Steering the Uncharted: Navigating Corporate Governance in Indian Startups

8th March, 2024 - 7:16 am Categories: Corporate Law News & Updates 0 Comments

The startup ecosystem in India has had a significant and rapid growth in recent years, which has garnered the attention and interest of investors and entrepreneurs from many parts of the globe. Corporate governance is predicated on the principle of ensuring sufficient alignment among the interests of several stakeholders, encompassing promoters, shareholders, employees, and customers. The four pillars of the organisation consist of accountability, honesty, transparency, and obligation. The 2013 enactment of India’s new Companies Act, which superseded the country’s prior Companies Act, was founded around these concepts. Nevertheless, the absence of sufficient corporate governance protocols in numerous startups has generated apprehensions over their enduring viability and the safeguarding of stakeholder concerns.

The term ‘Startup companies’ refers to nascent businesses that are in their early stages of establishment. Startups are established by entrepreneurs or a group of business owners with the intention of developing a product or service that they believe has a viable market demand. These enterprises generally incur substantial initial expenses and generate limited revenue, hence they pursue finance from diverse sources, such as venture capitalists. Startups are enterprises or initiatives that focus on a particular product or service that the creators intend to market. Typically, these businesses lack a well-defined business model and, more critically, adequate finance to progress to the next phase of growth. The majority of these enterprises are funded by their founders.

When we talk about corporate governance then, what it basically refers to is the methods, processes, and structures that are in place to enable efficient management and oversight of a firm. Effective implementation of sound corporate governance principles is crucial in fostering openness, accountability, and ethical conduct, while also protecting the interests of many stakeholders, such as investors, employees, consumers, and suppliers. Within the realm of startups, the implementation of effective corporate governance procedures is crucial to guarantee the enduring viability and expansion of the firm, as well as to allure and maintain the support of investors and other stakeholders. Corporate governance plays a crucial role in fostering the economic growth of India among the thriving nations worldwide. It achieves this by safeguarding not just the management but also the interests of stakeholders. Shareholders have much higher levels of confidence in a corporation that implements effective corporate governance. Autonomous and confident directors contribute to the business’s positive outlook on the financial markets, so enhancing the value of the shares. Foreign organisations investors consider several crucial issues, including corporate governance, when selecting companies for investment.

BENEFITS OF CORPORATE GOVERNANCE IN START UPS

Implementing efficient corporate governance practices in Indian startups offers numerous benefits to organisations, serving as a catalyst for corporate development and general economic progress. Companies equipped with strong governance systems not only instill confidence but also earn the trust of their shareholders. Trust is crucial for improving capital efficiency and overall business performance. The ripple effect leads to a decrease in capital expenses, leading to significant cost savings for the organisation. The share prices are experiencing a consistent increase, which serves as concrete proof of the strong connection between effective corporate governance and financial prosperity. Moreover, a culture of efficient corporate governance acts as a guiding principle for firm owners and managers, ensuring that their objectives are in line with the interests of both the company and its shareholders. This alignment promotes a mutually beneficial partnership that supports long-term growth and profitability. Good governance offers inherent advantages that go beyond financial aspects. It acts as a potent deterrent against risks, reduces corruption and wastage, and enables more streamlined administration. Proper corporate governance is fundamentally crucial for the growth and advancement of enterprises in India. It transcends being a basic statutory requirement and instead becomes a compelling factor that influences the way firms function. By implementing a well designed governance framework, businesses function in a manner that guarantees their own prosperity while also taking into account the well-being of all parties concerned. Hence, the extensive benefits of corporate governance establish a strong basis for startups to prosper and make significant contributions to India’s dynamic business environment.

CORPORATE GOVERNANCE CONCERNS IN START-UPS IN INDIA

The Zilingo Ankiti Bose controversy can be attributed to the founders’ initial mistake of regarding startup governance as a secondary concern. Many firms aspire to innovate novel products and services in order to attract and retain devoted consumers, make substantial revenues, and successfully bring their original concepts to fruition.

