Ingraining good governance in start-ups: buck stops with the investors

October 2023 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

With close to 100,000 recognised start-ups, India is currently the world’s third-largest hub for start-ups. The country saw a significant influx of deals, valued at approximately $25bn in 2022. India has also recently seen public listings of various start-ups, with overwhelming interest from retail investors. However, recent instances of corporate governance lapses in certain start-ups have, to some extent, shaken the faith of this market.

The most prominent and recent example is Byju’s, an educational tech company, which experienced significant growth, especially during the coronavirus (COVID-19) pandemic. Byju’s had a valuation of $22bn and was India’s most valued start-up. It became the first Indian company to be an official sponsor of the FIFA World Cup, was a major sponsor of the Indian cricket team and, in short, was on its way toward becoming a household name. However, the company has encountered a number of challenges in recent months, perhaps the most significant of which was financial scrutiny, which ultimately led to its valuation being slashed to about $5bn. Furthermore, GoMechanic, another leading start-up which was reportedly valued close to $700m, was sold off for just $30m. BharatPe, Zillingo and Mojocare are other highly-publicised examples of cases of governance failures in start-ups.

Far from being isolated incidents, several start-ups in recent years have shut up shop or faced significant value erosion due to critical corporate governance lapses.

In this article, we discuss the need for investors to be more actively involved in understanding and shaping governance measures in their portfolio companies. This is critical, but difficult to achieve given that governance can put the brakes on the pace of growth expected from start-ups, as well as making them less agile and thus unable to achieve their often unsustainable valuations. However, it is important to note that boards as well as investors are responsible for sustainable value creation and governance forms a core part of this process, which investors cannot ignore.

The ‘exit’ pressure

Several of the start-ups grappling with governance issues are backed by marquee investors with stringent due diligence processes. And yet, most investors deny knowledge of any irregularities taking place. These incidents generally result in the termination of the founders, but does the onus rest on the founders alone?

Expecting founders to consistently uphold ethics and fairness necessitates a system of checks and balances. Founders’ predisposition for risk-taking often clashes with the core principles of corporate governance, leading to a paradox.

In the case of GoMechanic, its founder Amit Bhasin admitted to making misjudgements, prioritising unchecked growth and succumbing to the overpowering influence of passion. This sparked a wave of discourse from investors and founders condemning the relentless pursuit of unchecked growth encouraged by venture capitalists (VCs).

VC-induced pressure for swift expansion is a key driver behind the rise of corporate misgovernance among start-ups. The cycle begins with VCs sourcing funds from limited partners (LPs) and channelling them into start-ups. Consequently, the compulsion to achieve unchecked growth remains constant. Initial financial irregularities might start small, with an assumption that they can be rectified later, however the relentless pressure to grow often prevents resolution.

Some investors have agreed that VCs show limited concern for a company’s long-term success, and have compared them to banks – detached from operational intricacies, provided collateral mitigates risks and loan repayments are consistent. VCs primarily achieve exits through secondary sales. Consequently, if founders secure subsequent funding rounds, VCs on the capitalisation table are content, regardless of tangible sales, performance, corporate governance or accountability.

The business case for VCs to invest in governance

VCs play an indispensable role in nurturing start-ups and propelling them toward growth and success. While the conventional focus might often be on metrics such as financial performance and rapid expansion, the significance of robust corporate governance should not be understated. Increased attention on corporate governance within portfolio companies can yield several compelling benefits.

Effective corporate governance mitigates risk and potential pitfalls. It establishes a framework of checks and balances that prevents unethical practices, financial irregularities and regulatory violations. By adhering to stringent governance standards, VC-backed start-ups can avoid legal entanglements and reputational damage, thereby fostering sustainable growth.

Furthermore, a well-structured corporate governance framework fosters transparency and accountability. Clear lines of responsibility and decision making empower employees and executives to act in alignment with the company’s long-term vision. This clarity resonates with investors, reassuring them that their investments are being managed responsibly and ethically. Such confidence not only attracts additional funding but also strengthens a start-up’s positioning within the market.

Moreover, good governance builds trust among stakeholders. Investors, customers, partners and employees are more likely to engage with a start-up that demonstrates a commitment to ethical practices and responsible management. This trust translates into enduring relationships that can amplify the start-up’s brand equity and customer loyalty, resulting in long-term profitability.

Furthermore, the correlation between corporate governance and profitability is undeniable. Efficient governance mechanisms lead to strategic decision making, efficient resource allocation and the identification of growth opportunities. Timely and informed decisions enable start-ups to adapt to market changes, innovate their products and expand their market share. All these elements contribute to improved financial performance and sustained profitability over time.

