Corporate Governance for Private Companies – Part I

While the primary focus of the well-publicized and sweeping corporate governance reforms adopted over the last decade, such as the Sarbanes-Oxley Act of 2002 (“SOX”), obviously has been public companies, elective compliance by privately-held companies with certain provisions of SOX can provide them with significant advantages.  In fact, many private companies are discovering that they can actually enhance the value of their businesses, and improve their operational procedures, by implementing changes in areas such as internal controls, board composition (e.g., independent directors), audit committees, and development and implementation of codes of business conduct and ethics.  While public companies are treated equally in terms of regulation under SOX, regardless of their size or type of business, private companies come in all sizes and formats, and it is thus important to evaluate the stage of development of the firm and its aspirations for the future when determining what changes are necessary from a corporate governance compliance perspective.
This article is adapted from material in Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.
Attention to SOX requirements, as well as the listing rules of the major securities exchanges, is essentially mandatory for private companies interested in the possibility of an initial public offering or potential acquisition by a public company in the foreseeable future.  Potential investors, investment bankers and acquisition partners will have little interest in a company that is not ready and able to assume the rigors of corporate governance compliance, and it is important for these companies to be able to demonstrate that steps are already being taken to voluntarily prepare for the next level of regulation and scrutiny.  The level and scope of compliance will depend, to some extent, on the timetable charted out for the IPO.  For example, if the company has determined that an IPO will likely occur within 12 to 18 months, it should be well along with establishing the organizational structures and procedures to achieve a smooth transition to public company status.  In any case, key action items include the following:

• The experience and composition of the senior management team should be carefully reviewed and consideration should be given to bringing in new members with the requisite background and familiarity with public company governance requirements. As time moves on and the practical issues relating to SOX compliance are raised and resolved, private companies will be able to evaluate candidates based on their experience with the specific regulations and other requirements.
• The composition of the board of directors should be modified to comply with applicable requirements relating to independent directors and establishment of audit and other committees to take on responsibility for corporate governance matters. Private companies with support from venture capitalists will already have a strong group of outside advisors on their board; however, the venture capitalists and other professional investors should recruit completely independent board members with relevant industry experience.
• Under the direction of the newly constituted audit committee, pre-IPO companies should commission an assessment of their internal controls to identify areas that need to be strengthened or perhaps eliminated as being redundant.
• Companies with aspirations of an IPO should already be subject to an annual audit by an independent outside auditor with public company expertise; however, if that is not the case, it is important to engage a qualified auditor to assist the company in preparing for the rigors of periodic reporting.

It is well documented that gearing up for compliance with SOX is not an inexpensive task.  For example, it has been estimated that the “start-up” costs for compliance in the first year that a company is subject to the requirements can average $3 million for companies with $2.5 billion in revenues.  Much smaller companies in terms of revenues are not, unfortunately, able to reduce the compliance costs significantly, meaning that smaller companies actually face a higher relative burden than their larger colleagues.  In any case, it is important for pre-IPO candidates to budget for these items in advance and build compliance costs in as a long-term investment in the advantages of being in the public markets.
Similar types of planning will be needed by private companies looking for liquidity for their shareholders through an acquisition by a public company.  In that scenario, the directors and officers of the private company should evaluate the risk that their operational activities and insider relationships might present to potential suitors.  Among the specific issues to consider are the following:

• The CEO and CFO of the acquisition partner will need to be comfortable that consolidating the company’s financial results with those of the partner will not increase the risk to those persons of providing the required certifications in periodic reports mandated under SOX. Private companies should ask their independent auditors or other consultants to evaluate their financial reporting systems to be ensure that acquisition partners will be able to analyze this issue in their due diligence investigation.
• The company will need to invest in the technology and human resources necessary to ensure that its systems and procedures with respect to internal controls will be adequate to allow management of potential suitors to make the necessary discloses in the management reports required under SOX. Once again, the company’s outside auditors should be asked to conduct an independent assessment of the company’s internal controls in the same manner as an auditor would do with a public company.
• Private companies with actual or potential “off-balance sheet transactions” should review the scope and extent of the possible disclosure obligations that such transactions might impose on potential suitors. While such transactions are not prohibited, the disclosures may have a material impact on the acquiring company’s financial statements and management’s discussion and analysis.  Accordingly, the company should be prepared to provide the suitor with full information on any such transaction.
• If it is anticipated that any director or executive officer of the company will assume a similar position with the acquiring company, arrangements must be made to retire any outstanding personal loan arrangement between the company and such person.

Private company acquisition candidates should anticipate that the pre-acquisition due diligence investigation will be extensive and that a premium will be placed on the ability of the company to provide all information necessary for the potential acquirer to verify that the business and financial condition of the candidate is adequate from SOX perspective.  In addition, the acquisition agreement will include specific representations and warranties on SOX issues, including internal controls and disclosure of off-balance sheet transactions.
Pre-IPO/pre-acquisition companies are not the only ones who should be contemplating changes to their corporate governance compliance strategies.  In my next post I’ll discuss ideas for private companies with multiple stakeholders, closely-held businesses and family-owned businesses.
This article is adapted from material in Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.
Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedIn, Twitter and Facebook.