Rahul Yadav fiasco: Investors call for proper due diligence, stronger monitoring after funding

“Just like valuation correction, funding correction, this (governance lapses coming out) is also a correction. From last year to this year more such startups will come out and then eventually you will stop seeing this. This is all a function of the excess that is stabilising now,” Vaish told Moneycontrol on the sidelines of TiEcon Mumbai.

Industry insiders believe with private equity and venture capital funding pouring in, many investors signed reckless deals overlooking certain due diligence checks.

“In the desire to win an investment with competition from all around, investors overlooked certain basic facts that they should not have. In hopes of superior returns, sometimes also wilfully ignored certain things that they should have known, checked and acted against,” said Abhay Pandey, general partner, A91 Partners, while speaking to Moneycontrol’s Chandra Srikanth during a session at the conference.

Also Read: Less than 50% of Indian unicorns will end up making money for their investors: A91 Partners’ Abhay Pandey

Sameer Nath, chief investment officer and head, venture capital & private equity, 360 One Asset, concurred. He said in the last 18 months of frenzy, everyone was behind getting the term sheet out the fastest.

"The race was on how fast you can get to signing and closing the deal. Those vanity metrics are out the door,” said Nath.

VCs under fire

Venture capital firms in India have since come under fire for being oblivious to mishaps and being caught off-guard when such instances come out.

“LPs (limited partners) do take these things very seriously because the GPs' job here is to take the capital, monitor deployment and make sure the company progresses well,” said A91's Pandey.

He added that investors cannot blame higher deal flow for not being thorough with their responsibilities towards diligent checks.

“It is clear that cutting corners in due diligence is unacceptable because it will come back to bite you at some point. Fundamental checks around financial accounting, tax, and legal integrity are not that hard to do,” added 360 One Asset's Nath.

He added that investors need to practise higher vigilance while making investments and ensure sufficient time and space to do proper diligence.

"An equally important part of the job is post-investment monitoring because if you have the right governance after you come in, good things will follow,” he added.

However, Nath also said that these checks are more likely to work in cases of mistakes and oversights, while wilful frauds are tougher to spot.

According to Vikram Gupta, founder and managing partner of IvyCap, in the former cases, the issue mostly arises due to skill gaps, especially with first-time entrepreneurs.

“If you look at India's evolution, in the startup investing space, it is still a young country and many of these founders are still learning. For instance, when you're coming to Series A, many don't even know that they have to conduct board meetings," Gupta said.

He believes such founders can be trained, however, those guided by human behaviour are a tougher lot to deal with.

"...there are some that are guided by human behaviour, no matter how much you work with them and train them, they do not budge,” he added.

Impact on LP sentiments

Insiders highlighted that the Indian ecosystem is not alone in creating such bad actors. Bankrupt crypto exchange FTX, failed blood-testing startup Theranos and near-collapsed flexible-working startup WeWork are among major instances of governance fallouts in companies abroad.

“There have been instances abroad where founders have even been jailed. Unfortunately, greed and bad actors exist everywhere, and are not limited to India,” Ashwin Damera, co-founder and executive director, Eruditus, told Moneycontrol on the sidelines of TiEcon.

Also Read: Impact of valuation markdown will only be clear in next funding round: Eruditus’ Ashwin Damera

He, however, added that more incidents lately can affect foreign investors' sentiments towards India to some extent.

Haptik's Vaish added that LP sentiment is negative globally during current times. "There will be concerns but my positive belief is they will also look at it as a correction and eventually it will all wither out," he said.

A91 Partners' Pandey agrees that five cases of corporate governance lapses amongst numerous startups are still passed through, however, he believes with the frequency of such instances in the venture capital ecosystem, an LP who is a participant in this ecosystem will raise some questions.

“India is still in favour but it does put a cloud in the minds of the LPs – are Indian GPs (general partners) not doing a good job or does India have a fundamental integrity problem? Those are things we cannot avoid,” he said.

Pandey believes that while instances abroad can be seen as bigger blowups, the onus lies on Indian startup ecosystem players to solve such issues.

"We can make negative arguments mentioning those instances and people will buy it because India is large, foreign money has to come India’s way but the responsibility is still on us to solve our problems,” he said.

“We have to make sure that we are managing pace and doing the work that we get paid the two percent for,” Pandey added.

More pain for founders

Meanwhile, increased caution among investors may turn out to be bad news for founders who are already facing the wrath of a worsening funding winter.

To be sure, funding to Indian startups has plunged to about a fifth in the first five months of 2023 to $3.3 billion compared to $15.7 billion in the same period last year, with no end in sight.

“The tightening in governance and stricter due diligence started right after the BharatPe case came out in the open but we will see much more of that happening now,” cautioned Eruditus' Damera.

He believes investors are getting stricter as it is not only the money but also their reputation that is at stake. “If they seek more rights, it is only fair,” he added.

“Investors looking at new startups will be more cautious, do more due diligence, ask for more rights than earlier around borrowings, related-party transactions and so on,” Damera also said.

On the flip side, some believe it will only weed out bad actors and bring more maturity to the ecosystem.

“I am not concerned about the long term at all. It's better that all of this comes out now and the ecosystem becomes a lot more mature,” said Haptik’s Vaish.