Prioritising governance at startups: A magic pill for better funding

Over the last two decades India has established a vibrant startup ecosystem. The Indian VC community has played a crucial role in this journey.

Until 2022, the significant liquidity in the financial systems also drove significant startup investments.  For the most part, the focus of investors and consequently founders was customer acquisition, revenue growth and market share gains.  This was often at the cost of an appropriate focus on profitability, internal processes, and internal controls. 

The increase in interest rates, reduction in liquidity, significant stress in the global economic environment and volatile capital markets have rightly resulted in a recalibration of investor expectations.  Growth at any cost is no longer the mantra, and profitability and cash flows are back in fashion.  In turn, this has resulted in a reallocation of capital and an impact on liquidity available for many unprofitable startups.  The capital constraints have also now exposed chinks in the governance ecosystem at startups. 

While common sense always suggested that growth, profitability, and good governance are all essentials for the success of a company, it may be useful to reflect on what may have gone wrong and more importantly how do we fix it.

What may have gone wrong?

Whilst the motives in each situation of a governance failure at startups may have been different, in our experience, the following factors may be drivers:

1. Pressure to meet expectations: founders may engage in certain acts to meet investor or general market expectations to maintain the appearance of success.

2. Incentives and rewards: stated financial performance, particularly growth in revenues and related metrics, were drivers of company valuation and enabled companies to raise subsequent funding at ever-increasing valuations resulting in a direct impact on the incentives and wealth of founders.

3. Lack of ethical standards: in certain cases, founders may engage in particular acts due to a lack of ethical standards or a general disregard for the law.

4. Opportunities: finally, the incentive to engage in inappropriate acts increases if founders see opportunities to do so, such as a lack of strong financial controls, internal controls, or weak monitoring mechanisms.

Where do we go now?

Like with many things, there is no silver bullet to solve for this. However, our experience suggests that a combination of the following measures may be helpful:

1. Focus on founder and management ethics: Investors may benefit from a renewed focus and diligence on founder ethics. Often, this drives the culture and governance through the organisation.

2. Setting the right expectations: Investors and other stakeholders drive behaviour through stated and unstated expectations.  It is important that such expectations should be balanced to ensure that they do not drive bad behaviour.

3. Board oversight: The Board should have appropriate independent directors, spend sufficient time and should be responsible for overseeing the company's governance framework, including the tone at the top.  The Board should see governance as an equally important part of its responsibilities as compared to a review of the business and operations. 

4. Investments in governance: Companies and their investors should realise that as companies grow larger, appropriate investments are required in a strong finance function (including a strong CFO), robust internal processes and controls and an independent internal audit function.  A confidential and well-designed whistle-blower program could also be helpful. 

5. Timely completion of external audits: Companies and their boards need to ensure that external audits are completed in a timely manner and auditors are given the platform and the confidence to share their findings and concerns with the Board.  To ensure high-quality audits, auditors should also be fairly compensated.

In conclusion

Good governance is an important enabler for value creation and should be given its due importance alongside growth, profitability and other financial metrics.  This is as truer for startups as it is for large listed companies.  Some reflections, backed by actions, on the part of all stakeholders involved in the startup ecosystem may help to ensure that India continues with its journey of being one of the largest startup ecosystems in the world.  

Author: Co-authored by Jamil Khatri, Co-founder and CEO, and Sandip Khetan, Co-founder and Global Head, ARC Practice, Uniqus Consultech