Is Silicon Valley strangled by SOX?

Earlier this month, venture capitalist and Netscape founder Jim Clark announced his departure from the board of directors at photo-printing site Shutterfly, where he served as chairman. In his resignation letter, he cited "the constraints imposed by Sarbanes-Oxley on (his) having any significant role on the board" as one of the primary reasons for departure.

It appears that Clark felt Sarbanes-Oxley--commonly known as SOX--had built an insurmountable wall between his status as a major shareholder and investor at Shutterfly, and his role on the board of directors.

"(Sarbanes-Oxley) dictates that I not Chair any committee due to the size of my holdings, not be on the compensation committee because of the loan I once made to the company, (and) not be on the governance committee," he continued in his resignation letter. "It even dictates that some other board member must carry out the perfunctory duties of the Chairman."

In a place like Silicon Valley, renowned for its entrepreneurial spirit and saturated with start-ups that might be the next Google or eBay, a heavy reliance on venture capital means that the line between investor and director is often blurred. SOX's internal controls, therefore, can completely change the corporate dynamic, and Clark's resignation brought to light the possibility that the tech industry may see more resignations like this one.

"Jim Clark is not atypical and not unique," said Steven Kaplan, a professor of entrepreneurship and finance at the University of Chicago's Graduate School of Business. "I have friends who've said they won't go on public (companies') boards," he added, noting that venture capitalists like Clark are often the quickest to bolt from their posts.

Jim Clark

Clark declined to further comment on the matter.

Executives and board members have thought of Sarbanes-Oxley as a nuisance, sometimes humorously, since its inception. The law, enacted in July 2002 in the wake of the Enron and WorldCom fiascos, requires better monitoring of auditing and accounting practices and improved boardroom transparency to ensure that a corporate crisis on the scale of Enron's could never take place again.

On the positive side, many shareholders have had their Enron nightmares assuaged; but on the negative side, the governing bodies of public companies have claimed that SOX makes it tough for them to get their jobs done. Most often, they cite the high costs of instituting the infrastructure needed to comply with the act's requirements as well as constraints on how much power can be held by boards of directors and C-level executives. It's a complaint that's heard from just about every kind of public company, but in Silicon Valley, the impact of SOX can be stronger.

An incentive to stay private?
Take the case of veteran investor Tim Draper, whose firm Draper Fisher Jurvetson has a foot in the door at some of tech's biggest recent success stories--Skype, for example, and Chinese search engine Baidu. Openly opposed to SOX, Draper cited the legislation as the reason he dropped off multiple public boards--much like Jim Clark.

Tim Draper

"Public boards before SOX were generally tolerable because the team could talk about R&D, and marketing and finance and sales, before the lawyers and accountants took over," he said in an e-mail. "Sarbanes-Oxley was a knee-jerk reaction to Enron, and the repercussions are far more disastrous than Enron was."

Some may find Draper's views on SOX extreme, but he's certainly not alone in his opinion. Restrictions on public companies' activity can be so stringent for an entrepreneurial culture like Silicon Valley's that some tech insiders think that the average company is better off not going public in the first place.

"Clearly being public today is a greater burden on younger companies and their executives, so it's probably better for everyone that these companies stay private," said blogging entrepreneur Jason Calacanis, former head of Weblogs Inc. and current "Entrepreneur in Action" at investment firm Sequoia Capital. According to Calacanis, SOX doesn't even need to be factored into the equation. "The public really doesn't have the skill set and time to invest and track very young companies like angel investors, VCs and private equity folks do," he said.

"There is a culture in Silicon Valley among these high-tech companies, about how things should be done," observed Jay Lorsch, a professor of human relations at Harvard Business School. "They've done things a little differently than other companies over the years." And Lorsch, like the University of Chicago's Kaplan, admitted that SOX can be a pain for those in high places.

"There's no question that there are people on the executive side of things who are bothered by the requirements of the act, and they will continue to complain, and they're trying to get the SEC to give them some relief," he said, agreeing with Calacanis that the burdens of being a public company hit the Silicon Valley start-up much harder than the Wall Street mainstay. "It's particularly true of people involved in smaller companies who do have a point that the cost to a smaller company of doing all this is obviously a greater proportion of their total revenue or total profits than a larger company."

This sentiment was echoed by Andy Goldfarb, co-founder and executive managing director of the Massachusetts-based venture firm Globespan Capital.

"I think that SOX was designed for different circumstances than we as venture capitalists and start-ups deal with," he said. "I think that it was designed for larger companies, and I think that the burden, both financial and operational, for smaller companies is disproportionate in its cost and management."

Goldfarb added that venture-backed start-ups, like many Silicon Valley companies, may aim for mergers or acquisitions rather than going public with an IPO.

"SOX has hampered our capital markets for start-up companies," he asserted.

But there's another side to the coin: yes, SOX might be less than ideal for a Silicon Valley start-up, but plenty of companies are going to have to deal with it anyway because it's not going anywhere. Lorsch said that the Shutterfly resignation was "an extreme case" and doesn't think that Silicon Valley will see many more Jim Clarks.

"I can't believe there would be a lot of people resigning because of Sarbanes-Oxley," he said. "They may complain, but I don't think they're going to cut off their noses to spite their faces because of it." The situation, therefore, could be analogous to some of the Federal Aviation Administration's limits on how much liquid can be contained in a carry-on bag: irritating and inconvenient, yes, but not enough to make the average transatlantic traveler opt to hop on an ocean liner instead.

Pain that's unlikely to go away
Les S. Stone, a Philadelphia-based partner in the finance and performance management division of consulting giant Accenture, asserted that high-ranking members of Silicon Valley and the rest of corporate America should just accept the terms of SOX.

"There are still a lot of people out there that had significant investments in companies (like Enron and WorldCom) that lost their life savings," he said. And though Silicon Valley's corporations may not have been home to the white-collar scandals that shook the country several years ago, they may be in particular need of regulations like SOX.

"Especially in the high-tech industry, there still continues to be a significant number of accounting issues in two areas. One, around stock option accounting. Apple's been all over the news lately. And the other reason, which has been causing a lot of reporting irregularity, is revenue accounting," Stone said. "I think it's here to stay. Compliance is part of everyday life."

In Stone's opinion, corporate America's pre-Enron years were not necessarily as unrestricted as nostalgic executives and board members may make it out to be.

"Internal controls have always been an important part of a company, whether it's the financial organization or where the financial organization has intersections with other parts of the organization, in purchasing or supply-chain or manufacturing," he said. "Theoretically, companies as well as auditors always needed to be concerned about internal controls."

Stone added that while compliance may have been a financial burden for many companies in Sarbanes-Oxley's early days, the cost has been going down over the past year or two, largely because new advancements in software are making it a cheaper and more efficient process. He also observed that keeping up appearances post-Enron may have caused the first few years of SOX compliance to be costlier and more stressful than they will be in the future. "Most companies will admit they probably were doing more than they needed to for SOX, and audit firms were probably auditing more than they needed to because nobody wanted to be the next headline in The Wall Street Journal or a major failure."

And companies can look on the bright side, in Stone's opinion. "Despite the high cost of compliance, (Sarbanes-Oxley) has investor confidence on the upswing." The moral of the story might be a simple one: for Silicon Valley's upper echelon, assuming the privileges of power and keeping a public company afloat means making some concessions here and there.

Then there's the other option: don't go public, and avoid the SOX scrutiny altogether, which Calacanis argued is a better option for most Valley companies anyway.

"Frankly, from where I sit," he said, "it's a much better life being private and profitable."