How The Indian Startup Ecosystem Can Take Proactive Steps To Prevent Syphoning & Fraud

In recent years the Indian startup ecosystem has seen tremendous growth. Several companies have emerged as unicorns and industry leaders, backed by both Indian and international venture capital and private equity firms. 

However, the ‘Blitzsclaling’ (termed by LinkedIn cofounder Reid Hofman) has also shown the dark side of this glamorous startup world, with certain startups coming into the limelight for the wrong reasons as well. In this article, we attempt to delve deeper to understand issues relating to fraud and syphoning of funds, the impact that they can have on a company and what can possibly be done to mitigate or address these events.

What Exactly Is Fraud And The Syphoning Of Funds?

The law on ‘Fraud’ in India is spread across several legislations, each having a different implication on events. The Companies Act, 2013 (CA 2013) defines this term to mean any act, omission, concealment of any fact, or abuse of position committed by any person with connivance, intent to deceive, to gain undue advantage from, or to injure the interests of shareholders and creditors, irrespective of the fact that there is any wrongful gain or wrongful loss, thereby focusing on the act rather than the consequence. 

The Indian Penal Code, 1861 (IPC) lists several offences where fraudulent activities can be covered, such as Section 420 (Cheating and dishonestly inducing delivery of property) and Section 421 (Dishonest or fraudulent removal or concealment of property to prevent distribution among creditors). 

While both the CA 2013 and the IPC provide for differing imprisonment terms for such offences (the CA 2013 also provides for the imposition of a financial penalty), Section 19 of the Indian Contract Act, 1872 gives a party (to a contract) affected by fraud the option to insist for such contract to be performed and to be put in the position in which he would have been if the representations made had been true.  

The term ‘Syphoning of Funds’ is a subset of the overall construct of ‘Fraud’ and specifically refers to activities in relation to the diversion of funds, which could be orchestrated through various means such as inflating expenses, diverting funds to shell companies, among other scenarios.

For startups operating at a nascent stage, activities in relation to fraud and/or syphoning of funds may often sound the death knell, as entities or individuals associated with or allegedly involved in such activities may find it next to impossible to reach out to external investors to raise funds in the future. In light of the instances mentioned above, it is imperative that startups put in place good corporate governance and other best practices in consultation with industry experts and investors, to prevent or address such issues. 

Why Do Companies Become A Victim?

As of January 2023, India was home to 108 unicorns, with 44 having been born in 2021 and 21 in 2022. The race to deliver unicorns at a fast pace requires companies to show, inter alia, innovative products with great potential, high growth and better financial numbers year on year in order to justify valuations. While issues of fraud have been seen and dealt with in more developed markets such as the United States in the past, the rapidly developing Indian market is still grappling with learning to deal with these issues. 

Chasing growth at all costs is not a successful mantra for all companies. In a recent instance, when a company’s fundraise was in process, the financial due diligence process reportedly pointed out several financial issues, which ultimately led to an admission by the company’s founders of financial misreporting.

Another reason for such instances could be attributed to the availability of large amounts of cash in companies with no or poor financial control systems in place. This appears to have been the reason for the fiasco at another company where the employment of a cofounder was terminated on alleged grounds of diversion or syphoning of funds to entities connected with him and his family members. The company has now also filed civil and criminal proceedings against the ousted cofounder.

What Are The Rules?

As mentioned previously, indulging in activities of fraud and syphoning of funds can attract ramifications under several legislations, including imprisonment terms, monetary penalties and even civil actions.

In addition, when institutional investors fund startups, detailed shareholders’ agreements are put in place which, inter alia, disincentivise founders from engaging in such activities by providing for consequences of such events. 

This is usually accomplished by defining a ‘Bad Leaver’ or ‘Cause’ scenario as one in which an act of fraud, diversion, or syphoning of funds is committed. This is usually verified by an independent third-party investigator, with the result of this event being an automatic termination of the concerned founder’s employment and giving the company the right to claw back all or a portion of this founder’s shares. 

Such a scenario may also result in an ‘Event of Default,’ in which investors may have the right, among other things, to seek an accelerated exit, drag along rights, or the right to re-jig the management and board of directors.

In cases where such instances have come to light, investors and companies have not shied away from using multiple recourses to address such issues.

What Implications Can It Have On Companies?

The implications of such events on companies could result in the imposition of monetary penalties, whilst it may also end their journey of raising external capital given the reputational damage they may cause. 

In fact, recent events have shown both sides of the spectrum, with some events leaving companies reeling and others leaving companies largely unscathed. 

What Can Investors And Companies Do?

Most early-stage investors either do not carry out due diligence at all or (even if they do) carry out limited due diligence at the time of investing in companies. One of the primary reasons for this is that, in most of these cases, there isn’t much data to review and analyze initially. In fact, post the rise of such instances in the recent past, some funds have reportedly initiated audits in several of their portfolio companies. 

Therefore, one of the most critical things that investors can do is to undertake a thorough diligence of companies prior to investing. Even in scenarios where this information is not available to diligence, they may elect to conduct such diligences subsequently through the inspection rights that they typically negotiate in shareholders’ agreements at different intervals of time. 

Another step in this direction is to require companies to put in place good corporate governance in place by adopting policies and best practices in relation to related party transactions, anti-money laundering and maker and checker principles. Investors are generally also entitled to receive several information-related rights, including MIS, and quarterly and annual financial statements from companies which should also be thoroughly screened by investors and their financial advisors. 

What Can The Startups Do? 

Due to cost concerns, early-stage companies are generally hesitant to hire the Big Four firms as auditors and instead opt for local players, who are frequently unprepared to handle such assignments. As a result, one of the most important things for businesses to do is to use reputable chartered accountants and company secretarial firms for audit and compliance purposes. This will also boost investor confidence. 

Other options can include close monitoring of transactions with related parties, putting in place whistleblower policies, hiring professional management for finance-related functions and even considering appointing internal auditors. 

Conclusion

Syphoning of funds and fraud are serious issues that can have a detrimental effect on a company’s reputation and that of its stakeholders. The Indian startup ecosystem has witnessed an increase in such activities in recent years, and it is crucial to take appropriate measures to address this issue. While the industry goes through its share of the learning curve, appropriate measures can be put in place to address these concerns.