A funding winter’s tale: Corporate governance failures hold many lessons for startups

The wrong practices include inflating revenue, diversion of funds and related party transactions especially with vendors of the startups being related to the founders.

While edtech major Byju’s has been making headlines of late for all the wrong reasons, especially on the corporate governance front, it is not alone. A number of startups have faced governance issues over the last 18 months, including BharatPe, Zillingo, DeHaat, Pristyn Care, GoMechanic and Mojocare. In every instance, the issues came to the surface only after close scrutiny of these companies’ books and operations.

A thorough investigation by PhonePe, which was looking to acquire the fintech ZestMoney, found the latter’s nonperforming assets to be higher than stated, and revealed holes in its collection process. This led PhonePe to abort the planned buyout after a long due diligence process of 3-5 months. If the funding boom of 2021 had sustained, ZestMoney could have roped in external investors rather than take the merger and acquisition route, and the issues may well have gone unnoticed.

When Softbank carried out due diligence of GoMechanic in the runup to a funding infusion, it found several service centres were inflating revenues and diverting investor funds. The funding did not happen and the company has since laid off more than 70 percent of its staff.

Agri-tech startup DeHaat saw its auditor giving it a qualified opinion for three consecutive years. Moneycontrol reported that investors had stepped in to scrutinise the company’s operations.

The most recent example of poor governance is Mojocare, which inflated sales bills and overstated revenues in order to meet its targets.

As for Byju’s, the departure of statutory auditor Deloitte Haskins has been in the works for a while now, according to founder Byju Raveendran himself. One of the red flags for Deloitte could have been Byju’s revenue recognition practices, which it had questioned almost a year ago. The last straw, apparently, was the delay in the edtech’s financial results for the fiscal year ended March 2022.

The auditor said it had written to the board several times seeking documents but did not receive them. The delay in releasing the results also landed Byju’s in trouble with its foreign lenders, as timely release was one of the riders of the $1.2 billion term loan they extended to the company. All in all, poor audit oversight and compliance may prove to be the undoing of India’s most valued startup.

Certainly, Byju’s many problems hold lessons for other startups on how not to do things. And deep audits to ensure every aspect of their activities is kosher is undoubtedly one of the most important of them.

Lack of oversight

In most startups, venture capital firms that have a large majority shareholding do not take a board seat. One reason is because of a lack of management bandwidth. Another key reason is the culpability of board members if founders are caught engaging in illegal activities, including tax frauds.

Sometimes issues come to the surface when founders go back to their original investors for more funding. For instance, Broker Network founder Rahul Yadav approached investor Info Edge multiple times for more money. The investors then asked for more details such as receivables and large vendor payments, only to discover that even salaries had not been paid for a few months, prompting suspicions of wrongdoing. Even after multiple requests from Info Edge, Yadav has not shared the company’s financial position with Info Edge, prompting the investor to seek a forensic audit. Yadav is yet to accede to that request.

Again, a company’s internal audit committee is usually headed by an independent board member, but Byju’s did not have an independent director. And, at the moment, it does not have any independent board members either. The three who were on the board resigned abruptly last week, on the same day that news emerged of Deloitte’s departure. The edtech’s board now has only Byju Raveendran and his family members on it.

While opinion is divided on whether venture capital investors should have a more hands-on approach (InfoEdge chose not to take a board seat in Broker Network), a senior venture fund managing director says that funds should have more principals and other financial executives under their own CFO to take a deeper look on a regular basis into how startups are run.

While all startups present quarterly reports to VCs, investors also have a portfolio MIS or management information system dashboard that is updated on a regular basis. However, most VCs don’t follow this system diligently and often end up giving the entrepreneur a free hand, trusting their instincts.

“Funds that invest in fewer startups and take more control with board seats have seen fewer governance issues. Better oversight will make it harder to do any such malfeasance,” the VC adds.

During boom periods, human resources are spread thin, another VC points out, adding that this had happened during the boom periods of 2001 and 2008. However, this time, the boom has been longer, from 2014, and hence startups had enough time to hire more executives.

“When there is time pressure on you to close deals during periods of exuberance, some things get overlooked. Also, companies are given more capital than they need, at higher valuations than they deserve. This puts pressure on founders to deliver unreasonable outcomes, leading to wrong practices,” says Abhay Pandey of A91 partners, a venture capital firm.

The wrong practices include inflating revenue, diversion of funds and related party transactions, especially with vendors of the startups being related to the founders.

“During boom periods, both VCs and founders are stretched for time and shortcuts are taken. This happened in the past and will happen again in the future. When you make investments at a 2-3x pace, you are bound to make more mistakes,” adds Pandey.

“In many startups’ cases, auditors will take a lot of time to understand the business model. The loss-making nature of the business, newer and innovative products and processes along with the biggest asset being a software product, means that it is more complicated,” says an auditor with one of the Big Four audit firms.