Corporate governance refers to the established set of standards, regulations, and processes that regulate the operations of a firm. Taking these factors into consideration, the firm can direct its operations and exercise more stringent authority over crucial determinations to actualize its vision, accomplish its goals, and eventually thrive in a manner that is advantageous to all parties concerned. Corporate governance encompasses the set of policies, practices, and relationships that regulate and manage a corporation. This phrase refers to the entity that exercises control and governance over a company. Effective corporate governance entails the operation of a corporation in a manner that optimises financial gain for its shareholders. The board of directors and other bodies responsible for the organisation make such decisions in order to achieve a harmonious equilibrium between the interests of individuals and the interests of society at large, as well as between economic and social considerations. Stakeholders encompass the company’s promoters (founders), stockholders (investors), workers (employees), and clients (consumers). The foundation of this concept is supported by four fundamental principles: accountability, honesty, transparency, and responsibility. The concepts laid the foundation for India’s revised Companies Act of 2013. Measures such as incorporating the notion of independent directors, elaborating on the liability of promoters, and establishing a whistleblowing mechanism were implemented to enhance transparency. The establishment of information standards encompassed the responsibility for various aspects, such as the formulation and implementation of risk management policies, CSR activities, and audit accountability. Organisational decision-making is frequently expedited by the utilisation of internal committees such as the audit committee, the nomination and remuneration committee, and the stakeholders’ connection committee. To cultivate a culture of integrity among corporate leaders, measures were implemented to restrict the remuneration of important executives, secure the interests of minority owners, and ensure the protection of investors.

Each emerging enterprise is the result of the founder’s resourcefulness and perseverance. Usually, these entrepreneurs are youthful individuals who are enthusiastic to demonstrate to the world the brilliance of their idea. and elevate their enterprises to unprecedented levels. Nevertheless, their limited availability, expertise, and commercial acumen. Their skills often provide the perfect contrast to their passion and excitement.

 Moreover, in the initial years of a business’s establishment, there is a scarcity of both human and financial resources, hence posing challenges in acquiring proficient counsel and assistance from accountants and lawyers. Occasionally, an excessive emphasis on innovation, enhancing the value of the product/service experience, and ensuring customer satisfaction can actually have a detrimental effect on the organisation.

Consequently, in order to make the company more attractive to a potential investor, corporate governance is sometimes given little priority or altogether disregarded.

The majority of startups are spearheaded by their founders. Entrepreneurs often opt for the private limited company structure, as it enables them to maintain confidentiality in their operations. Consequently, establishing a firm requires less exertion, and its creators are more likely to enjoy the advantages of a significantly reduced set of compliance obligations compared to a publicly traded corporation. They might exploit the reduced corporate governance standards by having less scrutiny directed towards their operations, choices, financial policies, disclosures, and overall performance. The ultimate objective of every company is to secure substantial cash through a sequence of financing rounds from investors and venture capital organisations, who want to generate profits by investing in the startup at a lower valuation per share. A startup’s long-term success would be compromised if its management fail to prioritise effective corporate governance throughout its first phases. Prior to investing and acquiring a stake in a startup, investors perform thorough due diligence. This process involves examining the company’s financial records as well as investigating its past decisions, disclosures, and any legal claims or complaints that have been made against it.

[Image Sources: Shutterstock]

 While funding may appear to be the ultimate solution, it also brings up a multitude of challenges. Once investors become part of a startup’s ecosystem, the founders’ tenure as the company’s leaders is almost over. The transition from a private to a public status is characterised by a surge in the quantity of stockholders. Due to these modifications, the board of directors, which serves as the primary governing authority of the corporation, has seen substantial restructuring. The implementation of fundamental precautions can be ensured by the unwavering commitment of the company’s founders. Conversely, complex procedures or mechanisms for oversight seem ineffective unless the company’s founders demonstrate complete dedication to doing the business with ethical principles. Numerous private and public companies have exhibited this conduct as well. Both Enron and Satyam had highly accomplished individuals serving on their boards and board committees. Both had a dramatic and sudden collapse. Such occurrences are quite common. Despite the selection of independent directors, founders tend to go for individuals that share similar characteristics to themselves to occupy these positions. A substantial amount of filth can accumulate unnoticed by some of the most intelligent board members before it is exposed, which would astonish everyone. The significance of appropriate mechanisms should not be underestimated. The importance of this grows. If the governance of a corporation is not up to standard when it is preparing to go public and raise cash, the founders and investors may suffer significant losses. Nevertheless, effective governance is crucial at all times, not alone during the initial stages of a company’s recognition. The governance style of a startup remains mostly consistent when it prepares to become a publicly traded company. Considering governance issues during a startup’s preparation for going public is an erroneous approach.

CASE STUDY OF RECENT STARTUP CORPORATE GOVERNANCE FAILURES:

Bharat Pe Case Study

BharatPe, a company aiming for an initial public offering (IPO) that facilitates digital payments for shops through QR codes, conducted a corporate governance assessment in January to alleviate investor concerns following a public dispute related to the personal investments of one of its co-founders. Following co-founder Ashneer Grover’s lawsuit against Kotak Mahindra Bank CEO Uday Kotak for financial compensation regarding a denied personal investment loan, the company garnered significant scrutiny from investors and the general public. BharatPe’s board has taken significant actions based on a thorough examination of a report to ascertain whether a former founder was involved in intentional wrongdoing or serious carelessness during the previous two months. Alvarez and Marshal (A&M), a firm specialising in management consulting and risk advising, was hired to examine the company’s internal processes and systems. The preliminary examination conducted by A&M.

