Now is the time to reform SOX section 404

Four years after its historic passage, Sarbanes-Oxley (SOX) continues to send ripples of change through corporate America. Of course, one company’s ripple can be another’s tidal wave. While the entire SOX law continues to be a drain on innovation and risk taking, it is Section 404 of the act—which stipulates financial reporting practices for public companies—that has created a treacherous undertow. For small companies, SOX 404 has drained away capital and resources, undercut management’s focus on strategy, diverted support from the accounting profession and driven opportunities overseas.

In recent months, however, two life preservers have appeared on the horizon. The first was the excellent work of the SEC Advisory Committee on Smaller Public Companies, whose recommendations, if enacted, would provide much needed relief for emerging enterprises. The second is the growing recognition in Congress that the law must change to protect our growth economy. If the SEC does not act on the Committee’s recommendation, it is our hope that Congress will step in and save our country’s innovators from this relentless riptide.

Treading water

When it comes to profitability, many small companies struggle to tread water under SOX 404. To wit: The financial costs of complying with the law’s stipulations at smaller companies approach $1 million each year. If one assumes a healthy company can achieve 10% net income, then SOX dictates that such a company would have to garner up to $10 million in additional revenue just to support the cost of compliance. Stressed by this high watermark for compliance, our small companies are in danger of becoming less attractive to investors and more vulnerable to consolidation acquisitions on unfavorable terms.

While some studies suggest that 404 compliance costs may eventually ease, the costs would have to fall dramatically to approach a reasonable level. To date, this rightsizing has not occurred, and it is unlikely to take place.

The drain on human resources to achieve SOX 404 compliance should cause perhaps even greater concern than the financial costs. Unlike at larger corporations, where dedicated departments handle the compliance process, the financial staffs at smaller companies usually take on multiple roles, all critical to the operation of the business. As a result, SOX 404 compliance can overwhelm the existing staff and necessitate the hiring of more hands on the finance department deck, often at the expense of the sales and technology headcount. These hires do not foster company growth in any way.

From a macroeconomic perspective, SOX 404 has transformed the IPO market in the United States from a pipeline to a lazy river.”

Mark Heesen, NVCA

Furthermore, SOX 404’s effects reach far beyond the traditional public/private breakwater. For many private companies, SOX compliance is not a matter of choice but a de facto requirement because they expect to one day move through an initial public offering or become acquired by a public company. They also need this credibility with their vendors and commercial banks. Therefore, they wisely choose to comply with SOX early on.

Thrown overboard

In addition to the resource drain, SOX 404 has also engendered a kind of double jeopardy with regard to accounting options. This comes at a time when small companies need their accounting firms more than ever. In large part, the Big 4 auditors have responded to Sarbanes-Oxley by shifting their focus from auditing companies of all sizes to leveraging lucrative 404 practices at large corporations. From a short-term perspective, it simply makes more business sense to put their talent to work for the biggest clients who, in turn, can pay the biggest fees. But by doing so, these marquee firms are effectively jettisoning the business of smaller companies, whose needs are equally critical, but not equally lucrative.

Although many have suggested that small companies should turn to second- or third-tier accounting firms for their compliance needs, most investment banks—whose interest in smaller companies has already cooled in the post-bubble era—generally request that companies engage a Big 4 firm. For many in the financial industry, the chosen auditor has become a matter of credibility and has led emerging companies to be held hostage by a reduced pool of accounting firms. In the end, these businesses simply cannot compete with larger corporations for the level of service and attention that they require.

From a macroeconomic perspective, SOX 404 has transformed the IPO market in the United States from a pipeline to a lazy river. An earlier article of mine on these pages last November focused on the growth of the M&A exit strategy for venture-backed portfolio companies. Now, a second strategy—one with far greater implications for the U.S. public markets—is beginning to emerge.

Increasingly, small and mid-cap companies are choosing to go public on foreign markets in order to escape the burdens of heavy regulation. (See “Jasdaq, other foreign exchanges become viable exit option,” March 2006 VCJ.) In 2005, there were 195 new listings on U.S. exchanges vs. 519 on the London AIM. In the first quarter of 2006, we saw two of the 12 U.S. venture-backed companies that went public choose the London AIM market over the Nasdaq. Eighteen months ago, if you queried a room of venture capitalists about the London AIM, few would have the market on their radar screen. Today, it is a viable and well-understood option for every VC-backed company, so much so that U.S. investment banks have begun actively marketing it to U.S. companies. As foreign tides continue to rise, the primacy of U.S. capital markets will most likely recede.

If one assumes a healthy company can achieve 10% net income, then SOX dictates that such a company would have to garner up to $10 million in additional revenue just to support the cost of compliance.”

Mark Heesen, NVCA

Turning the tide

As we have made clear as part of our MAGNET initiative, NVCA views the health of U.S. capital markets as a critical component of U.S. global innovation leadership. We recognize that SOX plays a critical role in that health, but we also believe that young companies must have access to capital from U.S. markets if they are to innovate and grow. Rightsizing the SOX 404 burden for smaller companies will not undermine the law or its intentions. Sarbanes-Oxley has many provisions outside of 404 that will continue to address the issues that gave rise to the legislation. Companies that seek to thrive and create value will always comply with the highest standard. It is critical for market credibility.

For these reasons, NVCA strongly supports the recommendations of the SEC Advisory Committee. The most important of these, in our view, is the committee’s recommendation that the SEC tier its regulations to differentiate among micro cap, small cap and large cap companies, and that compliance with the most costly components of SOX 404 be dependent on company size.

Some have suggested that a tiered system would create a second class of company, but the existence of scaled or size-appropriate structure in other regulations—the difference in listing requirements between the Nasdaq and NYSE comes immediately to mind—argues against such a conclusion. The reality is that investors will continue to look for value in small cap companies as they always have. In fact, I would argue that intelligent investors, if they could choose, would easily forgo a practically useless certification of compliance in exchange for the extra million in net income that would come with regulatory relief.

Others fear that a tiered system would pave the way for exemptions, but this also is false. Under the committee’s recommendations, even the smallest tier, for micro caps, would remain structured, thanks to several new governance provisions with which micro-cap companies would have to comply in exchange for a reduced SOX 404 burden. As the companies moved up in capitalization to the “small” level, additional requirements would then be activated.

In addition to the recommendations concerning the establishment of a tiered system, NVCA also supports any provisions that will help stimulate more competition in the accounting profession, including one that would allow accredited firms to perform attestation work. While many strong and qualified accountants continue to do work for smaller companies, the supply of such professionals is not meeting the increased demand spurred by SOX. Therefore, we wholeheartedly welcome additional resources and new entrants.

The committee’s work was thoughtful and its recommendations accurately addressed the challenges that our country’s small companies face under Sarbanes-Oxley. If implemented, these recommendations will strike the proper balance between investor protection, shareholder value and economic growth. Whether through adopting the committee’s recommendations or by passing separate legislation in Congress, the time has come to reduce the unnecessary frictional cost—financial and human—of SOX 404, before our small companies and our global innovation advantages drown in good intentions.

Guest Article Bios

Mark Heesen is President of the National Venture Capital Association. He may be reached at