“Investors are likely to enforce some of the processes and their rights rather than let it be. Investors in most cases have the right to approve auditor appointments, and access to MIS reports and operational metrics. The problem until now was that there was no money constraint in a bull market — they could go out and raise a new round rather than answer tough questions from existing investors,” says Ajay Rotti, CEO and founder of Tax Compaas, a tax advisory firm.

Exuberance and the lack of ‘due’ diligence

In late 2020 and in 2021, venture capital investors used to give auditors seven to ten days to complete the due diligence process, says a senior executive at a unicorn that raised money after a quick due diligence exercise during the boom period. “Since there was intense competition and surplus money to invest, the audit process suffered. It was a fear of missing out cycle then,” the executive adds.

"Whenever Byju's was raising a round in the late stages, our internal investors used to put them up as a good example. They would say Byju was powerful enough to negotiate shorter diligence periods, although it was an operations-heavy business,” says the founder of a unicorn. The person adds that his company’s investors took two months for diligence, even though it was a pure-play software product company with hardly any presence on the ground.

According to several VCs and auditors Moneycontrol spoke with, VCs are now giving 30-45 days or more for auditors to do the same job. They point out that a few issues had cropped up in recent times during due diligence, which led to the PhonePe-ZestMoney being aborted, and the discovery of issues at GoMechanic.

“Obviously, quality suffers when you are working under a tight deadline,” says the executive at the unicorn quoted above. While an auditing firm can use more executives to complete an audit in a shorter time span, this does have an impact on quality, say a couple of auditors.

The auditor quoted above says that he has advised a few startups that had completed due diligence in two weeks in 2021.

A second auditor says that collection methods, receivables and so on are very different from what most auditors and many team members roped in for such diligence processes are used to. A lot of them do not have the required expertise in assessing startups, the second auditor adds.

“We hired a CFO who would disagree with me and have fiduciary responsibility on top of his mind. Since we are a new-age business, sometimes there are differences of opinion on how a certain regulation should be interpreted. But if I am being too liberal, my CFO himself won't sign off on it. Because it is his reputation on the line. His name will get ruined if something bad happens," says a founder at another unicorn.

“You can't treat your auditor like a vendor. Sadly, that's how many people see auditors. In my view, an auditor should be treated almost like a regulator, so that you don't have to face an actual brush with the regulator," says a unicorn founder quoted above.

However, a venture capital investor says that the governance issues happened irrespective of the processes. “You can never say that the processes are not followed. Even for angel investment, the regulatory requirements are onerous. If a fraud happens, it is not because someone slept on the job. It is because a founder or senior executives did not want to follow due process and could hoodwink board members,” says the investor.

Step up and Step in

VCs have already started asking startups about their revenue recognition practices, says a founder at an edtech startup. “The concept of ARR (annualised revenue rate) may not work, these startups need to present their actual revenue,” the person adds.

The first auditor quoted above says that there has been severe lapses as evident from the goings on at Byju’s. The audit committee could have stepped in at the time of the revenue recognition controversy or with the PF issue or financials not being filed on time. Startups might have started their journey with minimal processes and oversight. But as they grow, the VCs and the board have to ensure that these are set up. “This is also the signal that however powerful the founder is, the VCs, board and audit committee should have oversight,” the auditor says.

The second auditor says that the audit committee, headed by an independent director, should ask for more details, such as salary payments, receivables, vendor payments and so on to ensure that any potential flaws or frauds are either caught early or signs of stress on the balance sheet are identified well ahead.

“Even then there have been instances where founders willfully try to confuse auditors with revenue recognition processes and business models. There should be more transparency and VCs have to ensure that. Auditing startups has become risky because of this as well as the losses they make,” the first auditor quoted earlier in the story adds.

‘Heads should roll’

The senior executive from a unicorn quoted above adds that when frauds happen, startup founders are expelled and even have cases filed against them, whereas there is much less accountability for VC partners.

“They deal with limited partners’ money and it is a responsibility similar to what a founder has with VC investors. When there was lax due diligence, money was invested without much control or oversight, so, now you cannot blame the founders alone. This is not about criminal accountability, but moral and ethical responsibility. How many VCs have resigned taking responsibility,” asks the executive.

“If such processes had been done, we would not have seen such issues with this regularity. This brings shame to our ecosystem — LPs losing confidence in the Indian startup ecosystem at a time when the whole world is looking at India for growth and potential is a shame,” says the second auditor.

However, the industry is yet to see the Byju’s effect on large startups, as most of them are not yet in the market for a new round.

“We are waiting for the so-called winter to play out. But, I am sure there will be an impact in terms of diligence when we go out to raise fresh money again. So far, there haven't been any problems with our internal investors as we have always been sharing MIS data monthly,” says the second unicorn founder quoted above.