The organisation employed HR consulting firms to recruit employees. The investigation also uncovered the company’s fraudulent suppliers. Madhuri Jain, who is the Head of Controls and also the wife of co-founder Ashneer Grover, is suspected to have been involved. Following the charges of fraud and misappropriation against Ashneer Grover and Madhuri Jain, the founders, directors, and investors engaged in a series of allegations and counteraccusations. Investors and directors allowed this misconduct to persist for an extended period of time. Sequoia Capital India, Tiger Global Management, and other firms had significant influence over the board. Investors prioritise the assessment of a company’s worth over the concerns and well-being of stakeholders. The company’s unclear communication about its commercial operations facilitated theft. Madhuri Jain, a graduate in design, held the position of controls manager.

The board ought to have scrutinised departmental allocations more thoroughly. This raised the issue of investors’ obligations towards entrepreneurs. Ashneer Grover’s influence on the company’s management was constrained by a small board, the absence of an internal auditor, and the absence of an external auditor. Stockholders and non-promoter board members had a passive demeanour. The sustained prosperity of an expanding small and medium-sized enterprise (SME) relies on effectively managing the competing interests of both the family and the shareholders.

Zilingo Case Study

The issues at Zilingo exemplify a widespread problem in the startup sector: a nonchalant approach to internal corporate governance. The company failed to submit its annual financial statements for two consecutive years, a requirement that is obligatory for enterprises of its magnitude in Singapore. Ankiti Bose, the CEO, was suspended due to suspected financial improprieties. In a matter of weeks, creditors demanded the repayment of loans, over 100 employees resigned, and Bose was dismissed from her position, even though she denied any wrongdoing. The company’s viability is presently uncertain.  The Zilingo collapse has profoundly impacted the Southeast Asian and worldwide technology sectors. Over $300 million has been garnered from prominent investors in the region, such as Temasek Holdings Pte and Sequoia Capital India, the regional division of the Silicon Valley firm that supports Apple Inc. and Google. Startups seldom fail to meet these deadlines, which can lead to a penalty of up to S$600 ($430), but this is frequently a sign that the board might consider taking more decisive measures. A comprehensive forensic investigation was carried out, supported by the majority of the company’s stockholders. An independent forensic investigations firm was assigned to investigate the above complaints with the support of the majority investor stockholders. Ms. Bose was subsequently terminated by the company based on the findings of the investigation, which was conducted over a period of over two months and involved multiple instances for her to provide documents and information.

CRITICAL ANALYSIS OF CASE STUDIES

The Bharat Pe and Zilingo incidents can be attributed to corporate governance shortcomings, highlighting the need for effective and mandatory governance frameworks in the Indian small and medium-sized enterprise (SME) sector. These frameworks should focus on the following areas:

1. Lack of transparency is attributed to the failure to provide relevant financial and nonfinancial information to shareholders and investors.
2. Appointing directors: Small organisations should transition from centralised decision-making to decentralised and collaborative decision-making over time. Entrepreneurs and chief executive officers (CEOs) of small and medium-sized firms (SMEs) often serve as the primary decision-makers throughout the initial stages of the organisation. It raises the probability of making less-than-ideal choices as a result of personal biases, restricted data, and a lack of experience. The delegation of authority is crucial since startup executive directors often consist of people from the founding families. A formal board of directors provides supervision and administration, along with strategic counsel and guidance. Furthermore, the legislation should require the designation of autonomous directors to promote accountability and facilitate impartial recommendations.
3. Implementation of internal controls and selection of auditors: It is imperative to establish internal controls to ensure the effective execution of the company’s plan and the mitigation of risks. Possible risks include fraud, excessive expenses, and inaccuracies in reporting. The implementation of internal controls falls under the responsibility of management, while the board of directors offers guidance and supervision. An independent auditor verifies evaluations and documents of substantial deficiencies in control. Internal auditors, management, and executive directors/founders have separate control over their respective areas, yet some of them may deliberately hide important information and auditing issues.
4. Mandatory auditor rotation: This policy will deter complacency and prevent undue influence from company promoters.

 Directors should actively involve themselves in the operations of the firm while refraining from direct involvement. Oftentimes, entrepreneurs desire to maintain active participation in the daily operations. Consequently, individuals develop narcissistic tendencies and become excessively focused on themselves.

