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MC ExpertEye | Have startup troubles made investors more vigilant?

Coronavirus, corporate governance and falling valuations, as companies face a host of issues, what are investors doing? We find out

December 11, 2020 / 05:06 PM IST

Note to Readers: MC ExpertEye is a weekly series of articles that will dive deeply into an important topic by seeking answers from experts.   

A failed WeWork initial public offering (IPO), falling valuations of most domestic unicorns in the aftermath of the coronavirus outbreak and a raft of corporate governance issues have shaken the confidence of venture capital firms. While most are still bullish on the Indian ecosystem, they are being more careful to ensure they are betting on the best.

We spoke to some experts to understand the reasons and what investors were doing to make sure they were backing the right companies. Take a look at what they had to say:

Avimukt Dar, founding partner, Indus Law: Venture capital and private equity investors have always regarded the founder and management team’s integrity as non-negotiable. This is because business plans and strategies can change quickly but people don’t. The systemic diligence levels have gone up much more recently because unicorns resemble listed companies in terms of stakes and governance risk.

Moreover, even early-stage companies often have mature founders with a business past. Therefore their ESG (environmental, social and corporate governance) matrix and the key management team’s background have become an integral part of good due diligence.

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Anand Lunia, managing partner, India Quotient: The startup space is attracting large sums of money that sometimes dwarf even the private equity space. These funds will naturally need large outcomes, which will likely come only when lasting institutions that go public are built. The style of investing in the past may not work.

"Culture eats strategy for breakfast" as Peter Drucker said. A lasting institution needs a great culture, however great a strategy may be. Things like early mover advantage, last-man-standing, winner-takes-all, etc are good terms but usually lead only to mediocre M&A outcomes.

Given these imperatives, it's surprising that some late-stage funds (and even some early-stage funds) investing in India have struggled to identify critical cultural and ethical issues inside some startups. While I have no late-stage investing experience, I feel that what we look for as a seed fund in founders, teams and culture might be getting overlooked when the number-games take over. We routinely reject companies on the basis of issues highlighted by customer calls, employee interviews, code reviews, social media comments and reference checks. One would think that such things are even more rigorous in the late-stage investing world. The DNA of the company needs as much analysis as the market opportunity or past performance.

The Indian startup ecosystem has come a long way in the last decade and unethical behaviours like financial irregularities are a thing of the past. One hopes that even these issues of culture and work ethics are also solved and all this funding gives birth to great Indian institutions on the lines of Intel, Apple or Microsoft.

Sidharrth Shankar, partner at J Sagar Associates: Venture Capital investing and risk have become synonymous in the corporate world. The need to conduct due diligence into startup companies is the need of the hour, as with the number of startups increasing, the rate of failure has invariably risen. With COVID-19, the startups are strapped for cash while those investors who are flush will use the pandemic-backed opportunity (ie buyer’s market) to negotiate for lower valuations. With the high failure rates, coupled with the unfolding effects of COVID-19, thorough diligence is required in key areas such as:

(i) Identifying debt triggers through debt funding arrangements, charges, loans, etc and capacity to pay off those debts without equity dilution

(ii) Intellectual property ownership/licence rights

(iii) Change of control triggers in third-party contracts/investment contracts

(iv) Pre-existing exclusivity arrangements if any

(v) Territorial competition restrictions, etc. A thorough due-diligence of the red flags will also be hand in glove with the investor’s intent to secure the right valuations.
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first published: Dec 11, 2020 05:06 pm

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