ARTICLE
21 January 2025

New Floor On Venture Capital And Private Equity Funding - Governance Issues And Trends

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India is home to the third largest startup ecosystem in the world, with roughly 2 to 3 technology startups being born each day, according to data from the Department of Promotion of Industry and Internal Trade under the aegis of the Ministry of Commerce and Industry.
India Corporate/Commercial Law

Introduction

India is home to the third largest startup ecosystem in the world, with roughly 2 to 3 technology startups being born each day, according to data from the Department of Promotion of Industry and Internal Trade ("DPIIT") under the aegis of the Ministry of Commerce and Industry. And yet, the past few years have marked what has often been referred to as a funding winter witnessed by Indian startups. The year 2024 witnessed a 9% decline in private equity deal activity, both in terms of deal volume and deal value, signalling investor behaviour tilting towards caution. However, this fall has not been as steep as the one from 2022 to 2023, as per a report released by research platform VCCEdge. The report further noted that while angel/ seed investments in 2024 were dominant in deal volume, such deals fell by around 18% in 2024 compared to 2023, another sign pointing towards investor caution in new ventures.

Amongst the several factors that acted as dampeners for investor sentiment in the year gone by, corporate governance issues and escalations in existing lapses in VC-funded companies have found a spot on the list.

Why Corporate Governance Took Centre-Stage

Of late, an increasing number of investors have turned up the heat on startups while looking into the affairs of such prospective investee companies. This change in sentiment has been triggered by the instances of corporate governance lapses in the world of Indian startups, some such startups having found themselves in the doldrums. From ed-tech fame Byjus and fintech startup BharatPe, to the controversies around others like Zillingo and GoMechanic, alleged malpractices in the state of affairs and management of such companies had investors on guard, resulting in a shift in focus in the VC world towards the finer aspects while negotiating documents.

Shifting Trends: What VC Investors Look For These Days

Over time, what investors seek during the course of deal discussions has undergone a shift. Outlined below is a detailed picture of some new asks that investors try to negotiate while finalising preliminary understanding under term sheets and thereafter negotiating clauses under transaction documents.

  1. Promoter background checks
    A preliminary step taken by investors when looking to put their money (and faith!) in a company is to look at the person pulling the strings and running the show behind the curtains. A thorough background check on the promoter's background, financial health, past and present business ventures and any existing interests, along with a general market reputation, are things investors look into at the very outset.
  2. Information rights to inspection rights
    Earlier, what was seen as a common ask by most investors while they sought to put their money into newer prospects were information rights in the form of monthly, quarterly and annual information statements, financial statements, business plan. However, more recently, VC investors have increased the scope of what they demand under information rights, including things like environmental, social and governance ("ESG") reports, impact reports and charitable impact implementation plans, among other things.
    Taking this a step further, investors have now started looking at retaining inspection rights from the start of negotiations, as opposed to the practice where they would exercise these rights at a later stage, say at the time of a future fundraise or an exit, to look closely into the books of companies.
  3. Deeper due diligence
    A more in-depth review of, and audit into, businesses of startups is now being undertaken by investors, with increased scepticism at any deviation from the ordinary business practices. Such a shift in investor attitudes towards fundraising has founders worried about increased investor compliance and stringent clauses in term sheets or shareholder agreements going forward, some such fears already taking shape in the form of increased asks from investors. Many investors have, as a matter of practice, started conducting (or demanding that the companies conduct) an independent audit undertaken by firms acceptable to the investors.
  4. Investor involvement in appointment of statutory and/ or internal auditor appointments
    A fairly new but common addition to the list of investor items of negotiations is their rights to have a say in the statutory and/ or internal auditor choice made by the Company. Now, before finalising the appointment of a statutory/ internal auditor, companies are having to run their picks past investors for their approval. In some cases, investors have gone one step further to outline a limited list of choices from amongst which companies have to make their auditor appointments.
  5. Adoption of policies and internal governance frameworks
    Greater emphasis being placed on requirements like ensuring investee companies have statutorily required as well as other policies like risk management, policy on prevention of sexual harassment at workplace, cyber security and data privacy policies, policy on employee stock option plan/ scheme (wherever applicable), employee handbooks, code of conduct and human resource policy, diversity, equity and inclusion ("DEI") policy, whistle blower policy, policies or plans towards managing ESG risks, and several such compliances.
  6. Greater oversight into C-suite affairs with increasing scrutiny on compensation
    One of the aspects of internal operations, practices and policies of management of organisations is the associated conduct risk, which is essentially the manner in which the board of directors as well as the executive/ management of a company run the show and control its environment. Investors look for ways to drive a better and more effective organisational culture, and one way they look at for implementing the same is through a more hands-on approach in ensuring oversight on executive appointments and their compensation structures.
  7. Employee focus
    In a rather welcome change in approach, investors are becoming increasingly cognisant and taking note of the employee-centric policies and frameworks implemented by organisations, beyond the usual statutorily required labour and environmental policies. More questions are now being asked by investors around topics like whether a DEI-friendly approach is adopted in companies, existence of employee welfare policies, and efforts undertaken towards promoting gender parity and gender sensitive culture.
  8. Environmental, social and governance (ESG) focussed investing
    ESG issues have garnered attention and are diligently examined globally at the time of investment, to avoid risks associated with problems faced by companies on account of violations of environment laws and other governance-related requirements. This has led to a more ESG-focussed responsible investing patterns, especially amongst PE/ VC investors where such principles underscore organisational ethos. Additionally, consumer satisfaction, equality and diversity, occupational health and safety, and human resource management policies of target companies have started featuring as markers used by investors to consider their business decision before investing their money. An investor-friendly approach, greater transparency into internal controls and processes of investee companies and periodic representations and information from companies is also becoming a common ask from investors. This is a reflection of the growing consensus within the PE/ VC investing space globally on the need for addressing ESG issues, as it not only makes good business sense but also provides opportunities to reduce risk and create value.
  9. Deferred payments tied to performance-based milestones
    Another emerging trend is deferred payment of purchase/ deal consideration, as opposed to the earlier practice of upfront payments. Such payments in tranches are often being tied to the growth of the company and made contingent on founders achieving set milestones. These metrics and adherence to the same are then being regularly tracked and reviewed by investors.
  10. Adjusting to global crises and geopolitical uncertainties
    What can also be seen as part of increasing number of definitive agreements, especially shareholders' agreements, are inclusion of covenants that obligate founders and companies to abide by policies chalked out in line with global perception on issues like anti-corruption, environmental, social and governance norms, increasing awareness and concerns around climate change.

CONCLUSION

What appears to be the key driver behind the aforementioned shifts in PE/ VC investing trends is investors' desire to pre-empt and prevent issues that could otherwise arise due to lapses in corporate governance mechanisms within organisations. By taking pro-active steps towards ensuring accountability and fixing liability on directors, promoters and other management personnel, as well as insisting on newer and more refined practices to be incorporated in existing structures (for instance, a higher value directors' and officers' policy, keyman insurance policy, framing and adopting and ESG plan for the entity, etc.), investors are now actively trying to nip these possible troubles in the bud. It remains to be seen whether these changing trends grow to become the norm or whether these are tried, tested and thereafter rejected by the industry players.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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