WHAT IS AMISS in start-up world over last 18 months is the ability to sustain frenetic growth with high-quality corporate governance. Relentless expansion without a corresponding increase in revenue, high investor expectations and pursuit of unicorn status at all costs have resulted in poor decision-making at several trailblazing start-ups. The result: blurring of ethical boundaries and erosion of governance standards. Once considered game-changers of a thriving start-up ecosystem, the apparent downfall of companies valued in billions of dollars not too far back, such as Byju’s and Paytm Payments Bank (PPBL), has rattled the start-up world. PPBL, Paytm’s fintech entity, recently got a rap from Reserve Bank of India (RBI), which imposed restrictions that effectively halted operations. RBI attributed its action to PPBL’s recurrent failure to adhere to banking regulations and ‘know your customer’ norms. Edtech firm Byju’s has been embroiled in allegations of money laundering against founder-CEO Byju Raveendran. He is also facing allegations of Foreign Exchange Management Act violations which he denies. Once valued in billions of dollars, Byju’s has witnessed a significant decline in market value from its heydays. Raveendran’s net worth has fallen from $2.1 billion a year ago to zero, according to Bloomberg Billionaire Index 2024.

Nikhil Bedi, who leads Deloitte’s forensic practice in India, says all start-ups are not naturally compliance- or finance-oriented as founders are preoccupied with product innovation or the “dream” as he calls it. “In most cases, start-ups focus so much on business side that compliance and corporate governance do not keep up with pace of growth,” he adds.

Echoing the view, Amarjeet Singh Makhija, Markets Lead Advisory, Start-ups and Unicorns, PwC, attributes governance lapses to inexperience of young entrepreneurs. “Most are techies who don’t have experience of the corporate world. They miss processes, controls and governance needed to run a corporate structure.” Despite consistently achieving average monthly growth rates of 10-20%, most fail to onboard seasoned CFOs or internal auditors until compelled by venture capitalists (VCs), says Makhija.

Analysts say VCs also overlook methods used to achieve top-line growth. “A company has to grow responsibly,” says Makhija.

Investor Purview

Out of 1,26,037 DPIIT-recognised start-ups as on October 3, 2023, 111 are unicorns with a total valuation of $349.67 billion, says Invest India. Of these unicorns, 45, with total valuation of $102.30 billion were founded in 2021 while 22, with valuation of $29.20 billion, were born in 2022. Indian start-ups raised around $26 billion in 2022, 2.1 times more than in 2020. Experts say such massive capital inflows triggered spike in start-up valuations which, in turn, created pressure for growing fast at all costs — one of the key reasons for lapses in corporate governance.

However, VC funding has witnessed a sharp dip of late. Last year, VC inflows into Indian start-ups plummeted over 60%, from $26 billion in 2022 to $10 billion in 2023. Zepto and InCred were the only entrants to the unicorn club in 2023.

Sateesh Andra, managing director, Endiya Partners, believes that VCs have become more guarded in the wake of corporate governance whiplash. “LDD (legal due diligence) and FDD (financial due diligence) have become more stringent and take longer now. External consultants are being brought in. There’s a lot more introspection, oversight and prudence,” he says. By auditing account books, FDD not only verifies past claims but also evaluates future projections and targets, while LDD is an integral “skeletons in the closet” check. It entails a thorough examination of all agreements and contracts, including arrangements with shareholders, suppliers, clients, employees, founders, banks, financial institutions and affiliated parties. “Up to Series A, start-ups don’t have enough funds. The mindset of the founder is that corporate governance requires huge costs. Not everyone in India is trained to consider cost as a necessary evil,” says Tej Kapoor, managing partner, IvyCap.

The start-up community is also divided between the need for self-regulation and enforced regulation. Absence of self-regulation is likely a significant factor for Byju’s downfall, though it also points at failure of investors and auditors. “What was the board doing for two years when accounts were not being audited and presented? It is not acceptable,” says Padmaja Ruparel, co-founder at Indian Angel Network. “How was such a slip-up possible at a company of their size? What was the auditor doing? Why did they resign after two years, and not after the first quarter, if things were not good?” she says.

