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Governance and compliance: why these mundane parts of building startups have to become priorities

Discussions on the growth of startups that turn into unicorns in just a few years are often peppered with terms such as “hyperscaling” and “blitzscaling”. But one of the downsides is the governance and compliance issues that such blistering growth may leave along the way.

While this is evident from the questions on such issues that have cropped up of late, why do they occur in the first place when marquee institutional investors are involved in such ventures?

In their rush to be part of the next could-be unicorn, are PE-VC investors prioritising scaling up over establishing sound internal controls and accounting systems? More importantly, are such practices being allowed to continue till they get too big to be ignored?

What is the intervention required to address these issues?

Differentiating between accounting issues and frauds Rakesh Gupta, managing director of investment-banking firm LoEstro, starts by pointing out a key difference in the recent issues that have come to light.

There is a fundamental difference between accounting mistakes and frauds. Most of the cases that have been talked about in the media are around frauds, not accounting mistakes, he says. “The primary driver was to achieve growth at any cost, including fraud, because growth is the only metric to showcase to drive valuation and fundraise.”

He adds that in the absence of proper oversight and corporate governance, there will be a small set of founders who will take shortcuts. “GoMechanic is not the first or the last one in this narrative,” he says.

Nishant, partner, Luthra and Luthra Law Offices India adds, “The Indian Companies Act regulates privately held corporations and has a sufficiently robust financial-disclosure requirement, along with stringent monetary penalties, including the threat of imprisonment for flouting them. Ideally, investors should review financial data, cash flows, and the business model when making a valuation decision. However, that is rarely sufficient. With minuscule historical data, operations in infancy, lack of production scale, and negligible personal investment by founders, startup valuation is ultimately a negotiation game. It is hinged on qualitative factors such as innovation, growth potential, scalability, market traction, and even the pedigree and passion of the founders.”

Nishant says, “In the light of increased concerns about startups with inflated valuations, the Securities and Exchange Board of India (Sebi), which regulates AIFs, has begun tightening fund managers’ transparency towards their investors, requiring them to justify their investment and divestment decisions.”

Another critical player in the ecosystem is the auditor. Generally, the Companies Act provides private companies with fewer compliance obligations owing to the high cost of compliance and lack of retail investment. But, the act requires every company to file its audited financial statements within 30 days of its annual general meeting. PE-VC investors typically mandate their portfolio companies to hire a reputed independent auditor to their satisfaction, based on the financial capabilities of the company.

Although the Companies Act provides for avenues for remedies, they are time consuming. Shareholder activism may offer some respite, owing to swift action. PE-VC investors must strive to establish a stricter system of internal control and accounting practices as a precondition to the investment, along with regular inspection of its implementation.

Over the past few years, despite institutional investors having been a part of the company boards, instances of fraud and financial irregularities have been discovered at the end, leading to very public battles between the PE-VC investors and the founder. Founders have been terminated without being provided a chance to defend, along with a media trial on the incident. With a greater and pervasive participation in establishing sound corporate governance, PE-VC investors can play a crucial role in preventing incidents of misgovernance.

What regulatory bodies and AIFs can do
According to Gupta, when it comes to oversight by a regulatory body, there is a need “to double click” on the problem. “There are two set of companies — angel-funded companies and institutional investor-funded ones. I don't feel that there is a need of a regulatory body to oversee the financial reporting and corporate-governance practices of startups funded by institutional investors,” he says. “The investors have fiduciary responsibilities towards their LPs to do proper diligence and monitor the businesses they have invested in ... that’s what they earn their fee for. The challenge is they also get carried away by the search of growth and often lower the bar of oversight into their portfolios’ corporate-governance practices.”

In his view, angel investors are akin to retail investors who have put their money in search for the next unicorn. They do not have enough rights and controls on the company they invest in, or receive regular update on its performance, and definitely have no say on corporate-governance matters. That is where a need for regulatory intervention is needed to protect the interest of angel investors (syndicated raise and not super angels). Regulations for companies that have angel investors have to be firm, especially on reporting and governance practices.

Mahesh Singhi, founder and managing director of investment-banking firm Singhi Advisors, adds that if intentions and incentives are aligned, PE-VC funds have the tools to control circular trading practices, which are aimed at pushing up revenue and justify valuation.

Although the Indian startup ecosystem is relatively nascent, there have been instances of frauds driven by founders’ greed and investors’ fear of missing out. PE-VC investors taking a firm stance, leading to the exit of founders in some recent instances, is a step in the right direction.

However, investors need to take more proactive action by conducting financial and governance audits of portfolio companies at a portfolio level, with the auditors being paid by them rather than the investee companies.

It has been a common practice for yearly financial audits to be paid for by investee companies, which leaves the chance that the auditors might willingly turn a blind eye to potential irregularities.

If the financial audit is independent and paid for by the PE-VC investor, there is a higher chance that potential red flags would be raised. It’s the least the PE-VC investors can do for their LPs, and could be done from the annual fees the latter pay to the fund.

Source: The economic times