Governance issues at Indian Startups: causes and impacts – Explained, pointwise

Introduction

India became the third-largest start-up ecosystem in the world after the US and China last year. Further, for the second time in a row, India topped China by creating 23 unicorns in 2022. At present, India, has more than 99,000 start-ups. However, the corporate governance issues faced by Byju’s have raised significant concerns and highlighted a broader problem within India’s startup ecosystem. Similar violations of corporate governance standards have also been reported in other Indian startups such as Mojocare, GoMechanic, and BharatPe. These incidents have highlighted the need for corporate governance and oversight in India’s startup ecosystem. 

What is a startup?

An entity is considered as a Startup in India if it fulfills the following criteria:

1. if the entity is less than 10 years old.
2. if the annual turnover is not more than 100 crores.
3. if the entity is involved in innovation or if it is a scalable business model with a high potential of employment generation or wealth creation.

What is corporate governance?

Corporate Governance refers to the way in which companies are governed and to what purpose. It identifies who has power and accountability, and who makes decisions.

Corporate governance is a toolkit that enables management and the board to deal more effectively with the challenges of running a company.

Corporate governance ensures that businesses have appropriate decision-making processes and controls in place so that the interests of all stakeholders (shareholders, employees, suppliers, customers and the community) are balanced.

Read more: What is the meaning of Corporate Governance?

Why is corporate governance important for startups? 

Startups usually want to focus on growth and see corporate governance as a burden. But sound governance is an enabler.  

Corporate governance ensures that startups are operating in a transparent and ethical manner, which is important for building trust with investors, customers, and other stakeholders. 

A good corporate governance framework and its implementation is important for the long-term growth and sustainability of Indian start-ups.  

Startups that have good corporate governance are more likely to build a stronger brand reputation, attract more financial resources and attract and retain top talent. 

Corporate governance also helps startups to mitigate risks and ensure compliance with regulatory requirements.  

Why Indian startups are facing governance issues? 

Founder’s fault: With considerable capital inflows and rapid increase of startup ventures across sectors, India’s startup ecosystem is highly competitive. This can influence some founders to overlook governance aspects. Also, first-time founders don’t have the required expertise on corporate governance. Focus on governance can also increase operational costs which founders may not like. In certain cases, founders may engage in questionable acts due to a lack of ethical standards or a general disregard for the law. 

Growth at all costs: VC-induced drive for fast growth is a major reason for the rise in corporate mis-governance cases in the start-up ecosystem. The pressure to grow at all costs forces the startups to abandon the systems and processes they may have set up for governance. 

Fear of missing out: India’s startup space saw funding of more than $131 billion between 2014-22. As global venture capital (VC) firms rushed to invest in promising Indian companies, there was a ‘fear of missing out’ among the investors. This made due diligence less important and entering into a deal became more important. 

Exaggerated valuations: With the rise of start-ups and VCs encouraging start-ups to grow at any cost, company valuations have started exceeding fundamental values. People have started to give more importance to company valuation than business processes. 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 for wrongdoing.  

Overestimation of the size of Indian Market: VCs and founders have overestimated the size of Total Addressable Market in India and exaggerated the India opportunity to their investors. But India is a small market with limited merger and acquisition opportunities which provide for large exits within seven years (the lifecycle of a fund within which founders are expected to give exits). The pressure to meet the expectations forces startups to adopt unprofessional practices. 

Read more: Reality check for startups 

How will governance issues impact the startup ecosystem in India? 

Tighter regulations: The government makes many exceptions for and gives concessions to startups so they can contribute to the economy. However, if cases of financial and operational failure become more regular, the government and regulators may start tightening the rules, which will kill innovation. 

Reduced investment: The startup ecosystem thrives on easy funding from foreign investors. But due to recent incidents of mis-governance, investors may lose confidence in an already challenging funding environment. 

Distrust: The emerging distrust between investors and founders due to a few badly managed organisations has caused litigations, layoffs, exiting directors, and forensic audits. Founders are experiencing longer due diligence processes, and closing funding rounds is no longer as easy as it was in 2020 and 2021. 

Growing Significance of Corporate Governance: Investors are increasingly looking at corporate governance practices while making investment decisions. This means that startups with good governance practices are more likely to attract investments. 

What should be done to address governance issues at Indian startups? 

Self-regulation: Clear norms of self-regulation are laid out in ‘Start-Up Governance Playbook’ for every stage in startup growth. Startups should recognize the importance of corporate governance and every start-up must follow the laid out self-regulation norms. Also, the start-up community should develop corporate governance standards based on which auditors can transparently audit accounts and report malpractices.  

Bring in the experts: A startup continues to be a founder-centric organization even after experiencing exponential growth. But start-up founders cannot be experts in every aspect of the business. VCs should bring in the relevant experts for various functions. 

Building for long term: Founders should focus on building a sustainable business rather than building valuations for the short term. 

Longer fund lifecycles: Building a sustainable business in India takes time but VC funds have seven-year lifecycles and push startups for exits within seven years. The fund lifecycles for India should be longer. 

Sources: The Hindu Businessline (Article 1 and Article 2), Mint (Article 1 and Article 2), Financial Express, Deccan Herald, New Indian Express.