Preventing Fraud in the Indian Startup Ecosystem

Preventing Fraud in the Indian Startup Ecosystem
How The Indian Startup Ecosystem Can Take Proactive Steps To Prevent Siphoning of fund & Fraud?

In recent years, the Indian startup ecosystem has seen tremendous growth. Several companies have emerged as unicorns and industry leaders, backed by both Indian and international venture capital and private equity firms. 

However, the ‘Blitzsclaling’ (termed by LinkedIn cofounder Reid Hofman) has also shown the dark side of this glamorous startup world, with certain startups coming into the limelight for the wrong reasons as well. In this article, we attempt to delve deeper to understand issues relating to fraud and siphoning of funds, the impact that they can have on a company and what can possibly be done to mitigate or address these events.

What Exactly Is Fraud And The Siphoning Of Funds?

The law on ‘Fraud’ in India is spread across several legislations, each having a different implication on events. The Companies Act, 2013 (CA 2013) defines this term to mean any act, omission, concealment of any fact, or abuse of position committed by any person with connivance, intent to deceive, to gain undue advantage from, or to injure the interests of shareholders and creditors, irrespective of the fact that there is any wrongful gain or wrongful loss, thereby focusing on the act rather than the consequence. 

The Indian Penal Code, 1861 (IPC) lists several offences where fraudulent activities can be covered, such as Section 420 (Cheating and dishonestly inducing delivery of property) and Section 421 (Dishonest or fraudulent removal or concealment of property to prevent distribution among creditors). 

While both the CA 2013 and the IPC provide for differing imprisonment terms for such offences (the CA 2013 also provides for the imposition of a financial penalty), Section 19 of the Indian Contract Act, 1872 gives a party (to a contract) affected by fraud the option to insist for such contract to be performed and to be put in the position in which he would have been if the representations made had been true.  

The term ‘Siphoning of Funds’ is a subset of the overall construct of ‘Fraud’ and specifically refers to activities in relation to the diversion of funds, which could be orchestrated through various means such as inflating expenses, diverting funds to shell companies, among other scenarios.

For startups operating at a nascent stage, activities in relation to fraud and/or siphoning of funds may often sound the death knell, as entities or individuals associated with or allegedly involved in such activities may find it next to impossible to reach out to external investors to raise funds in the future. In light of the instances mentioned above, it is imperative that startups put in place good corporate governance and other best practices in consultation with industry experts and investors, to prevent or address such issues. 

Why Do Companies Become A Victim?

As of January 2023, India was home to 108 unicorns, with 44 having been born in 2021 and 21 in 2022. The race to deliver unicorns at a fast pace requires companies to show, inter alia, innovative products with great potential, high growth and better financial numbers year on year in order to justify valuations. While issues of fraud have been seen and dealt with in more developed markets such as the United States in the past, the rapidly developing Indian market is still grappling with learning to deal with these issues. 

Chasing growth at all costs is not a successful mantra for all companies. In a recent instance, when a company’s fundraise was in process, the financial due diligence process reportedly pointed out several financial issues, which ultimately led to an admission by the company’s founders of financial misreporting.

Another reason for such instances could be attributed to the availability of large amounts of cash in companies with no or poor financial control systems in place. This appears to have been the reason for the fiasco at another company where the employment of a cofounder was terminated on alleged grounds of diversion or syphoning of funds to entities connected with him and his family members. The company has now also filed civil and criminal proceedings against the ousted cofounder.


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