Chasing Unicorns: Is all well in India’s start-up ecosystem?

Start-ups in India will need to realise the fact that governance and compliance are their friends and not their foes.

Till a few years back, unicorns only meant fantasy animals that existed in stories, but nowadays they have acquired a new meaning in the start-up world- an entity that has joined the coveted club of USD 1 Billion valuations.

Starting from the CEOs of MNCs to the local kirana store, India is in awe of start-ups, and everyone wants to join the bandwagon. Start-ups have been a catalyst for change in India and have brought innovation, convenience, job creation, and a chance for a better future to the forefront. The meteoric rise of the Indian start-up ecosystem makes every Indian proud. But is all really well? It doesn’t seem so, with an increasing trend of news regarding the alleged financial irregularities, corporate governance issues, and even allegations of fraud floating around.

The numbers game

Investment in a start-up is a high-risk-high-reward proposition. While start-ups may have started their journey to solve problems through innovation and to unlock opportunities, in the last few years, the pressure has built on the founders to churn numbers, grow profits, and show great increases in valuations, so that they can keep the trust of their existing investors and get new funding rounds at higher multiples.

There seems to be a rat race to be the next unicorn and that too, at any cost. The drive for higher valuations, better top line/bottom line, and extreme competitiveness has its positives, but it seems a dark side has also emerged along with it. Has the vision to change society and innovate started playing second fiddle to just numbers and valuations? Is it all about the numbers game?

Throughout the start-up lifecycle, founders face several constraints and challenges, starting from wearing multiple hats to dealing with shoestring budgets to the challenges of meeting the expectations of multiple investors/stakeholders, but the recent news regarding potential financial fraud, accusations of misleading the investors or withholding material information, is simply not acceptable no matter what the excuse for such actions is.

Is the one-track-minded approach to increasing valuations and having a bloated balance sheet real reasons why founders choose to ignore morality and legality and take decisions that may cost them their entire life’s worth of hard work? While one can blame the focus on numbers for some decisions, in a start-up, in situations such as these, the buck stops with the founders.

Exit but at what cost?

Simply speaking, investment funds have their life cycle, and their key goal is to ultimately exit at a high valuation before the end of such a life cycle with a juicy return on investment that benefits its limited partners. These investment funds not only bring money to the table, but also advise on various aspects of the business by leveraging their vast experience, help in making inroads into the right circles as well as hand-holding young entrepreneurs wherever possible in decision making. Despite all this, based on recent news, a closer look at the legal, compliance and corporate governance aspects from these investors are the need for the hour.

When investment funds put their money into start-ups, they enter into binding agreements where a plethora of rights are provided for them – starting from board seats to veto rights on critical matters to information and audit rights, etc. However, once the investment is made, seldom are these rights exercised. Often, it may be seen that board nominees are not appointed, especially in early-stage companies, or that the information rights/audit rights are not effectively utilized. Adding to this, companies that show growth are often less scrutinised in order to provide flexibility to founders. It’s not surprising to see that the all-powerful audit right is only used when things have already gone wrong, and founders are facing a termination for “cause” events.

Needless to say, the suggestion is not for investment funds to interfere in the day-to-day affairs of a start-up and stifle the innovations and creativity of the founders. The best and elite funds take pride in the independence allowed to the founders and act as enabling partners rather than roadblocks. Having said that the focus on investee company compliance and corporate governance by funds must increase with suitable checks and balances in place.

Compliance team is not your foe

Kartik Jain

The famous saying by Paul McNulty “if you think compliance is expensive, try non-compliance” is apt here and something that every start-up should remember.

The recent developments around potential irregularities in certain Indian start-ups highlight the need for adopting a more structured approach to governance and compliance. Certain start-ups tend to view their legal/compliance counterparts as merely cost centres or roadblocks, to which the lowest budget is attributed. This approach has to change. Start-ups have to invest in legal/compliance teams and tools with a focus on corporate governance. Funds will also have to push start-ups to appoint reputed law firms, quality independent auditors and deploy robust compliance teams so that while the business keeps growing, the growth does not come at the cost of non-compliance leading to the eventual disrepute that will ruin the brand image. In the long term, neither the start-up, nor the funds / founders benefit from a fiasco concerning corporate governance as huge value is erased in the process, leading to significant losses for all.

More importantly, founders have to realise that their responsibility towards their stakeholders is paramount. In the thirst for achieving fast and aggressive growth, corners cannot be cut. There is still hope and such instances of fraud and irregularities are rare exceptions and not the norm. However, start-up India will need to stand up to the fact that governance and compliance are their friends and not their foes.

(This article has been co-authored by Debottam Chattopadhyay, Senior Associate at JSA)

Disclaimer: The views expressed in this article are those of the author and do not necessarily reflect the views of the Economic Times – ET Edge Insights, its management, or its members

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