Better governance to boost trust quotient of startups

From FTX to GoMechanic, issues of corporate governance have come to the fore in the startup ecosystem—lack of transparency to stakeholders, related party transactions, fraudulent accounting, inappropriate expense booking, and short-changing business partners, to name a few.

One would think that the regulations that govern public companies and their boards would provide a guideline for younger unlisted companies to mitigate reputational damage, loss of trust among stakeholders, and increased legal and financial risks.

Why then do company management teams fall prey to temptations or ignorance and what can be done to create better checks and balances to avoid these situations?

Corporate governance can be a daunting term for young companies that are trying to grow. But at its core, it is a set of simple principles that are adhered to by boards, founders, management teams and employees through good times and bad.

Typically, these manifest in systems and processes that are put in place to manage a company’s operations. They are designed to avoid asymmetry of benefits between promoters and other stakeholders.

Startups tend to put off institutionalizing these processes until a few years before they plan to list publicly, and even then, not in entirety. They are viewed from a lens of compliance and cost rather than one of strategic priority that increases the comfort of investors, confidence of customers and clarity for employees. Companies must make the effort to do this early in their life cycle as it will increase their ‘premium’, whilst acting as a mitigant when temptations arise in the volatility of business cycles.

One only needs to study the early days of Infosys and the steps its founders took to establish benchmarks in value-based corporate governance.

For example, the company set up risk committees and voluntarily adopted accounting standards early on. The founding team believed that softest pillow is a clear conscience. Bad news travelled faster than good news from within the company to its stakeholders.

The unfortunate recent lapses of governance in startups can be traced to lacunae in the following — a pervasive values-based culture, the effectiveness of the board, and the importance given to financial discipline in the early years.

First up, consistent adherence to good corporate culture is, of course, the ultimate safeguard. Young companies rightfully encourage a culture of experimentation, of pushing boundaries in search of differentiation. However, entrepreneurs must realize early that process discipline and risk management are equally important to inculcate within their organization.

Secondly, unfortunately, many of today’s startups are focused on short-term valuations rather than long-term value creation. Boards tend to be filled with representatives of their largest investors, typically fund managers who lack operational expertise. This leads to an inherent disincentive to disclose anything that could hurt near-term valuation, at the cost of other stakeholders such as customers and employees. Boards will become more valuable if they balance their composition with experts who can question the effectiveness of internal controls, and if they are given the independence and authority to access internal finance and compliance teams.

And thirdly, the role of a strong finance function is frequently overlooked in the early years. Management tends to focus on the business and its operations. Benchmark comparisons and standardization of accounting procedures are not questioned thoroughly. MIS reports are not double-clicked to discover the process and assumptions used. CFOs focus on raising capital and producing reports, little realizing that time spent on institutionalizing processes will help them perform both those tasks even better.

In the past, a relatively small set of investors took the higher risk of investing into private companies. But that is changing fast—large amounts of capital from a wider set of investors is now flowing into this space and entrepreneurs need to awaken to the rising accountability resting on their shoulders.

With talk of a funding winter and delayed exits, this year promises to put more pressure on the cash flows of startups. It is in these moments that vested interests surface and value systems are challenged. By establishing good governance systems early, startups can build a foundation for success and ensure that they have the tools and processes in place to navigate the obstacles they will face along the way.

Deepak Padaki is president, Catamaran, the family office of Infosys founder Narayan Murthy

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Secondly, unfortunately, many of today’s startups are focused on short term valuations rather than long term value creation. Boards tend to be filled with representatives of their largest investors, typically fund managers who lack operational expertise. This leads to an inherent disincentive to disclose anything that could hurt near-term valuation, at the cost of other stakeholders such as customers and employees. Boards will become more valuable if they balance their composition with experts who can question the effectiveness of internal controls. And if they are given the independence and authority to access internal finance and compliance teams.

And thirdly, the role of a strong finance function is frequently overlooked in the early years. Management tends to focus on the business and its operations. Benchmark comparisons and standardization of accounting procedures are not questioned thoroughly. MIS reports are not double-clicked to discover the process and assumptions used. CFOs focus on raising capital and producing reports, little realizing that time spent on institutionalizing processes will help them perform both those tasks even better.

In the past, a relatively small set of investors took the higher risk of investing into private companies. But that is changing fast - large amounts of capital from a wider set of investors is now flowing into this space and entrepreneurs need to awaken to the rising accountability resting on their shoulders.

With talk of a funding winter and delayed exits, this year promises to put more pressure on cash flows of start-ups. It is in these moments that vested interests’ surface and value systems are challenged. By establishing good governance systems early, startups can build a foundation for success and ensure that they have the tools and processes in place to navigate the obstacles they will face along the way.

Deepak Padaki is president, Catamaran, the family office of Infosys founder Narayan Murthy