Why startup founders need to start taking compliance seriously
Monday May 15, 2017,
10 min Read
Non-compliance with Section 186 of Companies Act, 2013, relating to loans and investments by a company makes the top management liable for fine of Rs 25,000 to Rs 2 lakh and a jail sentence of up to two years.
Technology startup Picazzy is busy setting up plans to go pan-India. Its founders are experts at building rule engines based on artificial intelligence (AI), and marketing the platform. But when it comes to compliance they are dependent on lawyers, chartered accountants, and venture capital funds. “We are so busy trying to raise money that we are yet to look at the compliance parts,” says Tarun Kishore, Co-founder of Picazzy.
Indeed, this lack of knowledge is widespread across the startup ecosystem, where most ventures have little idea of legal compliance. But also one needs to go beyond just signing up a lawyer or a chartered accountant because startups need the backing of experts.
“The ramifications of non-compliance have been getting more serious. Jail time has been added to what some people may consider minor infractions in a company,” says Siddarth Pai, Partner at 3One4Capital.
For example, non-compliance with Section 186 of Companies Act, 2013 relating to loans and investments by a company entails a fine of Rs 25,000 to Rs 2 lakh, and a jail sentence of up to two years . This is the same as the punishment for manslaughter (Section 304 of Indian Penal Code).
“The fact that the punishment for making an investment against the dictats of law is same as the one for accidentally killing a person is ludicrous. However, until the law is revised, founders must not take the risk of being non-compliant,” says Siddarth.
Various registrations that need to be obtained while setting up a private limited company include provident fund, professional tax, ESIC, service tax/VAT registrations and shops and establishments. Each of these registrations has separate application processes and a sequence involved. The departments granting these registrations operate separately and there is no single-window clearance for the same.
“The entrepreneur alone cannot deal with the documentation involved in obtaining all these registrations,” says Anish Basu Roy, Co-founder of Shotang, underscoring the need for entrepreneurs to engage a qualified CA, CS, and perhaps a legal counsel as well to complete the entire process systematically.
Finding the right guides
When you go into the 3One4Capital office you notice the team, along with Numer, a company of legal experts, preparing a blueprint to guide startup founders in understanding compliance off the bat.
“The onus for compliance falls solely upon the directors and the officers of the company, not anyone who advises them. So a company secretary or an accountant cannot be held liable for gaps in compliance,” says Jugal Asher, Co-founder of Numer and also an entrepreneur in residence at 3One4Capital, where he takes care of due diligence of prospective companies.
This is why it is imperative for founders to have a rigorous 360-view of their compliance, and to ensure that their support systems are working to report all the necessary compliances regularly.
For a founder, compliance can fall under the following types:
- Routine and operational matters: General meetings, Board meetings, filing IT returns and remitting tax deducted at source (TDS).
- Fundraising related: These include mode of issue of securities, valuation for tax purposes, Reserve Bank of India (RBI) and Foreign Exchange Management Act (FEMA) regulations for foreign investors.
- IP related: Applying for trademarks, protecting your IP, attribution, and royalties.
As far as companies are concerned, there are three main bodies of compliances that are essential:
- Company Law (Company Act, 2013, and the associated rules)
- Income tax (Income Tax Act, 1961)
- Indirect taxes (service tax, value added tax (VAT), Central sales tax (CST) (soon to be subsumed by the Goods and Services Tax (GST).
There are other rules and acts–state-wise and sector-wise type of business, inventory or services or both types thereof. Each of them has different regulators, and each set is as equally important as the other.
Asking your investors for advice on these matters is also necessary. The right ones are positioned to help founders with routine matters and to also connect them to professionals for more nuanced work.
Ecosystem fraught with legal hassles
The travel commerce company Stayzilla saga, when founder Yogendra Vasupal went to jail for not paying dues to a vendor, is all too fresh in the ecosystem's memory. Here, the role of the lawyers and the funds in supporting the company was found wanting. Yogendra ended up in prison for close to a month.
Also, let us not forget the legal wrangles that K Vaitheeswaran, Founder of now defunct e-commerce company India Plaza, got himself into for not paying vendors. The court cases continue even after five years of closure of the company.
It is in this backdrop that technology startups like Numer are becoming increasingly important in helping disseminate crucial information to the startup ecosystem and to educate them on the intricacies of running a business. Technology is a great way to help you manage this as the right systems with fail safes and checks will help prevent any accidental non-compliances.
“Tools and utilities like these must be part of the foundation of new companies and can protect founders in critical areas,” says Jugal.
