The governance saga of the startup world

There is a common belief that corporate governance is important to the investors of the company, especially institutional (when have retail investors ever mattered!!). But the truth is, corporate governance is key to all stakeholders.

Would a startup be able to attract good KMP (Key Management Personnel) talent if it had governance issues? A strong independent board is key for startups–can guide them through their unstructured growth journey, show them the mirror, be passionately dispassionate about the venture, and still add value.

With increased liabilities and fiduciary responsibilities of independent directors, it would be very difficult to attract independents who can add real value if the startup does not come out clean on governance.

Public markets have always rewarded a strong culture of corporate governance. For me, Indian behemoths like the HDFC Group and Asian Paints, and global MNCs like HUL have been synonymous of corporate governance. This emanates from the fact that all astute investors check the box on corporate governance–whether it the best global investor Warren Buffet, or our very know Coffee Can Investor Saurabh Mukherjee.  

Also, markets have deeply punished stocks, which have had governance issues–Dewan Housing fell ~90% in one year on news of siphoning off money by promoters. Similarly, Yes Bank investors lost a fortune after the non-performing assets (NPAs) increased multifold due to aggressive lending.

The recent turmoil around the Adani Group is taking many shades, but the moot point being any smoke around governance issues could severely impact the valuation and fund raising capabilities of companies.

Recently, we have seen some instances of corporate governance issues with the startup world. Are these one-off instances, or is it the tip of the iceberg, we don’t know. There have been recent ripples; or should we say starting of a wave of corporate governance lapses coming to the forefront in startups like Bharat Pay, Zilingo, and GoMechanic. But the importance of corporate governance in the startup world is increasing, with investors waking up to the need and the ecosystem seeing the perils of negligence.

What is the reason for increasing instances of lapses by startups? As always, during up cycles in PE/VC investing, too much money and too many smart people chase too few good entrepreneurs. We saw shades of this euphoria in 2021--VC funding reached a record high of $38.5 billion, with investments growing 3.8x over 2020, faster than China which grew at 1.3x. It was a benchmark year, with India reaching 100 unicorns–adding more unicorns in 2022 v. behemoths like the US and China.

What happens when there is so much of money chasing few companies–it leads to immense pressure on promoters to GROW, and this results in GROWTH AT ANY COST.

Some of the key issues arise from the pressure to increase topline / GMV, as most valuations are based on growth and topline. This results in companies diversifying outside their core–pivoting to newer segments just for growth–like a baby care company entering cosmetics or an ethnic wear company starting active wear (nothing wrong if executed well, but done in a hurry could be counterproductive).

Also, it leads to adding revenue at lower margins, which results in dilution of unit economics. Sometimes, in the run to grow, lot of dollars are spent on marketing, but the supply chain does not support the resultant volumes, leading to poor experience to the customers. Working capital management, i.e. increasing receivables to attract business, is another important area which gets compromised to support growth.

Apart from financial engineering, in many cases, culture and treatment of various stakeholders seems to be compromised. To achieve tall targets, large teams are added, talent is attracted at high costs, and thus there is immense pressure on the teams to deliver. This leads to toxic work culture and later mass scale layoffs, which we are witnessing currently. In 2022, ~15,000 jobs have been cut across the startup ecosystem, with the tally already reaching 40% of the previous year in 2023.

Further, an independent board that can share unbiased views and an “outside-in” perspective is extremely important to improve corporate governance. Investors need to ensure the right board composition to ensure high level of independence at the board level.

Ideally, the fabric of India is changing. Corporate professionals are needed to herald the change and bring some sensibility to the Frankenstein style growth in the startup world. In the past few years, experienced professionals have stepped down from their ivory towers and accepted the challenge to shape the startup world. However, the culture, pressure of growth at any cost attitude, and inability to balance long term and short-term growth will restrict the flow of talent to the startup ecosystem.  

What can be done?

There are volumes written on corporate governance. And for every rule framed to increase adherence, there are various loopholes to play with. The most relevant insights and learnings come from working on the ground with startups.

The way they are built, the way they operate and the people at the helm of it are very different from the way our old economy corporates operate. Some of the points stated below are learnings from working with multiple startups and have helped build organisations with high level of governance consciousness:

1.     Board and investors should incentivise long term value creation and sustainability v. short term growth

2.     Recruitment of key personnel and their terms should be vetted by independent directors and investors

3.     Pay and ESOP packages to KMP should be linked to sustainable growth

4.     Team expansion should be done in a step manner, rather than putting the cart before the horse and expanding crazily to bring in revenue

5.     Cost of marketing / CAC should be agreed upon by investors and board members to ensure sensible growth

6.     Board should ensure that services providers like auditors, accountants, lawyers, etc., are appointed after appropriate due diligence and rotated every few years to ensure independence

7.     Board should conduct an annual survey of employees to get a pulse of the culture and health of employees; and take corrective action as required

8.     Getting formal lenders like banks and NBFCs on board also helps to bring financial discipline within the organisation

9.     Veto rights on excess spends, capex, leverage over the budgets should be exercised by investors and independents

10. Approval of annual budgets, along with a broad plan for the next 3 years, helps to understand the big picture as well as focus on execution for the near term

Net net, the importance of high-quality corporate governance is relevant across multiple levers of growth for a company–fundraising, valuation, attracting the right talent, and getting the right partners. Large corporates as well as the startups are equally impacted, the scale of impact dependent on the stage of the company is in its journey.

There is increasing awareness of this need in the startup world, and this needs to be strengthened by promoters by setting up tighter systems and processes, ensure independence on the board, and adoption of best practices for stakeholder welfare.