This is not just theory. If we look at companies that have historically been socially conscious and have paid closer attention to strict corporate governance measures, such as IBM or Tata Group in India, we can see that such principles have given them long-term profitability. They are still at the top of the pyramid in their respective markets.

What more should investors do?

Much has already been discussed about the need for investors to take it slow, and not pressurise the founders for an exit. That aside, what can investors do to ensure that their portfolio companies have proper checks and balances and follow good governance? Investors should not make governance a ‘compliance’ exercise and pass it on to the founders. It should be something they work on together, ensuring that the founders understand the need for good governance and pay close attention to it.

“Corporate governance is a journey, and start-ups should recognise its importance. Proper governance can be an enabler rather than a burden, contributing to the long-term success of the organisation.”

The first step toward ‘investing more’ in governance is trying to identify and understand common governance issues that have led to the downfall of some more prominent start-ups. While it is difficult to create an exhaustive list of issues in governance, the issues outlined below are among the most prevalent.

First, founders, especially those that have experienced success in a short timeframe, may build a culture within the organisation that resembles a ‘cult’. This may lead to a situation where the founders or leadership cannot be questioned on their decisions, retain all control, and push away any employees who may stand up to them, in the interest of the company.

Second, start-ups often do not have a whistleblowing mechanism, which is one of the primary reasons most investors tend to be unaware of any wrongdoing among investee companies. Investors should ensure that companies establish an efficient whistleblowing mechanism, as whistleblowing is not solely confined to insiders exposing dubious practices in large corporations. Frequently, it involves a concerned employee wanting to disclose unethical or questionable actions on a relatively minor scale and to convey their concerns internally to the appropriate parties for resolution before these issues escalate into public relations crises. Essentially, whistleblowing serves as a means for anyone associated with a public or private entity to draw attention to practices they believe violate laws or codes of conduct, irrespective of the magnitude of the violation.

Third, investors ought to focus on creating robust financial safeguards to protect the company’s assets and thwart instances of fraud or mishandling. Set up mechanisms for budgeting, financial reporting and internal evaluations. Conduct frequent assessments and harmonise financial records to guarantee precision and openness. These measures not only shield the company but also instil trust in financial operations among investors and stakeholders.

Lastly, there is a fine line between independence and no oversight. While founders should be given the autonomy and independence that they need to run the business, and execute what essentially are their ideas, investors should act as a watchdog to ensure they do not cross any ethical lines. Hence, investors must conduct scheduled board meetings and accurately record minutes, guaranteeing openness and responsibility. They should foster candid and productive dialogue among board participants, facilitating a range of perspectives and well-informed choices.

Conclusion

Corporate governance is a journey, and start-ups should recognise its importance. Proper governance can be an enabler rather than a burden, contributing to the long-term success of the organisation. While high-profile cases of governance failures make headlines, many start-ups run sound businesses with strong controls and processes, serving as a counterpoint to these exceptions.

The way forward requires a collaborative effort from all stakeholders. Start-ups must actively embrace good governance practices, integrate them into their DNA and view governance as an enabler rather than a burden. Boards, investors and founders must work hand in hand, communicating openly, setting clear expectations and continuously evolving governance structures as the company matures.

This journey toward enhanced governance is imperative for sustainable value creation. As Indian start-ups strive to make their mark on the global stage, responsible governance will be the differentiator that attracts investors, builds trust and sets the stage for enduring success. By weaving governance into the fabric of their operations, Indian start-ups can realise their full potential and contribute to the growth and transformation of the country’s entrepreneurial landscape.

Prashant Mara is managing partner and Pratik Bakshi is counsel at BTG Advaya. Mr Mara can be contacted on +91 (0) 22 2482 0820 or by email: prashant.mara@btgadvaya.com. Mr Bakshi can be contacted on +91 (0) 22 2482 0820 or by email: pratik.bakshi@btgadvaya.com.

Prashant Mara is a litigator specialising in white-collar and regulatory defence, internal investigations and complex disputes. His clients are from across a range of regulated sectors including technology, energy, defence, automotive, aviation, pharma, chemicals and extractive industries. Mr Mara works closely with cross border teams of outside and in-house counsel to investigate whistleblower allegations, act as defence counsel in regulatory prosecutions and assist in dispute resolution. Further, he spends significant time providing board-level compliance and crisis response support in ESG-related matters, especially to his listed company clients.

Pratik Bakshi is a counsel in the ESG and Impact practice of BTG Advaya. He is engaged by clients from various sectors, such as retail, technology and extraction, to advise on issues relating to business and human rights (BHR), environmental, social and governance (ESG), corporate social responsibility (CSR), human rights due diligence and business sustainability. Mr Bakshi has also been actively involved in policy and advocacy, and has been consulted on the drafting of modern slavery legislation, and legislation on strategic lawsuits against public participation (SLAPP).

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Prashant Mara

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