One-size-fits-all solution may kill startups in womb.

INTERRUPTION of a food chain can have dire consequences, regardless of the species involved. For fast-growing technology companies looking for financing, the Sarbanes-Oxley Act of 2002 is proving to be just such an interruption.

In this food chain, "Angel" investors provide the seed capital for a new company; venture capitalists step in later with additional infusions of capital; the company goes public through an initial offering of its stock; it grows further through follow-on offerings of stock; and, finally, it may acquire other companies or be acquired through exchanges of stock.

There's no question that Congress had to act to prevent further wrongdoing in corporate America. But the corrective measures are so stringent that they are discouraging companies from going public. In August, a Silicon Valley Internet startup named Tickle Inc. was on the verge of an IPO, but at the last minute, the president of Tickle canceled the offering, citing his concern over the rising costs of being public.

To be sure, the expenses a company must bear to comply with Sarbanes-Oxley are huge. But it isn't just the cost of compliance that is deterring companies from going public. The law also has the effect of depressing market value by reducing net income.

There is a way a company can go public without being subject to Sarbanes-Oxley. It can take advantage of Regulation A of the Securities and Exchange Commission, which permits public offerings of $5 million. But $5 million is pretty puny in the eyes of most company founders these days. And companies that do choose this method will find that they don't qualify for listing on any exchange, not even on Nasdaq's Bulletin Board. Instead they are consigned to the Pink Sheets, which are generally regarded as the least desirable place to be listed.

The problem with Sarbanes-Oxley is that it's a one-size-fits-all solution. But one size doesn't really fit all companies.

Sarbanes-Oxley requires that companies establish and maintain a system of internal controls. It also requires that a company's auditors report on and attest to management's assessment of the effectiveness of those internal controls, as well as the company's financial condition.

But Sarbanes-Oxley prohibits auditors from providing most non-audit services to their audit clients; this means the auditor may not design and maintain the internal control system.

The result is that companies have to retain, at considerable expense, a separate accounting firm to implement and perform periodic testing of the internal control system. It's understandable why this may be desirable for a large company with several levels of managers, but in a small company, controls are not as formal because the CEO is intimately acquainted with every phase of operation. He's in a position to spot any irregularities early on and can be held accountable if they're not corrected in a timely manner.

Small companies should be exempted from complying with the internal controls requirement for two years or so--enough time to allow the SEC to refine the rule. Unless the impact of this law on small business is softened, the capital needed for early stage companies may become an endangered species.

Lee R. Petillon and Mark T. Hiraide are partners in the Torrance law firm of Petillon and Hiraide LLP.