Sarbanes-Oxley Ripples across Silicon Valley — Free Upgrades Gone?

Five years since becoming law, high-tech Silicon Valley companies are now finding themselves running amuck with Sarbanes-Oxley Compliance regulations.

Small companies have argued that Sarbanes-Oxley hits them disproportionately hard on their financial bottom lines.  On Tuesday the Washington Post gives the example of no-revenue biotech companies being made to comply with the same accounting procedures of multibillion-dollar competitors, diverting money to accountants and lawyers that could better be spent in research and development.

Treasury Secretary Paulson headed a committee that made recommendations in late 2006 that attempted to reduce some of the high costs of implementing Sarbanes-Oxley, especially for smaller companies.  On the one hand, Paulson was criticized by the corporate governance group, the Council of Intstitutional Investors, for undermining the effectiveness of the original intent of the legislation.

But the National Venture Capital Association, coming from the perspective of many small Silicon Valley startups, criticized Paulson for not going even further to help out small companies that have been affected by the compliance regulations.  The group called it a “step backwards based on work and recommendations that have already been put forth.”

Venture Capitalist and entrepreneur Jim Clark stepped down as chairman of the online photo service Shutterfly earlier this month because he said that Sarbanes-Oxley had “gone too far”.  Clark said that because of Sarbanes-Oxley that he could not “Chair any committee due to the size of my holdings, because of the loan I once made to the company, not be on the governance committee, and it even dictates that some other board member must carry out the perfunctory duties of Chairman.  What’s left is liability and constraints on stock transactions, neither of which excite me.”

Cnet reports that more high-profile resignations from startups like those in Silicon Valley are likely to follow.  They also suggest that many startups will seek to stay private to stay clear of compliance requirements.  Another alternative is for those companies to go public on foreign exchanges, and many new company listings have shifted to the UK.

An interesting statistic is that while new listings in the UK are soaring, so is fraud.  The British accounting firm BDO Stoy Hayward found that the reported instances of business fraud in the UK jumped  30 percent last year and that the value of the fraud reported jumped 40 percent.

Consider also the ongoing scandal of backdating of stock options.  The ability to do this has been diminished with the introduction of Sarbanes-Oxley.  Options now need to be reported to the SEC within two business days of award.  The whole backdating scandal would never have come to light had it not been for stricter SEC rules on executive pay disclosure and the work of academics who analyzed the public data and uncovered strong correlations between option grants and stock price.

Now with Apple and Steve Jobs in the middle of the scandal, it is somewhat ironic they are invoking Sarbanes-Oxley as the reason for why they plan to charge for a software update.  Apple will charge $1.99 for users of Core 2 Duo Intel Macs to use 802.11n WiFi hardware.  Apple says “The nominal distribution fee for the 802.11n software is required in order for Apple to comply with generally accepted accounting principles for revenue recognition, which generally require that we charge for significant feature enhancements, such as 802.11n when added to previously purchased products”.

If Apple’s interpretation of Sarbanes-Oxley holds then many or all software updates, whether they are service packs or bug fixes, may need to be for a fee to be legal.  Are there any implications for Open Source software here?  Probably not, but it’s likely that this will get a lot of public companies looking more closely at the language of their end-user license agreements (EULAs).