or as their results are reflected in the public company’s financial statements as a result of the acquisition. In either case, these requirements mean that financial information about the acquired private company’s operations (and how it was generated) during pre-acquisition periods will take on enhanced significance.

Accordingly, to the extent venture funds anticipate exiting portfolio company investments through strategic sales to public company competitors, they likely will conduct much more comprehensive diligence of a company’s financial controls and related procedures before investing, and they may insist upon a company having the capacity to sustain internal systems that would satisfy public company standards in the future. These standards are much higher and more rigorous as a result of ongoing reform initiatives, and the expense of complying (which may include additional personnel that a private company might not otherwise hire at an early stage) will likely affect investment decision analyses by venture capitalists. Similar considerations obviously will be present where a future public offering is the expected exit from a portfolio investment.

Third, the Sarbanes-Oxley Act’s general prescription for much more rigorous corporate disclosure is part of a larger movement toward greater transparency at all levels of the financial markets. This evolution has created additional pressure on venture capitalists, among others, to likewise disclose additional information to the public, particularly in an environment where investors already are frustrated by increasing investment losses.

For example, in October 2002, the University of Texas Investment Management Company, the second-largest university endowment in the country, with $14 billion under management and $1.3 billion in private equity, disclosed financial performance information on dozens of venture capital funds, in response to public pressure to do so. Since then, several other investors in venture capital funds have similarly disclosed sensitive financial information. With over half of all venture fund investment coming from public endowments and pension funds, other venture capitalists may be forced to respond as well. In fact, there is a fear that investors will force funds to disclose financial information on individual private portfolio companies. Some of these investors are asserting that, without such transparency, investors in pension funds and elsewhere could be defrauded by venture firms.

If this trend continues, venture capitalists are likely to become even more demanding in their standards for portfolio companies. For example, they might impose de facto certification requirements on portfolio companies’ CEOs and CFOs, and require more formalized reports on operations by these companies, with a view to the venture capitalists having to make more extensive disclosures about portfolio companies to the institutional investors in their venture funds. That prospect might be daunting for private companies already strapped for cash and whose thin management teams have extremely limited time to focus on such issues.

Fourth, private technology companies are particularly anxious about the ultimate result of the debate over the accounting treatment of stock options. While the issue has long been considered by the Financial Accounting Standards Board and others, the position that grants of stock options should be recorded as an expense has gained new momentum and support as a result of the scandals that ignited the current corporate governance reforms. Many in Congress argued for mandating the expensing of options as part of Sarbanes-Oxley. While Congress stayed its hand in that regard, the Act did authorize the new Public Company Accounting Oversight Board it created to consider the matter, and it probably will do so.

Meanwhile, the International Accounting Standards Board already has proposed such a requirement, and FASB has requested public comment on such a requirement (the comment period ended February 1), indicating it will attempt to match its standards to those ultimately approved by IASB. In addition, some technology companies, such as Amazon.com and Computer Associates, have voluntarily agreed to expense option costs, although there remains significant objections from many others in the sector.

A mandate to expense stock option costs would have particularly adverse consequences for growing technology firms, in that the costs of recruiting talented employees and managers through generous option grants would lengthen significantly the path to meaningful profitability. In the current environment, that translates into reduced prospects for obtaining venture capital financing, because many venture capitalists will consider investing only in companies with a track record of profitability.

On the other hand, growing technology companies generally do not have sufficient cash for use in compensation packages to otherwise attract top quality personnel. Of course, to the extent these companies are therefore unable to attract such personnel to lead their operations, venture capitalists may become even more hesitant to invest. Clearly, a lot rides on this issue for private companies.

These and other impacts of the corporate governance reforms, while significant, can and will be weathered. As entrepreneurs and venture capitalists recognize the impact of these developments, they will adjust their expectations and conduct accordingly. However, even when venture capitalists become more confident that financial markets are moving in a positive direction, they will take a much harder look before investing in early-stage companies, whether technology or other. Such companies would be well advised to create contingency financing plans that do not rely on such funding becoming available in 2003, and potentially beyond.