GoMechanic crisis: Startup funding due diligence to get stricter and longer

GoMechanic was founded in 2016 by Bhasin, Kushal Karwa, Rishabh Karwa, and Nitin Rana. It operates a network of about 1,000 partner garages or workshops across India that provide quality car repairing and servicing at much lower rates than the automakers' service centres.

Focus on Sequoia Capital again

The episode has yet again put the spotlight on Sequoia Capital, which has been one of the biggest backers of startups in India and the largest institutional stakeholder in GoMechanic. The VC firm was already entangled in lapses found in governance portfolio startups, including BharatPe, Zilingo and Trell.

How things unfolded at GoMechanic since January has left the entire ecosystem introspecting and taking immediate measures to plug any peeping holes in their portfolios and balance sheets.

“The relationship between investors and founders is based on trust. Not just Sequoia, all investors will now recheck their portfolio companies to ensure nothing is wrong. Perhaps, forensic audit, too, will happen from time to time, and even on an annual basis, some portion of auditing will include forensic,” said Ashish Kumar, co-founder and general partner of Nandan Nilekani’s Fundamentum Partnership, which counts unicorns like Pharmeasy and Spinny on its portfolio.

Forensic auditing will become common

“During investments too, forensic auditing will become a lot more common than it has been so far. Usually, forensic audits don't happen during initial investments. There’s, of course, due diligence happening, but it’s not forensic,” he added.

Explaining the difference, Sonam Chandwani, managing partner, KS Legal & Associates said that forensic audits will involve tracking every transaction happening and can take months to close, unlike usual deal due diligences which can close in a couple of months.

"Forensic audits uncover financial statement misrepresentations, malpractices, errors, and frauds. This extensive business analysis reduces investment risks. Regular due diligence is brief and limited to finances and legal, which aids investment decision-making but doesn't identify business risks," she said.

“I expect more scrutiny to happen. Even founders with integrity will find their funding getting delayed and there will be more questioning,” an investment banker who has been advising startups on deals in the past said, seeking anonymity.

A venture capital investor who didn’t want to be named, concurred, “Overall, expectations have gone up. Investors expect you to have an internal auditor, and there will be real discussions on MIS numbers that will happen more often. This also coincided with a funding boom when investors have been going very fast and have been sleeping at the wheel.”

How it surfaced

In January, details of misreporting of performance numbers surfaced during a due diligence process for a $75-80 million funding deal at a valuation of about $600-650 million to be led by SoftBank’s Vision Fund and Malaysian sovereign fund Khazanah Nasional.

According to Moneycontrol’s sources, “GoMechanic had reported overinflated numbers and fictitious garages. Some of its favoured partner garages were found to be making disproportionately more money during due diligence.”

“Unusually high debt. The level of account inflation is 5x-6x, not 1.5-2x, which is worrying. We had worked with them in the very early days and did not have a good experience. It is bad for the ecosystem because it has eroded trust, this is almost like Theranos for India,” a prominent founder from the ecosystem told Moneycontrol.

Immediately, one of GoMechanic’s largest stakeholders, Sequoia Capital India, appointed EY to do a thorough forensic audit of the startup’s businesses. The previous due diligence report too was made by EY.

Meanwhile, GoMechanic has already started tapping startups like Cars24 and Spinny for potential sale.

“Early-stage companies, typically, are in need of funds the most. With due diligence getting stricter, the time taken for a deal to close will be longer. Naturally, these companies might come under stress by the time they close a round,” a second investor in the know told Moneycontrol.

“It is good also because this will make startups more disciplined right from a very early stage. But then, VCs will have to cut bigger cheques to make sure that startups have enough money in the bag to put all these things (being extra cautious, hiring good law and account firms etc) in place,” he added.

The second investor quoted above was also concerned about the image of the Indian startup ecosystem being portrayed globally and the toll it will take on the already slow funding activity within the startups space.

“Bloomberg and all have covered it. So the global audience at least knows some fraud. Not many (sitting outside India) will ever get into details. They just will see the headline, which says an Indian startup is a fraud. Now, investors sitting over there, who largely invest in all these startups, might get a bit more cautious, at least for a few years before the dust settles,” he said.

Not just the founders

Investors are also concerned about more such cases of startup frauds lurking in the shadows, adding that a part of the problem also lies with VC firms investing in them too.

According to angel investor and business strategist Lloyd Mathias, the larger issue is of inherent bad practices happening within startups like “conflict of interest in BharatPe or in terms of GoMechanic where fairly reputed founders altered data,” he cites.

“This puts a question on the corporate governance processes of these companies. The concern here is the lack of honesty among founders. With four very reputed investors, including Sequoia, Tiger Global, Orios Ventures and Chiratae being its investors, this is a serious issue,” he told Moneycontrol.

Mathias added that this incident will make investors cautious even about the numbers being shared by the founders. They will likely double-check the accuracy of such figures. He also highlighted that this will require a significant shift in the behaviour at the early stages of funding wherein startups, being at the initial phase of their journey, don’t usually go through stricter due diligence.

“Venture capital companies come at an early stage, overlooking some of these areas with the hope of passing on the can to slightly less-suspecting global firms and then exiting. A lot of larger global VCs are starting to wonder whether the corporate governance in these companies is good enough,” Mathias said.

“Earlier, foreign funds used to blindly go with the due diligence of Tier-1 VC funds in India like Sequoia and Accel, but that might change now with foreign funds doing their own time for diligence,” a second founder added.

More cases in the shadows?

A venture debt investor, seeking anonymity, said: “There is a realisation in the ecosystem that there are more such cases out there. This is not a one-off case. There are other startups that had pushed the envelope. There has been very limited board share, governance, and control of such issues.”

“The shock was more around how brazen this was, them fudging numbers and bumping GMVs. This reflects poorly on the ecosystem, founders or new investors--particularly late-stage investors who are not that vocal,” he said.

“Startup founders have done a mistake, but you can't just throw them under the bus. The VCs have to be equally blamed for this. Sequoia, for example, was on their board. It's difficult to understand why they didn't know,” said the first investor quoted above who didn’t want to be named.

The investor said there could be pressure to grow more revenue internally to justify the valuation before another funding round etc., which might have led to founders engaging in such things.

“I am in no way supporting the founders. I am just saying we should not be blaming just the founders. Everyone here, especially because it is a private firm, should be questioned,” he said.