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Google Flunks Governance

UPDATED

Oops.

When Google passed out some 23.24 million shares of stock and 2.5 million options to employees and contractors, it neglected to register them with the Securities and Exchange Commission, violating Rule 701 of the Securities Act of 1933 and the laws of 18 states and the District of Columbia.

That got the search engine star into trouble with the SEC, which requires companies to disseminate basic information when they issue options or stock, as well as comply with the antifraud provisions of securities laws.

"It looks like Google did none of this, and wouldn't have been able to rely on Rule 701 anyway, because they issued too much stock and options," according to Melanie Hollands, a former hedge fund manager who is writing a book on technology investments.

Now, Google must try to buy back shares at the price paid, which ranges from $0.30 to $80 per share; it's offered 20 percent of the strike price for unexercised options, plus simple interest. Someone who paid $4 per share for 1,000 pre-IPO shares would get $4,280. Someone with 1,000 options at a strike price of $4 per share would end up with $856.

Google disclosed the buyback plan, called a rescission, in its original April SEC registration, according to Google spokesperson David Krane. "The rescission offer is not an unanticipated development," he said. It's proceeding as disclosed in our public filing."

Krane said yesterday's SEC filing is part of the process; the actual buyback offers won't go out until after completion of the IPO.

With Google's initial offering priced at $108 to $135, it's not a deal that will fire up investors.

"We do not believe the offer will be accepted by our current and former employees and consultants in an amount that would represent a material expenditure by us," Krane said. He added that the SEC requires Google to make the rescission offer, which is designed to allow investors to get rid of stock that isn't up to snuff, but there's no penalty to the company if no one accepts it.

An unnamed officer of the company owns 52,783 shares of common stock that are eligible for the buyback, but he's declined to participate.

"I bet he has counsel," said Tom Taulli, a fund manager and author of "Investing in IPOs."

He said anyone with a significant number of shares should hire an attorney. "Probably a lot of employees and consultants don't know what to do and will just sign their rights away," Taulli said. "But these shares could be worth millions of bucks and $5000 for an attorney is a drop in the bucket."

Holders of illegal shares and options aren't obligated to participate in the buyback, Taulli said, nor will Google have to delay its IPO if they don't. The best bet for the Mountain View, Calif. search marketing company, he said, is to up the offer. "They have enough cash to pretty much make this go away. [Before an IPO], you want to have everything as clean as possible."

How did this mistake happen? Krane would not comment.

But its first SEC filing, the company admitted that it was only early last year that it began the process of documenting and analyzing its system of internal controls. That process began in response to the 2002 audit, in which external auditors said several problem areas amounted to a "reportable condition," that is, the kind of error that a public company would be required to report to the SEC and shareholders.

The auditors recommended streamlining the billing process, limiting internal access to some data systems and restricting employee access to the advertising system, according to the filing. "In 2003, we devoted significant resources to remediate and improve our internal controls," it stated, adding that the company would continue to invest in this area.

The company's CFO or COO has direct responsibility for making sure mistakes like this don't happen, said Scott Harshbarger, a former attorney general for the State of Massachusetts who consults on corporate governance issues. But the Sarbanes Oxley Act made the CEO responsible. "It starts with two people," he said, "the CEO and the chairman of the board."

For Google, those are one and the same: Eric Schmidt fills both roles. Little has been made of Google's board of directors, which is packed with insiders. In addition to Schmidt and founders Sergey Brin and Larry Page, seats are filled by John Doerr, Michael Moritz and Ram Shriram, three venture investors; John Hennessy, the president of Stanford University, which licenses its search technology to Google; Arthur Levinson, chairman and CEO of Genentech; and Paul Otellini, president and COO of Intel. The latter three each own 65,000 shares of common stock.

"It's a classic, pre-scandal, non-independent board," said Harshbarger.

Google's Krane pointed out that Hennessy, Levinson and Otellini were new additions to the board of directors, named around the time the company filed to go public. He declined comment on whether the company planned to add more board members.

While the dangers of insider boards has been pointed up by the Enrons and WorldComs of the world, many startups have the idea that good governance practices don't apply to them, that it's only for public companies, Harshbarger said. "But many of the things we're talking about are just good, basic, solid managerial techniques that ensure integrity. It's not for the SEC, investors or the press [that you should do them], but because it's central to your own capacity to function with integrity."

Harshbarger said independent board members would look after the rights of employees and investors, rather than the interests of the insiders.

In its registration to go public, Google's founders said one of their guiding precepts was, "Don't be evil."

Harshbarger said Google should consider "not just good business strategy, but how you do well by doing good, in terms of good business practices."



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