Impact of Corporate Governance Reforms on Private Companies

Private companies should consider prohibiting all officer and director loans or requiring that any loans made or modified after July 29, 2002 be repaid immediately prior to the filing of an IPO registration statement if at that time the borrower is a director or executive officer of the company. Private companies should also consider requiring repayment if the company is acquired by a public company and the borrower becomes a director or executive officer of the acquirer.

However, private companies should bear in mind that repayment prior to the filing of an IPO registration statement, or an acquisition, may not be practical since there will not yet be a public market for the company's stock, and forgiveness of such loans may result in unfavorable accounting treatment.

Stockholder Approval for Stock Plans

The NYSE has proposed changing its rules so that brokers holding stock of a public company in “street name” may vote those shares in favor of proposals to adopt a new employee stock plan or to increase the number of shares covered by an existing plan only if explicit voting instructions are received from the underlying beneficial owner. This change would affect all public companies, since it would apply to voting by all brokers that are members of the NYSE, regardless of where the shares being voted are listed.

This rule change may make it significantly more difficult for public companies to obtain stockholder approval of stock plans. This underscores the need for a company contemplating an IPO to evaluate whether it needs to increase the number of shares covered by its employee stock option plan and whether it wishes to adopt any new stock plans ' such as a director stock option plan or an employee stock purchase plan ' while it is still a private company and stockholder approval is easier to obtain.

Board of Directors and Board Committees

Private companies should be prepared to comply with the new rules relating to the composition of a board of directors and board committees prior to filing an IPO registration statement:

Board Independence. Proposed NASDAQ and NYSE rules require that a majority of the directors be “independent,” although the proposed definition of “independent” varies between the two exchanges.

Audit Committees. The Act and stock exchange rules impose heightened requirements for audit committee composition and impose additional responsibilities on the committee:

Independence. All members of the audit committee must be “independent.” Of note is a proposed NASDAQ rule that would prevent 20% stockholders from being considered independent, which may disqualify some of a company's venture capitalist directors from serving on the audit committee.

Financial Expertise. The Act requires companies to disclose in their Form 10-Ks whether the audit committee has at least one “financial expert;” the SEC's proposed definition of “financial expert” essentially requires experience as an accountant or as CFO or controller of a public company.

Responsibilities. The audit committee has the direct and sole responsibility for the appointment, compensation and oversight of the company's auditors. The audit committee is also responsible for pre-approving audit services and any permitted non-audit services.

Accounting Complaints. The Act requires the audit committee to adopt and implement procedures for receiving and handling complaints regarding accounting matters, including the confidential and anonymous submission of employee concerns regarding accounting matters.

Compensation Committees. Both NASDAQ and the NYSE have proposed that compensation committees must consist solely of independent directors.

Nominating Committees. NASDAQ has proposed that all director nominations be approved by a nominating committee consisting of independent directors or a majority of all independent directors. The NYSE has proposed that each listed company must have a nominating and corporate governance committee consisting solely of independent directors.

Relationship with Auditors

The Act will affect a private company's relationship with its accountants:

Prohibition of Non-Audit Services. The accounting firm responsible for performing a public company's audit is prohibited from performing specified non-audit services, although tax services are still permitted. Private companies receiving prohibited non-audit services from their auditors should be prepared to obtain these services from other parties upon the filing of an IPO registration statement.

Rotation. The lead audit partner and the concurring review partner must be rotated at least every five years, and proposed SEC rules would also require rotation of the client service partner and any other “line” partners directly involved in the performance of the audit. Thus, a private company beginning the IPO process with the same audit, review or other participating partner it has had for four or more years may see that partner rotate off the company's account during or shortly after the IPO process.

Hiring Restrictions. An audit firm is not independent if a company's CEO, CFO, chief accounting officer or controller (and perhaps certain other positions) is a former employee of the audit firm who worked on the company's audit during the past year. Therefore, a private company should be careful hiring from its accounting firm during the year before it intends to file an IPO registration statement.

