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In Defense of SOX
It is fashionable in the venture capital business to hate Sarbanes Oxley, aka SOX.
Most every VC I know of thinks it is bad for the VC business. Maybe it is. It certainly makes it harder to take companies public. And there is so much work that has to be done by a company to become "SOX compliant", particularly section 404 compliant, that many companies can't even think about taking that on while trying to grow their business.
Brad Feld got me thinking about this issue this morning with his post and link to Niel Robertson's post on how to automate SOX 404 compliance.
I believe that before SOX, way too many companies went public before they were ready to be public companies. They didn't have profits, they didn't have financial organizations capable of building and mantaining internal controls, they didn't have complete management teams, and they often didn't even have reality tested business models.
And once one company in a sector went public, they all went public, driven by a desire to maintain a level playing field with their competition. Chapter Two of Hackoff.com has a good description of those days.
I recall the late 90s when companies would hire the CFO weeks before the IPO road show. I recall that happening with a few CEOs as well. It was crazy. And it's no wonder that so many of those companies ended up being bad public companies.
With SOX, that really can't happen. It takes a year or longer to prepare to become a public company. We have several companies in the Flatiron portfolio that are going through this process now. And as much as I hate seeing them spend the money on SOX consultants and staffing up their finance departments, I see it as an important test of whether the company really wants to be a public company or not.
There are plenty of ways to raise capital privately so the public markets aren't always the best option for raising capital, particularly for young companies.
And the M&A market is very healthy, so going public isn't necessarily the best way for the insiders to get liquid on their investment.
The investment banks are supposed to be the gatekeepers of the IPO process, deciding which companies are ready to go public and which are not. Back in the day when they really "underwrote" the public offerings and took the risk on whether the deals got done or not, maybe they did provide some kind of readiness filter, but I don't think that investment banks can be relied upon to be the quality filters anymore. They make too much money on the IPOs, regardless of whether they are successful public companies, to be truly objective about the process.
So I think its a great thing that SOX has put a high hurdle that companies need to jump over to become public. In the past four years, we have seen that good companies can go public, but it takes a lot of work and preparation to do that.
My friends at Broadview (now part of Jeffries & Company) used to have a chart of the performance of venture backed IPOs six and twelve months post IPO. A sizable majority of them were trading below their offering price by the time that the VCs could get out. They made a persuasive, if somewhat self serving, argument that selling venture backed companies provided better exits than IPOs.
I've often felt that was true for all but the very best portfolio companies. Now with SOX we have a hurdle that forces entrepreneurs and VCs to be patient and prepared for the IPO process. I'd be interested to see that Broadview chart pre and post SOX. I bet it looks better now.
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Posted November 27, 2005 in Venture Capital and TechnologyComments
Slight segue, but the cottage industry that has sprouted as a result of Enron, SOX, Gramm-Leach-Bliley, SEC regs, CFR11, HIPAA, DoD 50.15 and all the European Union stuff is rather impressive.
Posted by: Raj Bala | Nov 27, 2005 2:44:19 PM
But Fred, per your comment:
"I believe that before SOX, way too many companies went public before they were ready to be public companies. They didn't have profits, they didn't have financial organizations capable of building and mantaining internal controls, they didn't have complete management teams, and they often didn't even have reality tested business models."
SOX was put into place to deal with holding the Bernie Ebbers, Ken Lays, and other host of big company management teams liable for the debacles they caused. While SOX could indeed address some of the issues you raise, that wasn't its original intent. Moreover, the controls being required are a might unreasonable on an entirely different level and require more costly systems implementations (that means investors must wait longer to see their investments yield profits ;-) for companies, while providing investors no more real protection or recourse than they had pre-SOX.
Posted by: P-Air | Nov 27, 2005 5:37:17 PM
But Fred, per your comment:
"I believe that before SOX, way too many companies went public before they were ready to be public companies. They didn't have profits, they didn't have financial organizations capable of building and mantaining internal controls, they didn't have complete management teams, and they often didn't even have reality tested business models."
SOX was put into place to deal with holding the Bernie Ebbers, Ken Lays, and other host of big company management teams liable for the debacles they caused. While SOX could indeed address some of the issues you raise, that wasn't its original intent. Moreover, the controls being required are a might unreasonable on an entirely different level and require more costly systems implementations (that means investors must wait longer to see their investments yield profits ;-) for companies, while providing investors no more real protection or recourse than they had pre-SOX, IMHO.
Posted by: P-Air | Nov 27, 2005 5:37:59 PM
This post is another example of why I read your blog -- you often have non-obvious insights that are unique in the VC world (in this case that SOX can actually be a good thing). I've seen this in another SOX-related arena. A portfolio company of ours (Entomo)has customers who have done the proverbial 'make lemonade out of lemons' with Sarbanes-Oxley. Rather than just look at SOX as an additional cost burden, they've used it as a catalyst to gain strategic advantage.
