In April 2012, President Barack Obama signed into law the Jumpstart Our Business Startups Act. Meant to encourage initial public offering activity, certain provisions of the act impact the application of Section 404 of the Sarbanes-Oxley Act, which requires management to establish and maintain internal control procedures for financial reporting. So how do emerging growth companies cope?
Smart Business spoke with Bill Philippe, a senior audit manager at Sensiba San Filippo LLP, about SOX compliance and the JOBS act.
How would you define an emerging growth company and the requirements in question?
An emerging growth company generally has less than $1 billion in revenue in the fiscal year prior to its IPO and its status generally lasts for five years after its IPO. It is exempted from the internal control audit requirement of Section 404 of the SOX Act. In practical terms, this exemption from the audit requirement should reduce the cost of compliance for an emerging growth company, as its auditors will not be required to audit its internal controls over financial reporting (ICFR), thereby reducing the scope and focus of the annual audit process. However, emerging growth companies are not exempted from the management reporting requirements of Section 404 of SOX.
The most challenging aspect of SOX is Section 404, which requires management and the external auditor to report on the adequacy of the company’s ICFR. This is the most costly aspect of the legislation for companies to implement, as documenting and testing important financial manual and automated controls requires a significant sustained effort.
Under Section 404, management is required to produce an ‘internal control report’ as part of each annual exchange act report. It must affirm ‘the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.’ The report must also contain an assessment of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. To do this, companies generally adopt an internal control framework such as that described in Committee of Sponsoring Organizations of the Treadway Commission (COSO).
What should an emerging growth company do following an IPO?
During the five years following an IPO, an emerging growth company should take a risk-focused approach to SOX compliance by specifically identifying, implementing and monitoring those internal controls that enable management to certify the design and operating effectiveness of controls with confidence.
You want to develop a SOX implementation process that is designed with clearly defined goals and executed by an experienced team. You need to lay the foundation for your company’s regulatory compliance requirements as well as practice effective corporate governance now and into the future.
How does the post-IPO process break down?
Activities in the first post-IPO year are focused upon the identification of high-risk processes and the implementation of the documentation and monitoring activities necessary to support management’s annual reporting requirements under Section 404.
The focus in the second and third post-IPO years is on evaluating and understanding the company’s internal control priorities in light of the company’s growth. Monitoring activities necessary to support management’s annual reporting requirements continue.
In the fourth post-IPO year, add the additional objective of documentation and assessment of the moderate- and low-risk processes. Evaluation of the company’s internal control priorities continues along with monitoring activities necessary to support management’s annual reporting requirements.
Monitoring activities necessary to support management’s annual reporting requirements continue in the fifth year, as do those needed to support the integrated audit work of the company’s external auditors.
What are the effects of the recent changes to the Internal Control – Integrated Framework?
On Sept. 18, COSO released Internal Control over External Financial Reporting: Compendium of Approaches and Examples.
It includes the Updated Internal Control – Integrated Framework, which reflects feedback from its recently closed comment period and the proposed Illustrative Tools: Assessing Effectiveness of a System of Internal Control.
The compendium illustrates how the principles set forth in the proposed updated framework can be applied in designing, implementing and conducting internal control over external financial reporting. It provides additional reference material for concepts discussed within the framework, including types of external reporting, suitable objectives, judgment, overlapping objectives, deficiencies in internal control and smaller entities.
The Updated Internal Control – Integrated Framework was initially made available for public comment in Dec. 2011, and incorporates the following major changes from the original 1992 framework:
- The financial reporting objective was expanded to address internal and external, financial and non-financial reporting objectives.
- An increased focus on operations, compliance and non-financial reporting objectives.
- Codification of the 17 principles that represent the fundamental concepts associated within the five components of internal control.
- Expanded discussion of the governance role of the board of directors and committees of the board.
- The changes in technology and how they impact all components of internal control.
Companies should assess the impact that the expanded areas of focus in the updated framework will have on their current internal control processes and draft an implementation plan for any enhancements deemed necessary by internal stakeholders and those charged with governance.
Bill Philippe is a senior audit manager at Sensiba San Filippo LLP, a regional CPA firm based in the San Francisco Bay Area. Reach him at (650) 358-9000 or firstname.lastname@example.org.
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The way business owners can raise private capital is undergoing an unprecedented expansion.