Year-end Audit Crunch. Venture-backed private companies are typically required to provide investors with audited financial statements within 90 days after the end of the fiscal year. Recently adopted SEC rules that require public companies to file Form 10-Ks sooner following fiscal year end, combined with the increased disclosure requirements for public companies, will likely make it more difficult and costly for private companies to get their audits completed within the required time frame. Private companies concerned about this “audit crunch” could change their fiscal year ends so that annual audits are performed later in the calendar year.

Disclosure Controls and Internal Controls

Public companies are now required to maintain, and periodically evaluate and report on the effectiveness of, “disclosure controls and procedures” ' that is, controls and other procedures designed to ensure that information required to be disclosed by the company in its SEC reports is assimilated and processed within the required time periods. The SEC has proposed similar rules regarding “internal controls and procedures for financial reporting” ' that is, controls regarding the preparation of financial statements for external purposes that are fairly presented in conformity with GAAP.

Any private company planning to go public should establish appropriate controls and procedures so that it will not need to substantially re-engineer its business processes following an IPO. The IPO underwriters will scrutinize the company's controls and procedures as part of their due diligence process. Similarly, any potential public company acquirer will conduct significant due diligence on the private company's controls and procedures so that the acquirer is in a position to provide all required SEC certifications following the acquisition.

Covenant Creep

As investors and financial institutions change their standard forms and operating procedures in response to the new regulatory environment, some of their new practices and the covenants, representations and warranties that they will require of public companies will inevitably begin to impact private companies. For example, investors in private companies may begin to require audit committees to comply with the membership rules applicable to public companies.

Public companies are facing dramatic changes in disclosure and corporate governance requirements under the Sarbanes-Oxley Act of 2002 (the Act) and new or proposed rules from the SEC, NASDAQ and the NYSE. While these new rules and regulations do not generally cover private companies, they do affect private companies:

• A private company will become subject to the Act upon filing a registration statement with the SEC in anticipation of an IPO.
• Certain aspects of the Act may indirectly become applicable to a private company if it is acquired by a public company.
• The boards of directors and management of many private companies are embracing various aspects of the Act as “best practices.”

Summarized below are the new requirements that are most likely to be relevant to private companies. Familiarity with these new rules will help private companies avoid pitfalls that could interfere with important future milestones, such as an IPO or acquisition, and help establish a culture of fiscal and corporate responsibility.

Prohibition on Personal Loans

The Act prohibits public companies and companies that have filed an IPO registration statement (even if not yet effective) from extending, maintaining, renewing or arranging personal loans to directors or executive officers. Loans that existed on July 29, 2002 are permitted to remain outstanding, so long as they are not materially modified or amended. Upon the filing of an IPO registration statement, all outstanding loans made after July 29, 2002 to a person who is a director or executive officer of the company at the time of filing will be illegal.

Private companies should consider prohibiting all officer and director loans or requiring that any loans made or modified after July 29, 2002 be repaid immediately prior to the filing of an IPO registration statement if at that time the borrower is a director or executive officer of the company. Private companies should also consider requiring repayment if the company is acquired by a public company and the borrower becomes a director or executive officer of the acquirer.

However, private companies should bear in mind that repayment prior to the filing of an IPO registration statement, or an acquisition, may not be practical since there will not yet be a public market for the company's stock, and forgiveness of such loans may result in unfavorable accounting treatment.

Stockholder Approval for Stock Plans

The NYSE has proposed changing its rules so that brokers holding stock of a public company in “street name” may vote those shares in favor of proposals to adopt a new employee stock plan or to increase the number of shares covered by an existing plan only if explicit voting instructions are received from the underlying beneficial owner. This change would affect all public companies, since it would apply to voting by all brokers that are members of the NYSE, regardless of where the shares being voted are listed.

This rule change may make it significantly more difficult for public companies to obtain stockholder approval of stock plans. This underscores the need for a company contemplating an IPO to evaluate whether it needs to increase the number of shares covered by its employee stock option plan and whether it wishes to adopt any new stock plans ' such as a director stock option plan or an employee stock purchase plan ' while it is still a private company and stockholder approval is easier to obtain.