For an entrepreneur, critical aspects to look into would be the ones on starting, building, and scaling a company. Larger companies need specialised tasks such as processing revenue from outside India, simulating multiple conversion events on cap tables, and structuring funding rounds with investors from multiple geographies.
“Startups do not take compliance lightly as much as not having information about how it works. There has to be a system that can help startups set up and close businesses with ease,” says Ganesh Prasad, Partner at Khaitan and Company.
So finding the right professional partner becomes very important.
Only certainty: death, lawyers, and taxes
While setting up a company the provisions for correcting inadvertent errors committed out of ignorance of the process are not easy. Most times there are errors that can happen due to oversight and should be allowed to be remedied in much simpler ways instead of seeking representation at the regional directorate levels. “Even the timelines for remedy are often too tight,” Anish Basu Roy of Shotang notes.
While the Goods and Services Tax (GST) is much awaited, even that requires maintenance of paper copies as evidence of tax filing. Until now the foremost challenge while paying and filing taxes is the multiplicity of taxes and different mechanisms for remitting each of them. Keeping track of tax and sticking to timelines is a distraction for the entrepreneur with limited resources.
A big challenge for a startup lies in the finding the right legal and financial experts. “Focus on an individual client is limited and hence chances of missing deadlines or errors are high,” says Arjun K Perikal, Partner at J Sagar Associates.
Legal costs of raising money
While raising money, it is not just the legal costs involved. There are several other expenses such as the ones incurred on drafting agreements, contract negotiations, financial due diligence, secretarial filings, stamp duties, etc.
At a ballpark level, seed stage fund raise could involve a total expense of Rs 3-7 lakh and for a Series-A fund raise it could be around Rs 10-15 lakh.
“Every startup should try to ensure that they have at least someone from the founding team looking specifically at this aspect of the business from day one,” says Anish.
But that has not happened so far with startups because for them the future is in money and not in securing the legal rights of their company. Elements such as compliance, documentation, and accounts, as a result, remain ignored right from the beginning.
The cost of correcting initial errors can be significant and prove costly in terms of time and money.
It is, therefore, important to factor the cost of engaging the right legal experts, CA and CS firm and internal audit in the business plans before starting up.
Founders admit that there are various sections of the Companies Act that are open to interpretation. This is more pronounced in case you are in a new-age technology business and existing definitions may or may not be applicable to you clearly.
For example, the definition and mechanisms of allowable capitalisation of expenses on R&D do not clearly apply to a software product business. Regulation around fundraising and venture capital can tend to be fuzzy and lack objective clarity. There need to be sharper definitions of Discounted Cash Flows for firm valuation and what constitutes scenarios taxable under the startup tax are some of the examples that come to mind.
A company in India can be setup in the form of a limited liability partnership (LLP), private limited and public limited company. All of them have their pros and cons with the Companies Act governing them. Depending on the area of operations or generation of revenue, there are various classes that one has to register under.
“Most business ideas do not stem from the principle of being able to get through registration with necessary authorities, but from the actual idea itself. We have repeatedly seen the world over the loopholes and expositions of today’s startups who know no boundaries,” says Rohit M A, Co-founder, Cloudnine.
Uber is one good example of someone stressing every known archaic law for bringing out the best in the business opportunities in every country that they set up business in. The recent row with drivers was settled by the company through direct talks with the drivers and did not encourage any interference from unions or politics.
“Self-governance is an important behaviour to develop, and periodic discussion with law firms and audit firms help,” says Rohit.
Unless there has been a fraud in the dealings of the company, usually the paperwork is something that should remain on paper. One has to respect the fact that investors are also answerable about generating returns, for which they will have to safeguard norms.
"It is also the duty of the VC to stand by the companies they believe in if they (invested companies) have aligned their goals together. Several times the founders do deviate from the original vision and plan, which they fail to communicate and convince their investors," says Naganand Doraswamy, CEO of IdeaSpring Capital.
There are important things to remember and they are:
- Shares: Issue, Conversion and Anti-dilution
- Board composition, exit obligations, rights and disclosures from the promoters and the investors and in regard to governance and functioning of the company: affirmative vote items and major matters.
- Penalising experts: As a startup, there should be ways and means to hold legal and accounting experts liable for mistakes made by them. Having penal measures in place will ensure better service levels. Also, there must be limitations on the number of clients that an auditor can engage with, and there should be a cap for lawyers, CAs and CS dealing with SMBs.
Having a system that can allow companies to have their legalities and compliance right will truly save the startup ecosystem from suffering from the fear of failure. Now you know what contributes to a failure of a startup too.