The Current Picture
India has the third largest startup-ecosystem in the world with more than 100 unicorns till 2023.
The funding environment for early stage Startups, especially seed and Series A investment continues to be vibrant in India, despite there being a decline in funding for growth-stage and late-stage Startups primarily due to the global macroeconomic issues. Early stage start-ups have recorded 20% growth in value, with Pre- Series A and Series A deals rising 38% to $707 Mn in Q1 2023.
Along with there being a global funding slowdown, the Indian startup-ecosystem has to an extent been affected by instances of corporate mis-governance and fraud. However, there is a silver lining – with an increased focus on ethical behavior and mitigation of legal / regulatory risks, sustainable business models will be built and there will be much more disciplined investing, and the Indian startup ecosystem will be on track to achieve a right balance of governance and growth.
Building Blocks Of Governance
In order to promote effective governance leading to sustainable growth, the Founders and Investors shall agree on some broad building blocks which can help ensure that the Startup is managed in a responsible, ethical, and transparent manner, while also safeguarding the interests of all the stakeholders.
The Founders and Investors shall also ensure that governance measures do not come at the cost of growth. As such, controls and processes put in place by the Investor shall not impinge the operations of the Startups. Further, if there are costs involved (for e.g., costs of conducting external audits, inspections, hiring of lawyers, etc.) then the Founders and the Investors need to have an upfront understanding with respect to the bearing of such costs.
For Startups, effective corporate governance should be seen as a value-delivering tool instead of being an inconvenience. By prioritizing transparency, accountability, and responsible business practices, Startups will build a strong foundation for long-term success while safeguarding the interests of stakeholders.
Startups shall, from the day of incorporation pay heed to the core principles of governance such as-
It should be noted that a “ one- size- fits- all” approach cannot be applied to a Startup at different growth stages as every Startup faces unique challenges and requirements. it is therefore important that governance frameworks be customized to specific needs and context and should tailor the governance model based on the type of business, industry size etc.
For Growth stage
At this stage, to ensure effective governance, a Startup should ideally set up committees having oversight over various operations and also formulate effective SOPs and policies in this regard.
These committees provide expertise, and recommendations to the board, ensuring specific attention to key governance aspects. The Startup shall also formulate mechanisms for employees to raise issues to management and there shall be sufficient mechanism in place to ensure their anonymity, such as having a whistleblower policy, internal complaints policy etc
For Early stage
At this stage, the key stakeholders include the management team and the founding team – the early employees of the Startup. It is pertinent to ensure that every stakeholder in the Startup is aligned in terms of expectations, values, and measurements of success. An internal code of conduct handbook, in line with applicable laws, providing practical guidance to everyone in the Startup shall be adopted.
It is pertinent to ensure that mandatory compliance with legislative requirements is met and prescribed committees are constituted, including POSH etc. In this respect, proper guidance shall be sought from attorneys.
A Well Governed Startup- Cynosure Of Everyone’s Eyes!
Founders require good corporate governance in Startups in order to build credibility, attract investors and talent, and build trust among stakeholders.
In the startup ecosystem, Investors require good corporate governance in order protect their investments, mitigation of risks, support long- term viability, facilitate successful exits, maintain their market standing and ensure legal compliance.
A Startup having well defined corporate governance structure ensures accountability to its investors, customers and employees. This further helps in bringing transparency, accountability and ethical behavior.
Better access to capital
A Startup having strong and committed corporate governance structure can attract and retain capital effectively, and that too at more favorable terms. Startups which have adopted good governance practices are more likely to attract higher valuation premiums.
Proactive risk management
A Startup having well defined risk management policies can identify and manage risks effectively and will be better equipped to avoid risks metamorphizing into significant problems.
A Startup with good corporate governance structure will be perceived as ethical and will attract customer loyalty and retain talent.
Fiduciary Duty of GPs
In a VC setup, general partners have a fiduciary duty towards the LPs ( limited partners). Implementing robust corporate governance measures provides VCs with the assurance that their investments are being managed responsibly, and their
interests are being protected
Investors invest in Startups with the eventual goal of exiting their investments at a later stage, either through secondary sale or IPOs. Potential acquirers or retail investors wouldoften choose Startups with strong corporate governance practices. A well- governed startup is more attractive, as it reduces the risks associated with integration, legal compliance, and regulatory issues. Therefore, good corporate governance enhances the likelihood of successful exits, allowing Investors to realize their investment returns.
By investing in Startups with which have adopted solid governance practices, Investors demonstrate commitment to ethical and responsible business practices. This enhances credibility within the investment community and consequently attracting Startups and co- investors.
Investors require Startups to have sound corporate governance practices to ensure regulatory and legal requirements. This leads to risk mitigation in form of reduction of the risk associated with penalties, legal disputes, or reputational damage that could arise from non- compliance.
When it comes to corporate governance in India, it is essential that Founders and Investors are in harmony to ensure effective decision- making. In this respect, there are certain key considerations to keep in mind for achieving a balanced corporate governance framework:
Composite Board structures
The board of directors is responsible for overseeing the decision-making of the Startup and monitoring the actions of the management. It is important that the Board should have a balanced representation of both founders and investors to ensure that the interests of all the stakeholders are aligned. It is also important, especially for growth-stage Startups to have independent directors who can provide an unbiased perspective and ensure fair decision- making.
Contractually defined roles and responsibilities
Founders and Investors should negotiate and document their rights, responsibilities, and decision-making processes in well-defined shareholder agreement/term-sheets. These agreements should address matters such as voting rights, appointment of key executives/directors, information & inspection rights, asset liability in case of fraud, vesting of founders’ shares, lock-in and cap on secondary sales, etc.
Compensation and Incentives
Founders and Investors shall create a compensation and incentive structure that aligns their interests with that of the Startup. Equity-based compensation, performance-based bonuses, and long-term incentive plans can help achieve this.
Founders shall take all such measures to ensure that the Startup follows relevant corporate laws, regulations, and guidelines in India. As the day to day management of the Startup vests with the Founders, the Investors shall ensure that the Founders along with the Startup’s legal counsel are taking active measures to guarantee that the Startup is in compliance with law.
In conclusion, all the stakeholders in a Startup ( including the Founders and Investors) shall understand that following the policies that promote transparency, integrity, and accountability throughout the organization will be beneficial for everyone involved.
Startups which engage with Investors through regular communications, along with transparent reporting and timely disclosure of accurate information, will always hold such Startups in a good stead. Effective governance also helps in the identification, assessment, management and mitigation of risks, which will play a major factor in protection of the Startup’ s assets, ensure compliance with regulations, and mitigate potential threats to the organization’ s reputation and financial stability.
Good Corporate governance measures in the Indian startup ecosystem is a sine- qua- non for creating a sustainable environment for fostering sustainable growth, attracting investments, nurturing innovation and ensuring long- term success.