Board of Directors and Board Committees

Private companies should be prepared to comply with the new rules relating to the composition of a board of directors and board committees prior to filing an IPO registration statement:

Board Independence. Proposed NASDAQ and NYSE rules require that a majority of the directors be “independent,” although the proposed definition of “independent” varies between the two exchanges.

Audit Committees. The Act and stock exchange rules impose heightened requirements for audit committee composition and impose additional responsibilities on the committee:

Independence. All members of the audit committee must be “independent.” Of note is a proposed NASDAQ rule that would prevent 20% stockholders from being considered independent, which may disqualify some of a company's venture capitalist directors from serving on the audit committee.

Financial Expertise. The Act requires companies to disclose in their Form 10-Ks whether the audit committee has at least one “financial expert;” the SEC's proposed definition of “financial expert” essentially requires experience as an accountant or as CFO or controller of a public company.

Responsibilities. The audit committee has the direct and sole responsibility for the appointment, compensation and oversight of the company's auditors. The audit committee is also responsible for pre-approving audit services and any permitted non-audit services.

Accounting Complaints. The Act requires the audit committee to adopt and implement procedures for receiving and handling complaints regarding accounting matters, including the confidential and anonymous submission of employee concerns regarding accounting matters.

Compensation Committees. Both NASDAQ and the NYSE have proposed that compensation committees must consist solely of independent directors.

Nominating Committees. NASDAQ has proposed that all director nominations be approved by a nominating committee consisting of independent directors or a majority of all independent directors. The NYSE has proposed that each listed company must have a nominating and corporate governance committee consisting solely of independent directors.

Relationship with Auditors

The Act will affect a private company's relationship with its accountants:

Prohibition of Non-Audit Services. The accounting firm responsible for performing a public company's audit is prohibited from performing specified non-audit services, although tax services are still permitted. Private companies receiving prohibited non-audit services from their auditors should be prepared to obtain these services from other parties upon the filing of an IPO registration statement.

Rotation. The lead audit partner and the concurring review partner must be rotated at least every five years, and proposed SEC rules would also require rotation of the client service partner and any other “line” partners directly involved in the performance of the audit. Thus, a private company beginning the IPO process with the same audit, review or other participating partner it has had for four or more years may see that partner rotate off the company's account during or shortly after the IPO process.

Hiring Restrictions. An audit firm is not independent if a company's CEO, CFO, chief accounting officer or controller (and perhaps certain other positions) is a former employee of the audit firm who worked on the company's audit during the past year. Therefore, a private company should be careful hiring from its accounting firm during the year before it intends to file an IPO registration statement.

Year-end Audit Crunch. Venture-backed private companies are typically required to provide investors with audited financial statements within 90 days after the end of the fiscal year. Recently adopted SEC rules that require public companies to file Form 10-Ks sooner following fiscal year end, combined with the increased disclosure requirements for public companies, will likely make it more difficult and costly for private companies to get their audits completed within the required time frame. Private companies concerned about this “audit crunch” could change their fiscal year ends so that annual audits are performed later in the calendar year.

Disclosure Controls and Internal Controls

Public companies are now required to maintain, and periodically evaluate and report on the effectiveness of, “disclosure controls and procedures” ' that is, controls and other procedures designed to ensure that information required to be disclosed by the company in its SEC reports is assimilated and processed within the required time periods. The SEC has proposed similar rules regarding “internal controls and procedures for financial reporting” ' that is, controls regarding the preparation of financial statements for external purposes that are fairly presented in conformity with GAAP.

Any private company planning to go public should establish appropriate controls and procedures so that it will not need to substantially re-engineer its business processes following an IPO. The IPO underwriters will scrutinize the company's controls and procedures as part of their due diligence process. Similarly, any potential public company acquirer will conduct significant due diligence on the private company's controls and procedures so that the acquirer is in a position to provide all required SEC certifications following the acquisition.

Covenant Creep

As investors and financial institutions change their standard forms and operating procedures in response to the new regulatory environment, some of their new practices and the covenants, representations and warranties that they will require of public companies will inevitably begin to impact private companies. For example, investors in private companies may begin to require audit committees to comply with the membership rules applicable to public companies.