Why Startups Need To Prioritise Governance To Attract PE Funding

The scaling influx of funds in the Indian startup industry has been accompanied by criticism for ignoring corporate governance norms, leading to allegations of corporate governance violations against startups like Bharatpe, Zilingo, and GoMechanic. This underscores the necessity of implementing effective corporate governance practices to safeguard the rights and interests of the relevant stakeholders.  

Role Of Corporate Governance In The Success Of A Business

Broadly, corporate governance policies assist startups in implementing robust, legally sound, ethical mechanisms that enable a startup to steer towards long-term sustainability, consequently enhancing its ability to attract funding from investors. This improves the transparency and accountability of startups in mitigating risks, which are attracted in the form of penalties and third-party claims. Private equity investors are more likely to invest in companies that have strong governance practices, given that it reduces investment risks.

The Indian legal regime provides a comprehensive framework vis-a-vis corporate governance and sets out the duties and responsibilities of all the participants in a startup ecosystem. Entrepreneurs must prioritise awareness and adherence to relevant laws and regulations to secure funding effectively and fully capitalise on the benefits offered by private equity investors.

Where To Draw The Line: Ethics & Responsibilities Of Fund Managers

In the private equity industry, fund managers are responsible for identifying and facilitating investments in promising startups, making their role critical. Fund managers must uphold high ethical standards and exercise due diligence to ensure that target startups comply with corporate governance practices. 

In instances where a conflict of interest arises, fund managers are obligated to prioritise their clients’ interests over their own. The Securities and Exchange Board of India and the Ministry of Corporate Affairs, which function as the governing bodies, have issued several regulations and guidelines for fund managers to hold them accountable and ensure that integrity and transparency are maintained.  The SEBI (Alternative Investment Funds) Regulations, 2012, SEBI (Prohibition of Insider Trading) Regulations, 2015, SEBI (Portfolio Managers) Regulations, 2020, SEBI (Investment Advisers) Regulations, 2013, and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 are few of the regulations that seek to ensure that fund managers maintain integrity and transparency in their operations

The Essential Elements Of The Due Diligence Process At Different Stages Of The Startup Lifecycle

Investing in a startup could be a precarious activity, and therefore potential investors should ideally do a thorough and comprehensive vetting of the startup they intend to invest in. At this stage, a due diligence exercise becomes critical and typically involves assessing factors that could potentially impact the valuation of a startup and consequently its ability to generate returns. Due diligence is generally conducted when funding is sought at various stages of the startup’s lifecycle, including the seed, pre-series, and growth stages.

The first major step undertaken prior to due diligence would be the signing of a Non-Disclosure Agreement as it involves the sharing of sensitive data of the startup. Subsequently, the target company’s business model, regulatory compliances, financial statements, market position and growth potential are reviewed and analysed. This will give an overall diagnosis of the company’s good governance practice along with its financial health. Further, the company’s operational efficiency and managerial potential is also investigated. 

The Role Of Governance And The Board Of Directors In Building A Sustainable Business

In India, the Companies Act, 2013, outlines the duties and responsibilities of the board of directors, including the obligation to exercise reasonable care, skill, independent judgement and act in good faith to promote the startup’s objectives for the benefit of its members. Non-compliance with these duties could result in directors being penalised up to INR 5 Lakh. 

Implementing good corporate governance practices by the board of directors promotes robust and effective decision-making through processes, practices and policies. This can be realised through regularly conducting board meetings, ensuring ethics and transparency at every step of the way. Thereby, providing a first line of defence against any allegation of malpractice. 

Conclusion

In conclusion, the importance of good corporate governance practices cannot be overstated in the context of the private equity industry in India. Startups that prioritise good governance practices are more likely to attract private equity funding, as this reduces the risks for investors and enhances the prospects of a successful exit. 

Fund managers also have a crucial role to play in ensuring ethical and transparent practices and exercising due diligence when selecting startups to invest in. With the right governance practices in place, startups can build sustainable businesses that benefit and contribute to the growth of India’s private equity industry.