Public markets become unfeasible for small companies.

SMALL public companies facing the higher costs of complying with the Sarbanes-Oxley law are considering going private at a time when education, not more regulation, is needed to fight corporate fraud.

It's hard to believe that tougher laws and regulation can stop such fraud without a lot of cooperation from the corporate world. Businesses would be better served with expanded educational standards to include more training in ethics, corporate governance and personal honesty.

The cost of regulation is taking its toll on small businesses.

Total audit and other expenses for complying with Section 404 of the law, in which senior executives must sign off on financial results, are costing companies with revenue of $25 million to $99 million an average of $740,000 annually, according to a Financial Executives International survey of 321 companies.

The average cost for all companies in the survey was almost $2 million for about 12,000 hours of internal work and 3,000 hours of external work, plus added auditor fees of $590,000, or an increase of 38 percent.

Driving small public companies private won't help the stock market because it prevents investors from getting a stake in future success stories. So maybe some of this new regulation can be stratified to help small public companies keep on the straight and narrow without paralyzing their efforts to earn profits and sustain growth.

"Any company under $100 million in revenues has to be asking itself whether it's worth it to stay public," said Brent Longnecker, president of Longnecker & Associates, a Houston-based consulting firm for executive compliance and corporate governance. He estimates that the cost of being public has risen more than 150 percent over the past year because of the new federal regulations.

Longnecker said he knows of six small private companies that dropped plans to go public and four small public companies in the South and Midwest that have requested analysis of the pros and cons of going private as a result of the Sarbanes-Oxley law.

Auditing conflict

A major reason for higher costs is the new requirement to audit internal controls--an area that accountants previously neglected because it might trigger lawsuits against them if audit clients went bust.

John Sinnenberg, managing partner of Key Principal Partners, an affiliate of bank holding company Key Corp. in Cleveland, said he's exploring going private with seven small public companies with annual revenue of less than $100 million. KPP has just helped two other public companies--Mobile, Ala.-based Integrity Media Inc., and Greenbelt, Md.-based OAO Technology Solutions Inc.--go private. Integrity Media has annual sales of about $75 million; OAO Technology, $175 million.

"Audit costs were already rising sharply for small companies because accounting firms are trying to make up for dropping certain consulting business that the government maintained conflicted with auditing," Sinnenberg said. "The Sarbanes-Oxley law was the straw that broke the camel's back by diverting profits that small companies need for growth to compliance areas."

P. Michael Coleman, chief executive of Integrity Media, a media and communications company, said "the requirements of being a public company, especially for a small company like ours, were becoming increasingly expensive and time-consuming."

Last December, Key Principal Partners provided $13.5 million in subordinated debt to help OAO Technology go private. OAO Technology provides outsourced information technology services and is a software provider. This month, Key Principal Partners invested $15 million in Integrity Media to help the company's management buy out non-management shareholders at $6.50 a share through a seven-year senior subordinated debt with detachable equity warrants. The transaction also included senior financing provided by Chicago-based LaSalle Bank NA.

While more small public companies are going private because of the stringent accounting and auditing standards, some private companies are embracing the standards without the legal requirement to do so. Witnessing the collapse of big public companies such as Enron Corp. and Adelphia Communications Corp. because of accounting skullduggery, the private firms see the increased corporate governance resulting from compliance as enhancing their reputations and growth opportunities.

Longnecker maintains there will still be more accounting and auditing scandals, even if the tougher standards are met. "Corporate executives who want to practice fraud will somehow find ways to get around the new law, and investors should still beware that other shoes will drop because of such dishonesty," he said.

Sinnenberg said the sins of big companies are hurting small public companies, and the tougher, more-expensive and time-consuming standards will only make going private more attractive.

"The new law may be political overkill because we all know that auditors can only do a small percentage of testing of receivables, inventory and other assets, even with the tougher standards," he said. "Just because everyone is working harder to prevent fraud won't stop malfeasance in the executive suite."

Lee Berton, a Bloomberg News columnist, is a consultant to the accounting department of City University of New York's Baruch College.