Entomo has a service geared towards companies that distribute through channels which makes the revenue recognition process particularly challenging (most companies are doing it with a tangle of manual processes and spreadsheets). Their customers have to deal with this regardless of SOX in order to understand what's going on in channels, how to properly pay commissions/spiffs, dealing with multi-term payments, etc. By automating this process, they not only can cut back on FTEs but have found they are often overpaying sales people and partners (they err on the side of keeping the revenue generators happy). In the process, they get a key portion of SOX-compliance for "free" while addressing the aforementioned issues.
While one would expect that the bigger, more complex companies would adopt this first, it's been the smaller public firms (or companies readying themselves to go public) that have been the first adopters. In fact, it was one of those that actually suggested Entomo take their supply chain product and reorient it towards the challenge they were facing on getting clear visibility of what was going on in their channels.
Interestingly, the phenomena of an outsider highlighting how their service is happening again. A leader in the online ad industry that deals with ad networks believe this technology can be used to address the situation of double/triple paying ad networks for conversions. As the old saying goes, "you have 2 ears and 1 mouth and use them in that proportion" applies where by being open to outsiders' (customers, partners, etc.) ideas can be a great source of new market development.
Posted by: dave chase | Nov 27, 2005 6:22:48 PM
Great post. The benefits to a small company in being SOX 404 compliant extend beyond being able to do an a IPO as it also makes a company a more attractive acquisition candidate for a public company with 404 (and 302) requirements. And as an M&A exit can be just as attractive, if not more so, than an IPO, then VCs should be focusing on the positive aspects of 404 in effecting an M&A transaction. Within the year I would think that being 404-compliant would be practically a requirement for being considered as an acquisition target by a public company. 3 key benefits quickly come to mind:
1. Better and Easier Due Diligence: Given a choice between two private targets, one with well documented and 404-compliant processes and procedures and the other with a more "seat of the pants" approach to managing its financials, a public company CEO and CFO would always choose the more buttoned-up company. Due diligence should be easier, quicker and more illuminating with the 404-compliant company. There is nothing (well almost nothing) more frustrating as a CFO looking to do an acquisition than waiting on a seemingly simple data request during DD and being told it will take a week to get or that the data is not available. While 404 processes and procedures won’t guarantee that this problem will go away, it should make data generation and analysis quicker and more dependable, allowing both sides of the transaction to focus more on the substantive issues of the deal rather than waiting on questionable data.
2. Faster and Easier Integration into Acquirers Financials: Incorporating the reporting and operations of a 404-compliant company into an existing public company should be significantly easier for the public acquirer than it would be for a company that had no 404-documented policies and procedures. Work will still need to be done to get the target’s operations documented as part of the acquirer’s operations, but doing it on the basis of already documented processes is significantly faster and cheaper.
3. Cost Synergies for the Acquirer: Looking at a potentially bright side of a costly finance staff, in many cases an acquirer should be able to significantly reduce a targets finance team as it rolls the basic controllership and a/r, a/p functionality onto its own platform. It can then show better financial projections for the target’s business, resulting in a better price paid. Now of course no acquirer wants to pay for the synergies created through an acquisition or a merger, but it has been known to happen :) Now it will be up to the VCs and the target company to make sure that these cost synergies result in a higher price for the target company.
Posted by: John McCarthy | Nov 28, 2005 10:39:25 AM
SOX was put into place to deal with holding the Bernie Ebbers, Ken Lays, and other host of big company management teams liable for the debacles they caused.
Those are the ones that made page one, but there were scores of similar cases buried in the filler, many of them startups. I don't remember the exact number, but hundreds of companies had to restate earnings during that period. I specifically remember a few that were competitors for the company I worked for (which also went public too quickly). You probably never heard of most of them, but they were all VC-backed.
Posted by: Derek Scruggs | Nov 28, 2005 1:26:29 PM
Like Derek said, though the headlines were grabbed by the criminals Bernie Ebbers and Ken Lay, there were a great number of scandals at smaller firms. They didn\'t make the news, but they often did turn into investor lawsuits.
I\'ve consulted for over three dozen startups during the nineties up to now, and while keeping in touch with most of them after my departure, I now know of at least four whose current legal troubles would have been completely headed off by Sarbanes compliance. That is to say, the approaches they took to deceive their investors would have been impossible under even minimal SOX 404 implementations.
John: I completely agree your point 1 is a very welcome effect of SOX compliance. On 2, my sense is that the jury\'ll be out for a while. Integrating two firms process by process is major hurdle in every acquisition. This remaines true regardless of whether we\'re talking about financial, operations, or manufacturing processes. I don\'t see 3 being \'real\' in the sense that it will be a _very_ hard quantification game.
Posted by: Carrie Locarno | Nov 28, 2005 8:58:01 PM
Your analysis that Section 404 has set the bar higher for companies wanting to go public is spot-on. Section 404 is designed more about investor confidence than the companies that have been complaining about the costs. Now, investor confidence is what healthy markets are all about but that hasn't stopped the backlash from corporate America. Now an SEC subcommittee has recommended exempting smaller companies. If that goes through, the bar is lowered. Your post raises a very good question: if we lower the bar, do we end up with bad public companies? The stuff on the SEC subcommittee can be found here:
http://www.soxfirst.com/50226711/sox_unwound.php
Posted by: soxwatch | Dec 10, 2005 4:39:24 PM
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