GenuineVC David Beisel's Perspective on Digital Change

June 15, 2005

I was recently chatting with a friend of mine about a well respected technology veteran whom we both mutually know. This executive has been considering joining the board of a venture backed company that is currently doing very well and on the cusp of IPO’ing in the future. The company wants him to join as Chairman, primarily to lend his connections to the banking and public markets world, as well as to ensure that the company is Sarbanes-Oxley compliant upon IPO.

Unfortunately, SOX regulations have made this executive extremely reluctant to join this company. Prior to 2002, reducing (eliminating?) the risk of fraud in public companies’ accounting statements was bourn by shareholders, auditors, and executives. Whereas, now the lawsuit risk shifts (or is at least in this executive’s eyes, perceived to shift) more towards the executives and board members.

If this executive’s risk has increased, has his return increased as well? A first look at Mercer’s annual study of CEO compensation indicates that it has, but closer inspection reveals that it has risen only commensurate with company performance in a rebounding economy, rather than with risk.

Should a CEO really be compensated for not lying? By no means am I a lawyer, but my understanding is that Sarbanes-Oxley makes a company’s board jointly and severally liable for actions that are not even their own. If a board member isn’t on the audit committee, he or she can still be held personally liable for the actions of a rogue CFO. (If I am off here, please do let me know, but that is his perception of the situation, which is what matters in this case specifically). Perhaps that kind of exposure does deserve extra compensation.

Regardless, late-stage startups are the most affected by this issue. Sarbanes-Oxley has erected a substantial cost and time barrier to tapping the public markets for capital. In addition, it is quite common for a soon-to-IPO startup to clean up the board and bring in seasoned veterans. However, this process is going to be more difficult. Candidates will spend more time and effort performing due diligence, as they bear more (perceived) risk, and the company will potentially have to raise compensation for an outsider to assume the risk of compliance in a company that he or she doesn’t know as well as the founders. If the candidate decides that their personal wealth is not worth risking, the company loses.

My interpretation of the lesson here: startups should begin cleaning up the board sooner than they would have in the past. They should identify and inform candidates early. They should place Sarbanes-Oxley procedures into the company sooner rather than later, and make these principles part of the company’s culture, so that the switch to full compliance is an easy one.

  • Brian

    If I can add some perspective on Sarb-Ox from the trench level? Be prepared for increased transaction cost in IT.

    We’ve found that compliance reporting for each server costs 45 minutes per week on average. Multipliy that by the hordes of servers some companies generate and a small company will quickly require a FTE simply for reporting.

    Other transaction costs might be hidden from view but have real impact, which include segregation of duties that break the support model and/or operating mode of a given application or Operating System.

    Yes, granted, most of what we’ve done in IT to cover Sarb-Ox IS best practices and a rational company will do them from the beginning. Also note that none of my examples fall into Best Practices but are simply administrative fluff.

    It is damned discouraging some days.

  • sun agee

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