Governance & Startups: Incorporate values for better valuation

There has been widespread entrepreneurship, with numerous success stories of businesses advancing from concept to market dominance and valuation in less than a decade.

The joint stock company has been at the heart of modern capital-driven enterprise for over 400 years, ever since the Dutch established the first one in 1602. It has powered explorations and conquests, propelled small trading nations to colonial empires, raised large-scale risk capital, created markets for mass manufactured goods, and transformed rural agrarian economies into powerhouses of industry and services. It has spawned an entire banking, capital markets and financial services industry in the process, which has facilitated the explosion of global trade and the interconnected dependency of goods and services across nations that we see today. In many ways, companies have written the history and economics of the modern world.

It is therefore unsurprising that the field of management theory arose from the musings of early economic writers. The writings of Adam Smith and David Ricardo on the division of labour, factors of production, wages, rent, profits, trade and its most visible manifestation, the "invisible hand" of markets, were best expressed by the ubiquitous joint stock company. With the explosion of manufacturing, commerce and trade following the Industrial Revolution, companies grew, often becoming large, unwieldy conglomerates with multiple locations of factories and offices, employing staff to conduct business on a scale never seen before in commercial history.

Organising operations

As these companies grew, theories were proposed to organise their operations according to certain principles to maximise efficiency and profit. Fredrick Taylor argued that simplifying jobs through scientific study and identifying the most efficient way to complete a task would increase productivity. Others contributed to the corpus of management knowledge as well. Henri Fayol sought to create an efficient company structure. Max Weber expanded on Taylor's theories, incorporating the concepts of chain of command and standardisation. Over time, the expanding theory of management spawned subdisciplines. Elton Mayo's and Douglas McGregor’s work resulted in the establishment of a branch of human relations management. Philip Kotler's work on advertising, sales, and marketing brought attention to what is now routine but was trailblazing in an era when pricing and production dominated management thought.

Financial management also developed in three independent but interrelated ways. The first was the double-entry bookkeeping system, as a theory of accounting and reporting of profit and loss and asset and liability statements. The second was the financial management of the company itself — revenues, wages, production costs, capital budgeting and marketing expenses — and the cash flows of its operations. The third was periodic access to capital — bank debt or market equity — which in turn led to significant work on theories of assessment of cash flows, present value, internal rate of return, cost of capital, et al. This was further extended to financial markets in capital asset pricing, portfolio theory, and option pricing in the works of Merton H Miller, Franco Modigliani, Harry M Markowitz, Fischer Black, Myron Scholes, and Robert Merton.

What all management thought had in common was that it addressed corporate concerns of that era: a landscape of industrial invention and manufacturing companies as market-dominant, multinational, listed and traded conglomerates that raised funds as debt or equity from banks or public markets and then applied them to turning the wheels of business. However, a transformational shift in the company's business model occurred during the first decade of the third millennium. Of technology and financial disruption destroying and creating corporate value in tidal waves of churn as product, company, and management lifespans became shorter; as industries were phased out and new ones were created; as manufacturing-based models of measurable immediate profit and net cash flow were overshadowed by brand success and capital allocation by markets on the future value of entrepreneurial ventures of yet unproven provenance, even as companies and finance tried to peer into an unclear future by reading technology and market trend tea leaves. This has only accelerated since, and the structure of the economy is shifting into uncharted territory. The future of that structure is uncertain, given the rise of artificial intelligence, robotics, large pools of aggregated private capital, increasing disparities in wealth and income across geographies, and a "hollowing out" of the middle class in many countries.

Emergence of communication

The areas of emphasis have also shifted. Manufacturing and traditional corporate processes are now merely routinely important “hygiene” concerns. These have been replaced by market-facing communication such as brand, design, and market dominance; financial communication such as earnings and forecasts, as well as fund-raising; and corporate communication such as public perception shaped by media and events. With the pervasive presence of information shaped as stories in 24x7 media, their impact is instant and disproportionate as compared to previous times. Accusations of pollution, harassment, fraud — the list of things that can instantly and severely damage companies is long. Boards and management are endlessly peering into a fog with limited visibility as they try to navigate these difficult waters of unknown risks.

Yet, for the longest time, management theory, companies, and markets have ignored the elephant in the room. Investors have focused almost exclusively on the financial performance and ability of leadership to achieve these — as reflected in a market price — but have paid little attention to improving governance as a means to higher returns and reducing risk, despite many spectacular failures over the years. It is a failure with rising costs as economies enter a disruptive phase fuelled by the fastest rate of technological change and the simplest fundraising in human history. There has been widespread entrepreneurship, with numerous success stories of businesses advancing from concept to market dominance and valuation in less than a decade. However, due to a lack of culture and values, many have imploded at various stages of their young, promising trajectories. Many were avoidable failures. Transparency and governance are more important than ever before.

Risk and governance

Two aspects of management must be addressed in this context. Risk and governance are two sides of the same coin. Yet both have remained confined to boardrooms and regulations rather than being absorbed as a part of corporate culture. There are reasons for this. Both have traditionally been regarded as strategic or oversight functions of the board for managerial accountability. As a result, discussions have focused on management agency or stewardship. They have rarely been seen as a critical component of organisational identity, in theory or practice. Similar to epiphanies, executives are expected to discover governance values only upon promotion to senior positions. Instead of a framework of values within which the everyday processes of companies are meant to be undertaken.

This is becoming increasingly important as a funding crisis spreads throughout the startup world. As liquidity recedes, valuations are slashed, and companies struggle, which of them has a better chance of survival? This is an increasingly important question for investors. In a valuation, how (and how well) do you value a company's value system as defined by its key principal actors? Which do you keep, which do you double down on, and which do you sell (if possible)?

As another once-promising startup story unravels in the headlines of financial publications, perhaps it is time for markets to start answering this question. For every Byju's, there is also a Zerodha. For every BharatPe, there is a Zoho too. It will require going beyond articulated plans, markets, strategy, and disruption to identify and parse the values that will, in the end, also be key drivers of value. And valuation.

Sandeep Hasurkar is an ex-investment banker and author of `Never Too Big To Fail: The Collapse of IL&FS’. Views are personal, and do not represent the stand of this publication.