CONCLUSION

Corporate governance pertains to the relationship between a company’s management and its many stakeholder groups. In order to ensure effective adherence, there needs to be adequate transparency among the parties indicated above. Despite the introduction of the Companies Act 2013 in India, corporate governance problems have nonetheless happened inside the Indian environment. Nevertheless, this legislation has offered companies a prescribed approach to adhere to. Updating the Companies Act 2013 is necessary to restrict the occurrence of corporate governance problems. The Ministry of Corporate Affairs in India has implemented robust corporate governance measures to enhance the operational efficiency of companies. It sustains the relationship between the stakeholders and the company. The firm could focus on long-term growth and substantial profits. In order to enhance profitability and ensure shareholder contentment, the firm must strictly adhere to the fundamental tenets of corporate governance. Companies that fail to implement efficient corporate governance face significant consequences, including the potential loss of shareholders and a decrease in share prices.  Irrespective of a company’s size, effective corporate governance is essential. Corporate governance management is frequently perceived as an expensive undertaking, particularly for small and nascent enterprises. Conversely, small and medium-sized enterprises (SMEs) have encountered a range of corporate governance challenges in recent times. A notable example that exemplifies this pattern is the Indian predicament of Bharat Pe. This necessitates the establishment of fundamental and inevitable principles of governance. Hence, it is imperative to integrate principles such as transparency, establishing a formal board, implementing internal control measures, appointing an external auditor, and preparing for leadership transitions. It is now necessary to implement these concepts in order to safeguard small and medium-sized organisations (SMEs) and new firms from experiencing the same outcome as Satyam.

RECOMMENDATIONS

Given the impact of fraudulent activities on the corporate and securities markets, it is imperative to pass legislation that specifically targets and resolves these shortcomings. Due to the high occurrence rate of corporate governance failures in businesses, there is a necessity for the implementation of governance measures. When corporations neglect to implement effective corporate governance, it has a cascading impact on both the economy and the investors who own a significant stake in the company. All institutions would effectively adopt corporate governance compliance requirements. Nevertheless, it is imperative to establish dependable protocols to guarantee adherence within enterprises. Startups and scale-ups should focus on four key areas of governance: strategy and collaboration, people and resources, technology and intellectual property, and processes and accountability. Effective governance policies are necessary to ensure the successful growth and value creation of high-growth enterprises. The establishment of the organization’s culture is the responsibility of the founders.

 Their stats are inaccurate, and they need to rectify them. They could allocate their efforts more effectively by identifying sources of income. The potential consequences of corporate governance concerns can be disastrous, as evidenced by the swift decline of major businesses such as Arthur Andersen and Enron. Additional prominent instances include Yes Bank, Satyam, and DHFL within the domestic context. Founders are unable to transfer or assign their power or control to others. This is a critical matter that warrants equal, if not greater, focus than watching corporate advancements. Effective governance is not discretionary; it is imperative. If the founders’ actions are both transparent and ethical, the organisation will conform without requiring excessive propaganda. In order for financial auditors to detect and disclose fraudulent activities within a startup, it is imperative that the firm establishes and adheres to well-defined corporate governance standards.

Author: Kushaan Singh, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.

BIBLIOGRAPHY

Journal References

• Corporate Governance Issues In Indian Start-Up Culture: A Critical Analysis. (2022, October 21). IJLLR. https://www.ijllr.com/post/corporate-governance-issues-in-indian-start-up-culture-a-critical-analysis
• CORPORATE GOVERNANCE ISSUES IN INDIAN START-UP CULTURE: A CRITICAL ANALYSIS. (n.d.). In https://3fdef50c-add3-4615-a675-a91741bcb5c0.usrfiles.com/ugd/3fdef5_7ff184ab7ac34d098c64231f3696b0df.pdf.
• Williamson, O. (1984). Corporate Governance. The Yale Law Journal, 93(7), 1197–1230. https://doi.org/10.2307/796256
• Claessens, S. (2006). Corporate Governance and Development. The World Bank Research Observer, 21(1), 91–122. http://www.jstor.org/stable/40282344
• Afsharipour, A. (2015). CORPORATE GOVERNANCE AND THE INDIAN PRIVATE EQUITY MODEL. National Law School of India Review, 27(1), 17–48. http://www.jstor.org/stable/44283645
• SUBRAHMANYA, M. H. B. (2015). New Generation Start-ups in India: What Lessons Can We Learn from the Past? Economic and Political Weekly, 50(12), 56–63. http://www.jstor.org/stable/24481943

Statutory References

• The Companies Act, 1956
• The Companies Act, 2013