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The initial public offering (IPO) market is coming back. Last year experienced more IPOs than in any other year since the 2000 dot-com bust. But the world of public companies has changed. Now additional regulatory burdens imposed on public companies make going public and being public costlier endeavors-in terms of money, time and risk. Private companies that are relying on an IPO to raise capital are wise to begin complying with at least some of the new corporate governance standards for public companies well in advance of beginning the IPO process, even though not yet applicable to them. Doing so will better position such companies to avoid unnecessary delays and to take advantage of favorable market conditions when they arise. The Sarbanes-Oxley Act of 2002, touted as the most significant legislation in the securities area since the enactment of the securities laws in 1933 and 1934, began a wave of new rules and regulations that have affected the way public companies govern themselves and communicate with investors. The Securities and Exchange Commission (SEC), New York Stock Exchange (NYSE), Nasdaq stock market and American Stock Exchange (AMEX) have imposed standards of compliance for public companies that are more onerous than ever before. Shareholder activist groups have added to these new demands on public companies. Two of the most well-known groups-California Public Employees’ Retirement System (CalPERS), one of the largest public pension funds, and Institutional Shareholder Services (ISS), the top proxy-advisory firm-have recently updated their voting policies to heighten the corporate governance standards that apply to public companies. These groups may recommend against voting for directors or company proposals that do not meet these elevated standards. Whereas corporate governance was once understood to mean the ethical leadership of management and the board of directors in general, it is now defined by a series of regulatory dos and don’ts designed to keep boards, executive officers and auditors in line. Many private companies, particularly those that have relied on venture capital investments, have reserved seats on their boards for management and significant shareholders. But under recent rules adopted by the NYSE, Nasdaq and AMEX, public companies listing with those organizations must have a board that contains a majority of independent directors. Standards of independence For a director to be deemed independent, he or she is prohibited from having a material relationship with the company that might be deemed to interfere with unbiased decision-making. Such a disqualifying relationship, for example, would include having accepted more than $60,000 from the company for services other than as a director in any of the last three years, a circumstance which often arises when a director also provides consulting services to the company. Even stricter standards of independence now apply to directors who serve on a public company audit committee. Under NYSE, Nasdaq and AMEX rules, all public companies are required to have an audit committee comprised of at least three independent directors. For audit committee service, a director cannot receive any compensation from the company other than in his or her capacity as a director. This includes compensation received through another company or partnership. For example, a director who works for an investment bank that provides financial consulting services to a company may not be permitted to serve on the company’s audit committee. This prohibition would apply no matter how qualified the director may be to serve on the committee. An audit committee must further have at least one member who qualifies as a “financial expert” under the new SEC rules. A financial expert is defined as a person that has a certain level of understanding of generally accepted accounting principles and the preparation of financial statements, through education and experience as an officer of a public company or other relevant experience. Not only must public companies have independent audit committees, but NYSE, Nasdaq and AMEX rules now require them to have independent compensation and nominating committees (or, in the case of Nasdaq, to have independent members of the board perform the functions of the compensation and nominating committees). The compensation committee is charged generally with setting the compensation of executive officers. The nominating committee recommends candidates for service on the board of directors and, in the case of NYSE companies, must also perform a corporate governance oversight function. Replacing directors These various board requirements force many private companies to restructure their boards prior to going public, sometimes losing the experienced and engaged directors who made the company a success. And replacing those directors will not be as easy as it used to be. Recent emphasis on director accountability, evidenced by the WorldCom and Enron actions, has deterred many a talent from accepting an invitation to serve on a public company board. Even if an appropriate independent director can be found, the fees associated with his or her service may be more than expected. Public company directors have traditionally received fees in excess of those received by their private company counterparts, but the disparity is greater than ever in the post-Sarbanes-Oxley environment. Personal loans will also need to be addressed prior to an IPO. Companies have historically arranged loans for their directors, officers and other employees, often to purchase stock of the company. Since the Sarbanes-Oxley Act, personal loans to directors and executive officers may not be made or arranged by public companies. This prohibition begins at the time the first IPO registration statement is filed, even though it has not yet been declared effective. Accordingly, many private companies will be in the awkward position of asking their directors and executive officers to pay off their loans even before there is a public market for the company’s stock. Because this may not be practical, companies considering an IPO should bear in mind that the loan may have to be forgiven by the company prior to the first SEC filing. Forgiving a loan extended for the purchase of stock, however, may result in unfavorable accounting treatment. Companies may also find that the strengthened auditor independence rules affect the speed and ease of going public. The SEC has revised the substantive standards applicable to auditor independence to broaden the circumstances in which an auditor will be deemed not independent. These include when the auditor has certain enumerated financial, employment or business relationships with the company. If an auditor’s independence is impaired, the company’s audited financial statements will not be sufficient for inclusion with the IPO registration statement or the company’s subsequent required filings with the SEC. Another independent auditor would then have to be engaged to get up to speed on the company and to reaudit the company’s financial statements, which could be extremely costly and time-consuming. A company planning its IPO on the NYSE may have to engage another independent auditor, in any event. The NYSE now requires that each company listing on that exchange have an internal audit function. This function may be outsourced to a third-party service provider, so long as it is not the company’s independent auditor. Private companies without an existing internal audit department need to consider the additional costs of hiring audit staff or engaging an outside provider if they envision a listing on the NYSE. Once through the IPO process, a company will be subject to the SEC’s reporting requirements, including the filing of an annual report on Form 10-K and quarterly reports on Form 10-Q. In the post-Sarbanes-Oxley Act world, the principal executives have increased personal responsibility for these reports. A public company’s chief executive officer and chief financial officer must now file certifications with each Form 10-K and Form 10-Q as to, among other things, the accuracy of the report, fair presentation of the company’s financial condition, effectiveness of the company’s disclosure controls and procedures, and reliability of internal control over financial reporting. The SEC and private litigants alike have begun to name chief executive officers and chief financial officers personally as defendants in actions alleging false financial statements, based on the certifications that they are required to file. These certification requirements and other corporate governance reforms have resulted in skyrocketing costs of directors’ and officers’ insurance, yet another ancillary cost of being public today. To support these CEO and CFO certifications, a public company must establish and maintain a system of “disclosure controls and procedures” designed to ensure that the company accurately records, processes, summarizes and reports information required to be disclosed in its SEC filings. These controls and procedures must extend beyond financial matters and cover all matters required to be disclosed in the company’s reports. Depending on its size, a company just completing its IPO is not likely to have a significant legal or accounting staff to manage these disclosure controls and procedures. Such a company is left to rely heavily on its outside counsel (which can be expensive) or on officers dedicated to other business functions (which can be time-consuming and impractical). Moreover, a Form 10-K must also now include a management report on the effectiveness of the company’s “internal control over financial reporting,” which must be attested by the company’s independent auditor. Internal control over financial reporting includes policies and procedures that track transactions in assets, control receipts and expenditures, and protect assets. Compliance with this new rule has cost companies thousands, and even millions, of dollars on their independent audits to support the required attestations. Companies contemplating going public will have to consider these costs, as well as the thousands of hours required by their employees to comply with the internal-control report requirement-hours they will not be able to devote to running the business. It is no wonder that today’s IPO preparations require more significant corporate changes to ensure compliance with the new public company standards. Long lead times and substantial start-up expenses are not unusual for the company considering going public. Before a company decides that an IPO is the right way to raise capital, the company, its directors and its shareholders should adequately prepare for this new environment in which public companies must survive. Heather Badami is a partner in the Washington office of Bryan Cave, where she is a member of the firm’s corporate finance and securities and transactions groups. Her practice concentrates on federal securities and corporate governance.

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