Pursuant to the Jumpstart Our Business Startups (JOBS) act, the Securities and Exchange Commission (SEC) has proposed new rules that would permit general solicitation and general advertising for certain private placements.
Comments were due by Oct. 5, with the final rules due out shortly.
“It should certainly spur investment,” says Peter J. Smith, a member at Semanoff Ormsby Greenberg & Torchia, LLC.
“The average small business owner might have a $10 million per year company and want to raise a million dollars for an acquisition, a new product line, division or plant, or want to hire or need to grow,” he says. “They may not know the kind of people who can write those checks, and if they don’t, they can now advertise for
Smart Business spoke with Smith about how private placements work and what the future holds.
What is a private placement?
Under the Securities Act of 1933, the sale of securities must be registered or meet a ‘safe harbor’ exemption.
These exemptions are primarily contained in Rules 504, 505 and 506, although Rules 504 and 505 are not often used. Rule 506 provides that a company can sell an unlimited dollar amount of securities to an unlimited number of ‘accredited’ investors, and up to 35 nonaccredited investors.
An individual accredited investor is someone who meets one of the qualification criteria, including:
- Net assets in excess of $1 million, excluding private residence.
- An individual annual income of $200,000 per year or a joint income of $300,000 per year for the last two years and anticipate reaching that level again in the current year.
Entities have to meet different criteria to be considered accredited. Under current rules, companies can take up to 35 purchasers who do not meet the accredited investor test. If you are issuing securities to nonaccredited investors, however, you will want to provide adequate disclosures.
Additionally, there are prohibitions on general advertising and solicitation. This significantly restricts who you can solicit.
Why might a business owner utilize a private placement to raise capital?
Growing companies in need of capital and not in a position to borrow could benefit from a private placement. In this lending environment, banks are extremely conservative in their underwriting criteria. So, if a company is growing quickly, capital is generally not available to it through traditional means if it doesn’t have the collateral.
Smaller, privately held companies can’t afford a public offering’s cumbersome registration and reporting requirements. By doing a private placement, the business can raise additional capital through the issuance of equity. Owners give up a piece of their company, but theoretically, are growing the company, so the owner has a smaller piece of a larger pie.
By retaining an experienced attorney, you can structure a private placement in a way that meets your long-term business goals and is attractive to potential investors.
The attorney can assist the business with preparing a private placement memorandum, describing who they are, what they do, why they’re raising capital, the uses of the funds, and includes their business plan, projections, financial statements and risk factors.
This information becomes part of the solicitation materials used to attract potential investors and also protects the company from liability.
What are the new rules for private placements?
The new SEC proposed rules will permit the use of general solicitation and general advertising to offer and sell securities so long as you meet specific criteria, including:
- The securities can only be sold to accredited investors.
- The issuer of the securities has an obligation to take reasonable steps to verify that an investor is in fact accredited. For example, if a purchaser claims his net worth is in excess of $1 million, the issuer should ask for a personal financial statement and supporting documentation to demonstrate that net worth.
The intent is to open up additional avenues of capital for small business in order to stimulate the economy and job growth.
How much will the solicitation rule change private placements?
Most small businesses don’t have a group of high-net-worth individuals waiting to invest. It’s hard to go to your friends and family and ask for a million dollars. There are a lot of companies with good stories to tell and solid financial statements, but without the right kind of investor contacts. So, if they could go to an attorney or investment banker, put together a package, advertise and openly solicit accredited individuals and companies, it’s going to significantly increase the flow of funds into small businesses.
What are the risks regarding general solicitation and advertisement?
It does create an environment where there is more opportunity for fraud and misrepresentation. Investors will have to be careful and do their due diligence to assure they are making good investments in good companies. The documentation and disclosures will become that much more important. If we weren’t coming off a very difficult recession and sluggish economy, it’s unlikely this rule would have been implemented. For now, it is a way to get capital to small businesses to spur growth. Banks can say they have money to lend, but they’re not lending it. There are many companies that are struggling to get capital; they’ve had lines of credit reduced and borrowing bases limited. It’s very difficult for a growing company to get enough capital to continue on its growth cycle. This new rule should help.
Peter J. Smith is a member at Semanoff Ormsby Greenberg & Torchia, LLC. Reach him at (215) 887-4132 or email@example.com.
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The crowdfunding component of The Jumpstart Our Business Startups Act (JOBS) is designed to help startup and emerging growth companies raise capital through new securities exemptions.
