The impact of financial misreporting on Indian startups

The confession of financial misreporting made by the co-founder of TargetOne Innovation Private Limited—the parent company of GoMechanic (valued at $285 million last year)—and the joint forensic investigation initiated by its investors have had a significant impact on the Indian startup ecosystem.  

In the due diligence done by a prospective investor, the discrepancies in the company’s revenue and misreporting were flagged, leading the co-founder to confess the errors that crept into its reports and initiate the process for investigation. 

Amit Bhasin, one of the co-founders, has expressly admitted to making errors in judgement, including financial reporting, which would not only impact the company’s revenue, business operations, and employability but would have a serious blow on its investors, investing heavily through the different series basis of its “reports” and carried out regular governance/check through “monthly statements” supplied by the company.  

It is unclear as to how the previous series of investments, valuations, and due diligence were carried out without any flag on these “errors”, particularly when different investors and professionals were involved. 

While the commission and magnitude of “misreporting” are under investigation, the report may, in all probability, expose the degree of financial misreporting and the alleged negligence or oversight by the institutional investors and the professionals it engaged. 

The Companies Act 2013 emphasises punishment for fraudulent acts under Section 447, which lists out punishments that may be imposed besides damages and penalties under other applicable laws. 

For instance, Section 36 of the Act specifically deals with “investment fraud”, whereby an investor is fraudulently (under any false, deceptive, misleading, or deliberate concealment of any material facts) induced to invest funds into the company or to enter into any agreement, for which the persons involved would be punishable under Section 447. 

Similarly, Section 448 deals with “false statements” (any return, report, certificate, financial statement, or other documents(s) containing false material particulars, knowing it to be false or any omission of any material fact) are also punishable under Section 447.

Section 447 is clear as to the applicability of other remedies and enforcement actions under the applicable laws, and any fraudulent “false statement” may also lead to proceedings under the Indian Penal Code and Indian Contract Act for misrepresentation, breach of trust, negligence, and fraud, among others. 

ALSO READ

GoMechanic’s unravelling raises questions over investors’ due diligence

With this in mind, a forensic audit report will have a crucial impact on Indian startups, stakeholders, and professionals involved in institutional funding.

GoMechanic was forced to come clean only when Masayoshi Son’s Softbank Group withdrew its investment deal citing failure to meet the due diligence parameters.

While these are exposed only during a fresh investment process, one cannot overlook the fact that the company—which went through a series of investments, due diligences, valuations, and audit reports by the professionals without any qualifications or adverse remarks—is under a microscopic scanner, and the founder has admitted to certain discrepancies in reporting. 

The oversight by the existing investors in the company and the professionals could, in turn, make investors sceptical of investing in startups.

Any flag in the investigation may not bode well for startups or promoters, as the list of startups with lapses in corporate governance enlarges with GoMechanic joining the likes of Zilingo, Trell, BharatPe, etc., recently. 

Such incidences of financial misreporting would increasingly put startups under serious scrutiny, and investors would become more cautious in their approach going forward.

Other consequences include acquisition, restructuring, investors exit, and the layoff of employees, besides adversely affecting future funding rounds.

Further, due diligence would also be given more emphasis and reliance on the startup metrics would be under greater scrutiny.

ALSO READ

Sequoia considers reviewing South Asia, SEA investments: Report

Therefore, ensuring startups are built on sound value systems is important, whereby due compliances and corporate governance are followed strictly throughout their business operations.

All financial reporting must be backed by real data/evidence without misstatement of material facts, and financial projections must be practical. Investors certainly put their trust in the promoters’ management abilities before investing huge amounts in funding the startups, and hence, it becomes pertinent to ensure the accountability and integrity of the promoters and the startups.

With the statutory authorities moving towards ease of doing business and simplifying various compliances under the Companies Act, labour laws, etc., for small companies, and simultaneously introducing various schemes for funding and financial assistance for startups, any non-compliance or misreporting will have an overarching impact on the funding and lending schemes, and consequently, will negatively impact the startup ecosystem.

Public companies are sufficiently regulated and subject to the Securities and Exchange of India (SEBI) and other regulators’ supervision. However, startups being relatively new in the business ecosystem, require other stringent measures, including forensic audit before funding as a regular norm, whistle-blower mechanism, quarterly reporting, and audit testing. 

Companies need to implement efficient corporate governance coupled with business operations for their survival and integrity, as they may be naïve in those compliances and jargon, considering the background and the exposure they may have. 

It only demonstrates that long-term business sustainability does not solely depend on “figures” but also on sound legal, financial, and ethical corporate governance.