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| Home - Industry Article - May 03 Issue |
Pre-IPO software companies: meet the Sarbanes-Oxley Act
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Relationship with Auditors
The Sarbanes-Oxley Act will affect a private company’s relationship with its accountants.
Prohibition of Certain Non-Audit Related Services. The accounting firm performing a public company’s audit is prohibited from performing specified non-audit services, including bookkeeping, appraisals, valuations, financial information systems design and implementation, investment advisor services, actuarial services, fairness opinions and human resource services. If a private company is receiving any of those services from its auditor, the company should be prepared to obtain those services from another party upon the filing of an IPO registration statement. Tax services are still permitted.
Rotation. The lead audit partner and the concurring review partner must be rotated at least every five years, and certain other partners involved in the audit must be rotated every seven years. Thus, a private company beginning the IPO process with an audit 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.
Restrictions on Hiring from Accounting Firm. An audit firm is not independent if a company’s CEO, CFO, chief accounting officer or controller (or another person in a “financial reporting oversight role”) 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. Private companies that are venture-backed or have bank loans are typically required to provide investors or the lender with audited financial statements within 90 days after the end of the fiscal year. Frequently, private companies experience difficulty getting accounting firms to complete an audit any time between January and the end of March, given the Form 10-K filing deadlines for public companies with calendar fiscal year ends. Recently adopted SEC rules will require that public companies file Form 10-Ks in an even shorter time frame following fiscal year end. This change, combined with the increased disclosure requirements for public companies, will likely make it more difficult and costly for private companies to complete their audits within the required time frame. Private companies concerned about this “audit crunch” should discuss this with their auditors and, if necessary, could change their fiscal year ends so that annual audits are performed later in the calendar year.
Disclosure Controls and Internal Controls
Perhaps no aspect of last year’s changes was more dramatic than the new requirements for CEOs and CFOs to personally certify their companies’ annual and quarterly reports. Companies are now introducing and updating a wide range of processes designed to ensure that information is identified and disclosed in a timely and accurate manner. The SEC codified the need for these processes through new rules requiring public companies to maintain “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—as well as to periodically evaluate them and report on their effectiveness. 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 potential public company acquirer will likely want to conduct significant due diligence on the private company’s controls and procedures and will insist on representations in the acquisition agreement covering those controls and procedures. This will be necessary to help ensure that the acquirer is in a position to make the required statements and certifications in its SEC filings with respect to its own controls and procedures—which, following the acquisition, will subsume and depend in part upon the controls and procedures of the private company. A private company may face a similar level of scrutiny by a potential acquirer that is seeking to go public or be acquired by a public company. Moreover, having controls and procedures in place that approximate those required by the SEC is a sound business practice.
Also, any private company planning to go public should have a level of controls and procedures in place that will enable it to comply with these SEC rules. The underwriters of a company’s IPO will almost certainly scrutinize the company’s controls and procedures as part of their due diligence process.
Covenant Creep
As banks, institutional investors, insurance companies and service providers change their standard forms and operating procedures in response to this changing 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, and insurance companies may introduce new obligations based on heightened corporate governance standards.
Summary
Becoming familiar with the new corporate governance and disclosure rules applicable to public companies will help a private company prepare for an acquisition by a public company or an IPO. In addition, private companies should take this opportunity to use these new rules to help them implement best practices and adopt a company culture that is less susceptible to the problems that prompted the enactment of these new rules.
William Gehrke is a Senior Partner in the Corporate Department of Hale and Dorr LLP. He is a member of the firm's Software and Telecom Group and concentrates his practice on corporate and securities law, including public and private securities offerings, and the representation of technology companies. To send feedback, email: William.gehrke@haledorr.com or visit www.haledorr.com for more information.
 
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