Startup Due Diligence Playbook: Why Investors & Founders Need To Embed Corporate Governance

Even though their intentions were not malicious, Theranos came across as a complete con job. Her conviction was for fraud against investors at the time, but what about her customers? It was playing with their lives by providing false data, which had disastrous consequences for them. Her investors, on the other hand, appeared to be so taken in by Elizabeth Holmes that they didn’t want to fail and have their reputations ruined. The fraud continued unabated. 

WeWork experienced a total corporate governance failure as a result of Adam Neumann’s ‘super vote,’ which he used to hire his wife, brother-in-law, and other family members. Again, like Elizabeth Holmes, I wonder if Neumann hypnotised the board/investors. 

Is it time for investors to prepare a playbook in the event that one of their star portfolio companies implodes? Sure, since the larger the team, the larger the number of customers bear the brunt of the consequences. In some cases, the effects are felt throughout the startup ecosystem. 

Value Creation Through Founder-Investor Due Diligence

There have been numerous tweets and posts about governance, the blame game, and other topics. Governance, in my opinion, begins with the founders and senior management. The investors/board have no way of knowing about fraud or any of the aforementioned issues because they are not involved in the day-to-day operations. However, once discovered, the board of directors and investors are responsible for resolution. 

Consider the case of a company in the news: many prominent Sillicon Valley and New York-based investors participated despite the fact that one of the cofounders was convicted of identity theft. If they believe in second chances, why not make this cofounder a full-fledged director of the company? 

There is also the role of regulatory bodies such as the RBI, given that some of these startups (particularly fintech) are governed by them because they have a stake in a bank. Laws and regulations that encourage collaboration to ensure there is no “conflict” or, for example, our regulations make it impossible for investors to liquidate and take their money back. 

Why can’t our regulations make liquidation easier, ensuring a return of capital to investors rather than simply throwing good money after bad? What role should regulatory bodies play if there is a fraud, especially if it involves a fintech player and third-party funds? 

As an ecosystem, we must address these issues in order to implement better practices. We hear of financial impropriety, toxic culture, and allegedly some of this was public knowledge… yet as participants, we were willing to look the other way for greed or to maintain the market perception of being founder friendly. Isn’t it the responsibility of ALL investors to step forward rather than pointing to one? 

Ditch The Blame Game

Instead of blaming, why don’t we look at what we’re going to do from now on? For instance, if the team is found to be incapable of transparency and possibly committing fraud, the management should be replaced. There are numerous others who operate in the grey area, such as accounting irregularities such as revenue recognition, conflicts of interest, and financial transactions with parties related to the founders. 

Can we write a playbook for such disasters in order to save a company, its growth potential, customers, and innocent (junior level) employees just trying to make ends meet? As investors, we must recognise that we have a responsibility to many stakeholders, including limited partners, founders, employees of our ventures, and customers. 

I believe that a well-thought-out and structured playbook can assist us in balancing our responsibility with our strong belief in this asset class and ecosystem to foster innovation. Balance is essential for any relationship to thrive, including the founder-investor relationship. In light of recent events, it is critical to restore some balance to the founder-investor partnership, as they must coexist. 

4 Key Takeaways

• Investors’ Role & Better Oversight: This includes short-term solutions versus long-term solutions; having a team on the ground to oversee investments; and due diligence of the founding team, including senior management hires at the CXO level, that is shared with the board/investors, versus just ad hoc hiring. 

Perhaps there should be different due diligence requirements for a pre-seed/Series A company versus a growth company, which could benefit from lessons learned from PE investors. 

• Financial Irregularity: how can we quickly correct it while causing the least amount of harm to the rest of the team, customers, brand reputation, and value created? 

For instance, when you’re caught for match-fixing in cricket, do you ban the founder(s) from raising funds for 5 or 10 years? 

• Role Of Regulatory Bodies: It appears that in India, we make it impossible for investors to get their money out because liquidation is not an option; does this lead to imprudence? 

What should regulatory bodies like the RBI do in light of a recent fintech case in which a fintech startup owns a bank and involves deposits from third-party investors? 

• Values’ Introspection: Anand Lunia brought up valuation and founder exits, which coincided with some of what I was debating. We appear to value alpha personalities more than integrity and honesty. We are all guilty of admiring hustlers and storytellers when the truth is that integrity and honesty are also virtues to consider when looking to build something of lasting value. 

*Disclosure – I consider myself an investor (debt provider), and these are my personal thoughts after being a part of the ecosystem for the last 15 years. They do not represent the official views of the venture debt firm where I work. 

I am a staunch supporter of the ecosystem and value its contribution to the country. As an optimist, I believe this is not a systemic issue, this is a global issue, not an Indian one.