Sarbanes-Oxley Act impacting startups, too

New laws are like new drugs, it’s the unintended side effects that can hurt you.

In the wake of the dot-com bust and accounting scandals of 2000 and 2001, the federal government stepped in with a new law, the Sarbanes-Oxley Act of 2002, to protect investors.

But some entrepreneurs are saying the new laws are too broad and are affecting private companies, which they weren’t meant to regulate.

“Part of it’s tangential in a sense unrelated to the new laws’ purpose,” say Ken Fromm, a San Francisco-based entrepreneur.

Fromm now works as director of business services for enterprise software startup Modulant Inc. of Charleston, S.C.

He says an unintended side effect of Sarbanes-Oxley is hurting some startups.

“Any company that we’re looking at to get funding from, any companies that we want to get acquired by and any companies that we want to be in a partnership with have additional measures they have to go through in order to do business with us,” he says.

Fromm says this can be twice as hard for private startup companies dependent upon venture capital from larger public companies.

In the past, a public company that wanted to form a strategic partnership with a private startup to develop a new technology had an option to form a limited partnership called a “special purpose entity.”

That allowed a technology-sensitive company to invest money in possible breakthrough products without alerting its competition by disclosing the investment expenses in its quarterly or annual reports.

Making matters confusing, the U.S. Securities and Exchange Commission, the federal agency in charge of enforcing Sarbanes-Oxley, has no simple mathematic litmus test to determine when one of these “off-balance sheet” investments by a public company should be reported.

The SEC says off-balance sheet investments that “have or are reasonably likely to have” a current or future effect on the public company’s financial performance, should be claimed on earnings reports.

That can hurt a startup that may have trade secrets or emerging technologies that would be endangered by public disclosure.

“We’re looking at additional funding from a company and with this ‘special entities’ provision in the new laws Å  they may have to include us on their books — which is not something either of us wants,” Fromm says.

This is a direct result of the Sarbanes-Oxley Act as well as other federal accounting regulations of public companies.

Startups that already are facing a squeeze in VC funding are facing more red tape in corporate partner financing, Fromm says.

But, one prominent Cupertino software company, known for investing in startups, says so far it’s been unfazed by the new laws.

“I spoke with some of our finance team about this and I do know that we have not yet been impacted by Sarbanes-Oxley,” says Genevieve Haldeman, a spokeswoman for Symantec Corp. “But that doesn’t necessarily mean that we won’t be.”.

Market watchers have been warning of this danger for months.

Shortly after Sarbanes-Oxley became law eight months ago, Burlingame-based Forbes magazine publisher Rich Karlgaard wrote a column ruminating that well-meaning lawmakers may be killing viable companies before they leave the womb of their incubators.

“The dilemma for public policy makers is that most entrepreneurs do fail,” Karlgaard wrote, explaining that in these cases market conditions are more likely than misconduct to kill a startup.

Karlgaard also argued management at startups could be pressured by legal advisers to tone down the cocky entrepreneurial spirit out of fear of possible lawsuits if the company ever goes public or gets acquired by a public company.

“That would be a travesty,” he wrote. “Entrepreneurs are neither saints nor sober-minded.”

Fromm says the new regulations are expanding beyond their legislative boundaries.

“You’ve got these regulatory issues written for public companies spilling over into private startups,” he says.