Makhija highlights a crucial aspect that investors overlooked: thorough background checks on entrepreneurs. He attributes certain failures to this oversight. In fact, regulators, too, initially adopted a liberal approach to foster the growth of the ecosystem. However, when they became aware about the likely impact of bad corporate governance on consumers, they became more vigilant.

The founder can run amok if there is minimal oversight and accountability, especially if he wants to show growth even when it’s lagging, leading to fund diversion or artificially pumping up the performance. Preventing this is tough but possible.

Founder Vigilance

“It’s easy to understand what they are doing and how they are doing it. But we spend a lot of time understanding what’s driving them,” says Kapoor.

Are they primarily focused on financial gain, perhaps at the expense of ethical practices, or outmanoeuvring competitors through questionable means? Alternatively, are they determined to establish a tangible footprint regardless of costs? Are they genuinely committed to creating lasting value? Ultimately, the key lies in discerning whether they are in it for the long haul and passionate about solving the problem at hand. “This tells you whether they are serious about corporate governance. From ethics and way of doing business to team-building, managing customers and raising funds, everything stems from this value system,” he adds.

Ruparel agrees, saying the bet is on the founders. She narrates the story of Avendus, a technology-centric investment bank. Originating in 1999 amid the dot-com bubble as coolstartups.com, mirroring Silicon Valley’s garage.com, the venture faced setbacks when the dot-com bubble burst. However, fuelled by determination, the three founders — Gaurav Deepak, Ranu Vohra, and Kaushal Aggarwal — emerged from the ashes and transformed Avendus into a billion-dollar enterprise.

At the same time, it is incumbent upon investors to make entrepreneurs internalise the importance of good corporate governance right from the outset. This is exactly what they have started doing.

The Metamorphosis

Serious corporate governance failures at well-funded start-ups have made investors cautious about betting large sums. In 2023, funding was a little over $10 billion, a 60% dip from 2022 and 76% from the peak in 2021. This reflects how prominent investors are viewing the space as they add layers of oversight while dealing with early-stage start-ups. “Investors are not at the driving wheel all the time. We are at best co-pilots looking at governance framework,” says Andra. VCs are rising to the occasion by asking tough questions, be it on asset acquisition, marketing expenditure, customer demographics, board composition, transparency in financial reporting or operational efficiency. Interestingly, IvyCap board recently discussed inclusion of corporate governance expenses as a dedicated line item in business plan before investing in a company. Substantial changes are taking place even in term-sheets, non-binding agreements outlining basic terms and conditions under which the investment will be made. Over last 15 years, the start-up world has behaved like a seesaw, oscillating between sellers’ market and buyers’ market. “VCs today ask for an equitable term sheet,” says Makhija. Andra says with respect to operational nuances, investors now have more visibility and greater control.

While some experts say term-sheets have tilted in the favour of investors, others say founders, backed with an army of lawyers to incorporate their rights, have become more inflexible. “Unfortunately, founders are not able to differentiate between investor A and investor B,” says Kapoor. He says A may be a pure financial investor content with certain rights and unconcerned about adding value or addressing specific operational matters. It may lead them to agree to terms that satisfy the founders; conversely, investor B may adopt a more strategic, long-term approach, he says.

Moving Forward

While increased oversight and due diligence may promote accountability, there is a looming question of whether this will rejuvenate the ecosystem or stifle innovation and investment. The balance between investor protection and entrepreneurial freedom is delicate, and it’s yet to be seen whether the current wave of scrutiny will pave the way for a sanitised and resilient start-up environment or choke the flow of funds and stifle the very innovation it seeks to safeguard.

Although a lot of value has been destroyed and significant capital gone down the drain, Ruparel remains optimistic that a new, transparent ecosystem will rise from the mess. “The idea is not so much to cry foul but give guidance to entrepreneurs to follow best practices,” says Andra.

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