Business Lessons From The Front Line: Sarbanes-Oxley

April 19, 2004

By GARY MATHIAS

Should an owner of a privately held $20 million company with a 40 percent profit margin have many worries? No shareholders to sooth, no board of directors to manage, no high-ego executives to coddle. While revenue growth had recently flattened, it would be back on track if he decided to spend more time selling.

When we met with this executive, he talked about a high valuation for his company. He was thinking of selling, knowing that he should try to exit at the peak. However, he wouldn't sell for a dime less than $50 million. While this objective was aggressive, it was achievable provided that the company was pristine and well managed.

On closer inspection, we found several red flags that led us to step back from selling the company, including lack of audited financials, poor financial reporting systems, tangled intercompany accounts between related entities, 16 direct reports, family members in the business and so on. Our advice was simple spend a year cleaning up the company, building the organization and repositioning for a strategic buyer.

In our corporate finance practice, we come across many "hot" companies whose owners believe they are ready to be sold at a premium to a strategic buyer or undertake an expansion requiring outside capital. Unfortunately, when we look under the hood, we often identify "housekeeping" issues that surprise even the strong management teams.

Why should owners of private companies care about these "housekeeping issues"? Two words: Sarbanes-Oxley. Congress passed the Sarbanes-Oxley Act of 2002 to control accounting abuses at public companies. Although the provisions of Sarbanes-Oxley are specifically applicable to public companies, they have important implications for private companies that are focused on maximizing shareholder value. Here's why:

Investors: More and more angel and venture capital investors are demanding audited financials, assurances of audit-committee independence and controls as well as disclosure of insider transactions. Private companies with "best practices" in place often receive a premium valuation. For the top tier of venture capital firms, such compliance is seen as an indication of a company's ability to scale quickly and meet the demands of becoming a merger or an initial public offering candidate.

Sale to a Public Company: Chief executive officers and chief financial officers of public companies now must certify compliance with certain controls and procedures in their quarterly filings to the U.S. Securities and Exchange Commission. These executives are concerned about their corporate and personal exposure when looking at the acquisition of a private company, and many are requiring target acquisitions to be compliant with Sarbanes-Oxley before completing a transaction.

How should owners of private companies think about this if they are not currently compliant? In many cases, public companies will simply take a pass. Otherwise, they should expect a lower valuation because the acquiring company will perceive greater potential liability and incur costs to achieve compliance. In short, the "once-in-a-lifetime" transaction that an owner has worked toward over the years is impacted or put "at risk" due to noncompliance.

Sale to a Private Company: Private companies that are compliant with Sarbanes-Oxley have already gotten "religion" on compliance. The same applies to many buyout funds that want to exit from their investments through a sale to a public company or IPO. Many will take the same perspective on acquisitions as their public company brethren - compliance matters. From a negotiation standpoint, acquiring companies will take advantage of "non-compliance" to seek reduced valuation, increased indemnifications, larger escrows and closing delays. Private companies that are compliant can insulate themselves against these "strong - arm" tactics when negotiating a sale.

Preparation for an Initial Public Offering: With the IPO market warming up, private companies that aspire to go public will run into a buzz saw unless they are compliant with certain provisions of Sarbanes-Oxley when they file a registration statement and other provisions when a registration statement becomes effective. Prospective underwriters expect IPO candidates to have implemented steps toward compliance. Without such efforts under way, quality underwriters will be unwilling to proceed.

Critical Third Parties: Key business partners, such as lenders, insurance companies and board members, are concerned about potential accounting abuse. The may require certain aspects of compliances as a precondition to entering or continuing a relationship with private companies.

A recent survey of 1,400 private company CFOs conducted by Robert Half indicates that 58 percent are planning to implement certain practices in response to Sarbanes-Oxley. Of those surveyed, 44 percent are reviewing or changing current accounting procedures, 36 percent are creating or expanding their internal audit function and 23 percent are hiring outside professionals to assist with implementation.

Undoubtedly these compliance efforts will be costly and distracting, particularly at the outset. The "best" private companies see this cost as an investment in building shareholder value and a necessary part of doing business.

Is your company prepared to take advantage of a strategic market opportunity such as a sale or financing? Complete our "readiness checklist" to find out.

Does your auditor provide non-audit services that could impair their independence?
Does the company have audited financial statements?
Do you have a board with independent directors?
Does your board have an audit committee led by an independent director that meets regularly and does it meet separately with the company's auditor?
Does the company have policies and practices to avoid conflicts of interest?
Are insider transactions subject to approval by a board committee led by an independent director?
Has the company documented its processes for financial reporting, internal controls, determination of executive compensation arrangements and enforcement of ethics policies?

Very few private companies can answer "yes" to all seven questions. The bottom line is that compliance with Sarbanes-Oxley is a good investment in building shareholder value.

Gary Mathias is a managing director of Carter Morse & Mathias, an investment banking firm based in Southport, Conn., specializing in raising capital, mergers and acquisitions, and valuations.