Small companies paying big for the sins of Enron

By Philipp Harper

Entrepreneurs planning to take their ventures public must come to grips with an unfortunate fact of life after Enron: Small businesses are being made to pay disproportionately for the sins of the big boys.

The penalty small companies are shouldering is in the form of higher regulatory compliance costs mandated by the Sarbanes-Oxley bill, which Congress passed in 2002 in response to accounting scandals at a number of Fortune 500 companies -- Enron, Tyco and WorldCom most prominently.

The intent of the legislation was to instill greater confidence in U.S. equities markets and more accountability in boardrooms through major changes in corporate governance, including:

Truly independent boards of directors.
More detailed reporting by companies to the Securities and Exchange Commission (SEC).
Greater personal accountability from top corporate officers.
Adherence to new accounting standards set forth by a new oversight board.

Steep increase in compliance costs

While the reforms were prompted by the malfeasance of major corporations, the heaviest costs of adopting them have fallen on small public companies or small businesses filing to go public. Some companies have even postponed or canceled initial public offerings because they can't afford the increased costs.

Robert W. Walter, author of "Financing Your Small Business" and an attorney specializing in securities law at the Denver firm of Holland & Hart LLP, estimates compliance costs for newly public companies have risen by about 50% since 2002.

Audit costs in 2004 are 20% to 30% higher, he says, and legal fees are up by 10% to 15%. Also to be considered is the 50% increase in the cost of insurance for directors and officers.

Add it all together, Walter says, and the compliance costs for a typical small business -- defined as a market capitalization of less than $100 million -- are about $200,000, compared with $125,000 prior to Sarbanes-Oxley.

The bulk of the added expense is for outside professional advice. Small companies shouldn't have to add workers to beef up their internal audit staffs.

Sarbanes-Oxley requires that more time be spent on compliance by existing employees, especially those at the top of the pecking order.

The bill requires chief executive officers and chief financial officers of publicly traded companies to sign certifications guaranteeing that public filings and audits are accurate and do not misrepresent material fact. In 2005, a further certification will be required attesting to the soundness of the company's internal controls.

The certification requirements "have gotten a lot of attention from the CEOs and CFOs who have to sign off," Walter says. "Previously, a lot of small businesses might have said, ‘We're going to sign off on the 10k. If it's wrong, we can amend it.' There was a laissez-faire attitude going on. Now I don't get that sense.”

Small-company IPOs won't disappear

Some small-business owners and managers will be dissuaded from going public by the added costs and personal accountability, but small-company IPOs will not dry up entirely. Compliance will remain a moving target for the foreseeable future.

So what can management do to prepare itself for the new world of Sarbanes-Oxley before going public? Walter offers the following four recommendations:

1. Make certain the CFO or comptroller has public company experience. It's important that financial officers have a "degree of sophistication" and understand the types of issues they'll be facing as a result of Sarbanes-Oxley.

2. Line up independent board members. A majority of the board must consist of outside directors and two each must sit on the audit and compensation committees. One of the outside directors on the audit committee must be an "expert" — generally a CPA or someone experienced in financial analysis — and able to pass scrutiny as such. “If a company runs into a restatement of its financial statement, the expert is going to get an awful lot of attention,” Walter notes.

3. Perform corporate cleanup. The SEC is devoting more resources to scrutinizing public offerings, so deal ahead of time with these mundane matters:

4. Line up good outside help. Your lead corporate counsel should be able to recommend a good securities lawyer to assist with the IPO. The investment banking firm handling the new issue often will require that a particular accounting firm be used. If not, look to one of the 600 companies that have registered with the Public Company Accounting Oversight Board (PCAOB), which was established by Sarbanes-Oxley.

The PCAOB's central mandate under Sarbanes-Oxley is to come up with new and more stringent public accounting standards. After the board's creation in 2002 it adopted as an interim step the accounting industry's existing standards.

Only now is the board producing the new rules, which, he says, "are going to have a tremendous impact not even felt yet."

He adds: "Over the next five years, you're going to see tremendous developments in this area as a result of the PCAOB putting in place more effective auditing standards."

And those new rules will bring with them new expenses for businesses large and small.