“It’s a promising platform for companies that are already doing small-dollar raises of capital,” says Jeff Roberts, a director at Kegler, Brown, Hill & Ritter. “With the high cost of capital from venture and angel funds and the general unavailability of bank funding, small businesses, startups and emerging growth companies are looking for different ways to raise funds, so they are very excited about the possibility of crowdfunding. It’s worth the hype because currently, raising capital is expensive and investors are hard to locate.”
Smart Business spoke with Roberts about how to benefit from crowdfunding.
What is crowdfunding?
Crowdfunding concepts have been in the market for quite some time with companies like Kickstarter providing a platform for businesses to raise money through donations. With the passage of the new JOBS Act, businesses will soon be permitted to issue equity to investors based upon a securities exemption that allows companies to raise up to $1 million annually from non-accredited, small-dollar investors such as friends and family, and those who want to place their money somewhere other than the stock market. Funds will be raised through regulated online crowdfunding intermediaries.
Investors will be limited in the amount of money they can invest. According to the JOBS Act, investors with an annual income or net worth of at least $100,000 can invest up to 10 percent of their annual income or net worth. Those with a net worth of less than $100,000 can invest the greater of $2,000 or up to 5 percent of their income or net worth. The dollar amounts at risk on the front side are small, which helps alleviate the fear of some skeptics who think some investors may spend their life’s savings on a fraudulent venture.
What kinds of companies should consider crowdfunding to raise capital?
Local restaurants (or other small businesses with dedicated customer followings) that need to make certain capital improvements can go out and raise the money for those projects through these online intermediaries. Any startup company that doesn’t generate a lot of income up front could also take advantage of the crowdfunding platform, though such companies may have more difficulty in generating a buzz.
The financial disclosure requirement for raising $100,000 or less is not as great as raising between $100,000 and $500,000. In the latter case, you have to provide reviewed financials, and in raising more than $500,000, companies have to provide audited financials. The cost of providing those financials has been a roadblock for some small startups. When their accounting bill can be $10,000 to $20,000 before they raise a dime, it can be prohibitive to their market access. Given the cost profile, companies with less than $100,000 in financial needs may be best served by this new platform.
What are the potential legal risks associated with crowdfunding?
Companies seeking to raise funds though this exemption need to be more concerned about compliance with state laws that govern corporations, limited liability companies and other entities because, given the relaxed federal regulation, greater emphasis will likely be placed on state law fiduciary duties.
If Ohio can come up with some sort of regulatory scheme that makes it efficient to raise capital this way, then it could become the Delaware of crowdfunding. A lot of the governmental bodies and politicians like that idea and are behind it, but it’s still early. And since federal regulations will trump state law, how this will be regulated between states is still up in the air.
What could change about crowdfunding regulations?
Crowdfunding won’t become a reality until the end of the year because the SEC has 270 days from the date of enactment to put its regulations in place. While some specifics are included in the JOBS Act, there are still some open questions and equity cannot be raised through the crowdfunding securities exception until the regulations are released. What worries me is that the SEC, in an attempt to hurry up and get something out there, might throw out proposed regulations that are not really well thought out, which may create additional road blocks that effectively eviscerate the purpose of the JOBS Act, which is to make it easier and cheaper to access money.
What can companies do now?
Put it on your radar as an opportunity. Some companies considering doing raises in the next six months are operating under the old SEC rules and might put off those investments until they can see what happens with crowdfunding. But otherwise, not much can be done until we know what that landscape looks like.
If a company is interested in crowdfunding, where should it start?
Seek out legal counsel because this is such an unknown area. Issuers of crowdfunding equity are going to have questions about which intermediary to use. Should they go through a licensed broker/dealer instead of a crowdfunding intermediary? How much money should they raise? What are they going to have to provide in the way of financial disclosures? Hopefully, as the market develops, the process will become more efficient and well defined and the cost of fundraising will decrease.
The ability to go to nonaccredited investors online and the ability to reduce transaction costs by not expending substantial amounts of money on securities compliance is a step in the right direction, but time will tell how successfully crowdfunding can be implemented and what type of demand it generate.
Jeff Roberts is a director with Kegler, Brown, Hill & Ritter Co., L.P.A. Reach him at (614) 462-5465 or firstname.lastname@example.org.
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