Should VCs/PEs maintain silence when start-ups have governance issues or fail?

The contribution of private investors in the Indian startups so far is huge considering that they take investment bets on ventures where the probability of success is not determined.

Venture capital (VC) and private equity (PE) firms have played a crucial role in fostering innovation and driving economic growth in India. The India story includes strong consumption fundamentals, young demographics that would be labour-productive for at least the next two decades, a nation where the government is the biggest digital promoter and has enabled a digitally-literate user population, and a large ambitious innovation base. That’s why private investors are investing here.

The contribution of private investors in the Indian startups so far is huge considering that they take investment bets on ventures where the probability of success is not determined. In many cases, they are the only bets on initial ideas. Here is where the due credit for their perseverance has to be given. Their job is to take bets on multiple ideas, with a probability of a few of the lot succeeding. It includes writing-off losses on the other failed or slower bets. With the overall success of the Indian startup ecosystem and its increasing growth potential, a better value system is needed for this entrepreneurial space.

Being Accountable

Often the unchecked power and influence wielded by these firms overshadow the responsibility they bear in the success or failure of their portfolio companies. The VC and PE industry holds immense power and influence over the entrepreneurial ecosystem, the Indian policy circles and the business media. To ensure a fair and equitable playing field, it is essential that these firms face the same level of scrutiny and accountability that is demanded of startup founders. It needs introspection from PE and VC firms regarding their engagement, management, influence and governance of their investments. Most of the influential private investors have been championing the theme of governance, and preaching to others, including to the regulators and the government. Isn't it time to start putting their house in order?

In India, many of these investors seem to operate in an environment where they are rarely held accountable for their actions. They possess the power to shape the destiny of promising startups, yet the level of scrutiny directed towards their decision-making and governance practices remains disproportionately low.

One of the problems plaguing the startup ecosystem is the prevailing perception that the failure of a venture lies solely on the shoulders of the founders. When a startup goes under, founders are left carrying the burden of blame, while VC funds often escape scrutiny. This lopsided narrative overlooks the significant influence and control that VC and PE firms exercise over the companies they invest in.

In the realm of portfolio companies, instances of governance lapses by founders are not uncommon. When such lapses occur, it is imperative that investors who have direct access to information and hold board positions shoulder their fair share of responsibility. They cannot simply absolve themselves of any blame or accountability. They are expected to take action against the founders for business and governance lapses, instead of simply quitting.

Avoiding Responsibility

Investors, by nature of their involvement, possess significant influence and decision-making power within the portfolio companies they invest in. They are often privy to critical information and actively participate in shaping the company’s strategy and direction. Consequently, they must accept their fair share of the onus when governance failures or bad business decisions take place.

Most of the time, VC and PE firms are deeply involved in the operations and strategic direction of their portfolio companies. Many large private investors even have operating partners on their payroll, to quasi-run their investee companies. In many companies, their shareholding agreements empower the key investors to give prior approval for all capital expenditures or large operating expenses on a monthly basis. They also have regular access to business updates (often in the templates sought by the key investors), appoint key management personnel (KMPs) and CXOs, and often have additional board observers. Many times, they also run the process for appointing independent directors of their choice, but with necessary board documentation to showcase. The regulations have not addressed this aspect of 'independence' yet, where some of these independent directors, who have a prior commercial understanding with investors that are embedded across various portfolio entities and multiple vehicles of such funds, to comply with the regulatory ask of 'independence'.

A troubling trend has emerged where investors, faced with a failing business or questionable governance practices, opt to resign from their board positions while claiming to “disagree with the founders”. This convenient approach allows them to distance themselves from the situation and portray themselves in a positive light, potentially bolstering their chances of securing the next India fund they seek to raise. However, this practice is deeply flawed and undermines the principles of accountability and responsibility. Investors cannot simply resign when things go awry, especially if they have been actively involved in and are party to all the decisions that led to the current state of the failing business. By doing so, they evade their duty to address and rectify the problems they helped create.

Need To Call Out Issues

To truly foster sustainable growth and innovation, VC and PE firms must be held accountable for their decisions and actions. They must demonstrate a commitment to transparent governance practices, robust risk management, and ethical conduct. Merely appointing board observers or resigning from boards when faced with adversity is not enough. There should be a higher level of responsibility placed on these firms to actively engage and support their portfolio companies, especially in challenging times. They should call out issues, before resigning from the boards.

VC and PE investors who hold board positions cannot treat governance as an outsourced responsibility. They cannot delegate their accountability to founders or other stakeholders alone. Instead, they should actively engage in governance practices, exercise due diligence, and take proactive measures to ensure that the portfolio companies operate ethically and responsibly.

The larger optics risk that India faces without such transparency is that global investors might wrongly perceive that issues are with the Indian corporate governance ecosystem, and miss the point about the poor accountability of some of those PEs/VCs. Rarely do global investors get into the mechanics of independent audits of governance practices of the private investment vehicles in which they repose trust to invest in startups.

VC and PE investors in India can strengthen governance practices within their portfolio companies, promote responsible investing, and contribute to the sustainable growth and success of the Indian startup ecosystem. After all, their role is not just working on valuations, but also nurturing an honest value system.

Only by holding these firms accountable, India can create an environment that encourages long-term value creation. But then, for the majority of the investors who don’t mind the scrutiny, this should not be a worry. There should be no free pass, just because they make bets on India, innovation and ideas. Intent counts.

Srinath Sridharan is author, policy researcher & corporate advisor. Twitter: @ssmumbai. Views are personal, and do not represent the stand of this publication.