Being compliant: Why startups & funds end up in a bad marriage

Due Diligence in Startups

Over the last six months, the startup ecosystem has seen headline-making news, the kind of which some of us would never want to hear about.

There have been accusations of financial mismanagement, tax evasion, harassment, and firing of key employees.

Infra.Market (funded by Nexus Venture Partners), Trell, Zilingo, and Bharat Pe (the latter three funded by Sequoia India) have all left a bad aftertaste for founders and funds alike.

Everything turns awry when skeletons come out of the closet and the funds cannot believe that the founders were capable of such mismanagement.

Sequoia India and its team recently turned to a blog with those three companies coming under scrutiny or investigation.

"Recently some portfolio founders have been under investigation for potential fraudulent practices or poor governance. These allegations are deeply disturbing. We have always strongly encouraged founders to play the long game. We focus on the enduring and discourage focussing on vanity metrics. Despite that, we find some counter-examples of what we espouse. It makes us reflect on what we could have done, along with other investors who have partnered in these companies, to prevent such situations," wrote Sequoia India's team. Read the entire blog here.

Why wasn't there an enforcement of compliance and deeper due diligence? 

 

Quote 5In the life cycle of startups, the funds or investors come in after about a year or more after inception. There is already history by the time seasoned investors or funds come in. So, while funds may insist on startups paying attention to corporate compliance, many of them simply seek a form of undertaking that the founder will ensure is doneQuote 7 - says Meghana Bhargava, a Bengaluru-based independent lawyer specialising in compliance and risk mitigation strategies.

Compliance requires attention

Most start-ups are strapped for cash or are looking at ROI in the early stages, and hence are unable or unwilling to prioritise corporate compliance.

Startups believe compliance is a one-time activity. Regulatory compliance includes all things such as registrations, licenses, approvals, filings in ROC, tax returns, registers, display or notices.

"While some of these are a one-time activity many of them are recurring in nature and require someone to actively track and ensure compliance," says Meghana

Then there is contractual compliance. Unlike regulatory compliance, it varies with each contract, especially if a company executes contracts on another’s paper.

Corporate Compliance has two main elements, which are statutory/regulatory compliance and then contractual/internal policy compliance.

"Contractual compliance is fairly simple, do what you say you will do, very few founders pay attention to what they have signed up for.  This is also true for large companies that do not focus on contractual compliance audits," says Meghana.

Most of us want to know if the valuation is accurate. Are there any hidden issues, which may be unknown to the founders? Funds have to make sure that the company has been run well and check if there are policies and procedures in place to ensure risk management/ mitigation.

"If funds are getting due diligence wrong it is because they are focused on immediate ROI rather than evaluating the long-term viability of the business," says Meghana.

 

Quote 5A fund rarely helps a startup with compliance. They are a machine which invests money and needs to give returns to their LPs. They will do things that help them accomplish that. Compliance is the last thingQuote 7 - says Sathya Pramod, founder of Kayess Square Capital, an advisory firm.

Also Read

This CEO and CA predicts bigger frauds likely in 2022 and governance is the key especially in startups

Why do startups get compliance wrong?

"It always starts from the top. The founders are so obsessed with their product, customers, and investors that they believe that finance just happens. It does not. They need to put that effort to bring in that discipline in the system," says Sathya Pramod, founder of Kayess Square Capital, an advisory firm.

Startup founders will hire a CFO or head of finance, but, even this does not sort out the problem because the culture of compliance does not exist. After all, a CFO is paid by the founder and will listen to what the founders say, so culture becomes important. 

As long as one looks at compliance by the letter and not by substance, it will never be accomplished. It is also important for funds to look at professional firms that can give this service without having an obligation to the company.

"A statutory audit happens at a very superficial level and will not serve the purpose. In fact, I have been talking to a few new funds and they like the idea of doing a health check periodically to avoid surprises" says Sathya.

If the founder is only focussed on valuation, he will not be in a position to set up something compliant. It should get ingrained in his mind that compliance helps increase valuations. It is actually a fact.

If a company is ready for due diligence and completes it quickly, the story gets stronger in the mind of the investor. So, like I said earlier the culture of compliance needs to come from the top.

Also Read

How this CA quit his Big 4 job & against all odds built a thriving due diligence firm in the sandy shores of Goa

The need for due diligence

"I believe this is something everyone is missing. I have seen diligence for the sake of doing it and not with a good spirit. Diligence needs to cover many aspects and should be forward-looking as much as it is historical. If a person doing diligence cannot gauge the mindset of the management team, it does not serve any purpose. Unless we can have people go deep and put their experience on the line, diligence will be a futile exercise. We need senior people doing diligence and especially people who have been in the corporate world who can read such situations better," says Sathya.

The problem, however, is cost. Advice comes at a cost, and according to many senior experts, just advice again does not serve the purpose. Unless the advice comes with execution it is a waste of time for founders. It would be even better if there is skin in the game for the advisor.

Every founder holds on to equity and thinks it is precious. Having a good advisor on board in fact increases the value of the company and gives you a sounding board.

There will be rotten apples everywhere, but, that's a chance a founder should be taking if she believes in the person.

Many times founders think they have conquered the world because they have got funded and that is just the start of all the problems. They will need these advisors to act as their shock absorbers. So, the right people giving the right kind of advice is extremely important.

According to PWC, the startup ecosystem in India has raised more than $10 billion in each of the three previous quarters. India has 100 Unicorns already and the list is only going to go up. One thing is true: the Indian startup ecosystem is going to be flush with funds.

Founders, please be compliant & funds do focus on due diligence.

 

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