There is a new element that start-up founders can no longer ignore as they search for success. Alongside a strong value proposition and a credible team, the post-pandemic investor expects sound governance principles to be built into the way the business is run.
This year market darlings BharatPe and Zilingo have grabbed headlines in India for the wrong reasons. Zilingo, a start-up in the business-to-business supply space, is under investigation for its financial and accounting practices. Fintech company BharatPe witnessed its co-founder being accused of misappropriation of company funds. The failures in their corporate governance systems hit hard.
Venture capital investor Sequoia India, in a much-discussed press release from earlier this year, emphasised that corporate governance is the ‘cornerstone’ of an ‘enduring company’. While it did not name names, the press release is widely understood as having been issued in response to the crises at its portfolio companies Zilingo and BharatPe.
In a 2017 survey over 60 percent venture capitalists named ‘poor business ethics’ as the reason for a start-up’s failure.
And with over 90 percent of start-ups in India failing within the first year, a founder must consider ethics as much as earnings in terms of plotting sustainable growth.
Much ink has been spilt on cultural factors contributing to the differences that separate Indian start-up founders from their western counterparts when it comes to issues surrounding corporate governance. Academics have also pointed to regulatory uncertainty as contributing to the problems. However legitimate these factors may be, start-ups will now find themselves increasingly having to tighten the reins on business practices.
This task however is not as daunting as it appears. At its heart, corporate governance is simply a system that directs and controls a corporation’s function.
Kamala Naganand, managing partner at Aarna Law, sets out seven key principles where a founder should focus.
- Employee relations: e.g. ensuring that contributions to provident fund, insurance, etc. are met;
- Basic compliances such as any licenses and permits needed for manufacturing and employee/ workplace safety;
- Clarity and transparency regarding basic organisational structure and hierarchy;
- Tax related compliances such as any registrations (e.g., GST) and filings;
- Ensuring that all commercial relationships are governed by unambiguous written contracts;
- Ensuring that all intellectual property. being used is licensed appropriately; and
- Routine compliances such as annual return filings and regular board and general meetings.
These are indicative of the kind of concerns that start-ups need to be mindful of as they run their business (a fuller checklist can be found in the table below).
“No fund or bank wants to invest in a start-up unless the governance house is in order”Kamala Naganand
The earlier a corporation is able to frame a policy that can be implemented and monitored, the fewer the legacy problems that require to be handled post-hoc. Naganand’s experience at Aarna has made this clear: an upfront investment in legal advice pays off substantially later.
She says: “Earlier, compliances were for venture capital funds and bankers to push for. Promoters would only focus on growth. Now, that has dramatically changed. No fund or bank wants to invest in a start-up unless the governance house is in order”.
Start-ups are a large segment of Aarna Law’s client base. Feedback from clients has consistently been that there is long-term value in a start-up obtaining advice right at the beginning.
For example, Naganand has worked with founders on business plans that were not fully viable from a legal or regulatory perspective. Offering upfront and candid assessment has often saved Aarna Law’s clients from pouring resources into developing an idea or plan that is not workable within the existing regulatory framework.
Founders are able to take the advice, go back to the drawing board, and rework their ideas into something that can be brought to the market fully compliant. This also helps them avoid the expense and the distraction of having to work around subsequent regulatory trip-ups.
This is especially significant in highly regulated spaces such as fintech, where non-compliance often results in business disruption, potential penalties and sometimes even shut downs. In August 2022, Bangalore-based fintech start-up Uni Card announced it was suspending use of its prepaid cards after falling foul of Reserve Bank of India guidelines on digital lending.
Another key factor is that poor corporate governance can affect your exit strategy. Karishma Chanana, Corporate Advisory Practice Lead at Aarna, explains: “Non-compliance often affects the valuation that potential investors ascribe a start-up. Keeping a start-up compliant helps them not just to avoid penalties but also ensures that they stay viable for any potential acquisition.”
India is the world’s third largest start-up ecosystem, boasting of over 60,000 start-ups and over 65 unicorns. The health of this system rests, to a large extent, on founders and start-ups focusing on the what (that is the product/ service) but not forgetting the how (compliance).
As funding becomes tighter and regulations increasingly complex, one factor which will separate successful start-ups from the 90 percent of failures is going to be their investment in good governance.
A CORPORATE GOVERNANCE CHECKLIST FOR START-UPS
|Decision making||Is organisational and decision-making hierarchy clear?Are the independent directors on the Board truly independent?Do shareholders and other stakeholders have a say in management?|
|Accounting and financial practices||Does the company follow globally recognised standards such as GAAP?Are domestic legal mandates on accounting practices being followed?What internal checks are in place to ensure that the books are accurate?Are registrations with the relevant tax authorities (such as the GST registration) done?|
|ESG||Do operations impact the environment?What is the corporate social responsibility policy?Is there an employment non-discrimination policy?Is the team diverse and inclusive?|
|Integrity and ethics||Is there an anti-corruption and anti-bribery policy in place? Is there a whistleblower protection policy in place?What are the limits on executive compensation? What is the ratio between the highest and lowest paid employees? What are the protections available to minority shareholders?Is privacy of customer data being maintained?|
|Regulatory requirements||Are employment related regulations being met (such as provident fund requirements and insurance)?Have all the required licenses and permits been obtained?Is there a policy in place to prevent sexual harassment at the workplace?Are there qualified and competent secretarial and compliance staff?Are shareholder and Board meetings conducted regularly and minuted accurately?Are all the required returns being filed on time?|
|Broader business concerns:||Are all the relationships covered by a written contract? Is all the intellectual property being used appropriately licensed? Are the co-founders bound by a shareholders’ agreement or other co-founders agreement?|