ARTICLE
11 October 2024

Corporate Governance In Startups: Building Sustainable Growth

MA
Metalegal Advocates

Contributor

Metalegal Advocates is a law firm having offices in New Delhi and Mumbai, specializing in economic offences, tax disputes, commercial laws and general corporate advisory. We advise and represent clients in various forums including lower courts, Tribunals, High Courts, and the Supreme Court.
The trajectory of any company directly affects the interests of various stakeholders, such as debtors, creditors, and shareholders. Thus, every company, including startups...
India Corporate/Commercial Law

Prefatory Note

The trajectory of any company directly affects the interests of various stakeholders, such as debtors, creditors, and shareholders. Thus, every company, including startups, is accountable to its stakeholders for its actions. Corporate governance ('CG') practices provide a framework for checks and balances necessary to protect these interests.

CG involves a clearly defined set of relationships between a company's management, board, shareholders, and stakeholders1. It is a structure of relationships between the company and its stakeholders aimed at fostering responsibility and accountability while monitoring the overall performance of the company and its management. It provides assurance to those contributing capital to the company that they can participate in its affairs and ensure its growth.

Importantly, a business does not exist in a vacuum; it consumes the resources of the society. Its customers and the society at large are also stakeholders in the company. Thus, startups owe society and their customers a duty to act responsibly towards the environment or give back to society. Therefore, the scope of CG in today's scenario is not limited to the general idea of governance; it has extended to ethical practices and environmental issues with a view to conserve the environment for the next generations, which is why it is called Environment, Social, and Governance (ESG).

Well-structured CG policies within a company can foster innovation, entrepreneurship, productivity, and sustainable growth. These policies can also aid the company in securing financing and influence the cost at which it accesses capital. If investors are satisfied with a company's governance practices, the cost of capital is likely to be lower. Thus, it can be inferred that the cost of capital is inversely proportional to the level of security provided to investors through effective CG policies.

Startups are companies in their initial stages, working toward an innovative idea. Startup founders often handle operations, growth, and strategy on their own and thus need help forming the structures required for checks and balances due to various factors, such as failing to observe guiding principles. However, strong and well-structured CG policies are imperative for startups to access capital and foster innovation and growth.

The startup ecosystem is proliferating in India. It is the third-largest startup ecosystem, with over 1,17,718 recognized startups and 111 unicorns2. An innovative or scalable business model, a dynamic environment, and rapid scalability can characterize startups. However, they are often severely resource-constrained and require capital to expand their operations. Therefore, they may need to access investors to fulfill their working capital requirements or for expansion.

In India, the CG framework is still in its nascent stages. It is primarily activated in cases involving whistleblowers or when institutional or proactive investors take steps to ensure the smooth functioning of the business. This article examines the challenges Indian startups face in establishing robust CG frameworks. It explores the adaptations necessary to ensure growth and sustainability, especially in the context of India's legal environment.

I. CG: A Conceptual Framework

The Pillars of CG

The most common principles of CG have been recognized as follows:

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  1. Accountability – Shareholders can hold the board of directors accountable for their actions and initiate the removal of directors in cases of default or mismanagement. This ensures that any actions of the board do not adversely affect the prospects of the company or hinder its growth.
  2. Transparency – The board of directors is responsible for providing accurate and timely information to its stakeholders, especially in the event of any conflict of interests or related party transactions.
  3. Fairness and equity – Fairness entails equal and just treatment for all the shareholders, ensuring that the policies of the company are designed in a manner that the resources are allocated equitably.
  4. Compliance with legal frameworks – The company should operate within the legal framework established by the law to protect the interests of the shareholders and avoid any contraventions that could lead to penalties.

Benefits of CG

  1. Risk Assessment and Mitigation: Well-structured CG policies enable management to assess risks associated with the business and position the company to handle and mitigate any potential challenges that may arise in the future.
  2. Investor Confidence: CG policies can enhance investor confidence in the functioning of the business and the overall viability of the business idea, thereby facilitating investment.
  3. Cost of Capital: The cost of capital is inversely proportional to investor confidence; the higher the investor confidence, the lower the cost of capital. Thus, effective CG policies can reduce the cost of capital for startup companies.
  4. Sustainable Growth: Sustainable growth entails the company not sacrificing future needs for present growth. It promotes ethical growth, ensuring that the company is responsible to society at large and does not compromise the needs of future generations.

Legal Foundations of CG in India

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  • The Companies Act, 2013 ('CA2013'): Provisions related to the appointment, duties, qualifications, and structure of the board of directors, as well as the extent of the board's powers and compliance requirements (including penalties for mismanagement), provide a framework for the exercise of powers by the board of directors. This framework establishes mechanisms for checks and balances regarding the appointment of directors and the exercise of their powers while discharging their duties.
  • The SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015: This applies to startups transitioning from unlisted to listed companies. These regulations shape the governance structure of companies by imposing stricter disclosure requirements to protect shareholders' interests and maintain the integrity of the stock market, thereby facilitating value generation and economic growth in the country.
  • The National Voluntary Guidelines3: These include a set of nine principles applicable to all business entities. They were formulated to enable businesses to monitor their functions and enhance productivity while ensuring that the interests of various stakeholders are not compromised. Although the guidelines are voluntary, the principles enshrined therein promote the holistic growth of a company.
  • G20/OECD Principles of CG: These principles consist of six guidelines applicable to all business entities. They are designed to help businesses monitor their functions and enhance productivity while safeguarding the interests of various stakeholders. Although the guidelines are voluntary, the principles provide for the holistic growth of a company.
  • Global Reporting Initiative (GRI): These principles consist of six guidelines applicable to all business entities. They are designed to help businesses monitor their functions and enhance productivity while safeguarding the interests of various stakeholders. Although the guidelines are voluntary, the principles provide for the holistic growth of a company.
  • Confederation of Indian Industry ('CII'): The CII has outlined ten essential principles of CG for startups in its Charter of CG. These principles apply to all startups, regardless of their age. Additionally, the CII has provided a voluntary scorecard that startups can use to evaluate their implementation of CG policies.
  • Other Regulatory and statutory authorities: Regulators may impose sector-specific CG requirements on entities as necessary to ensure stakeholder protection. Furthermore, regulators are authorized to act upon any contraventions on their own to safeguard the interests of society at large, as deemed appropriate.

II. Legal Implications of Governance Failures

  • Investor Actions: Governance failures in these companies led to significant investor exits and pressure on the leadership to step down, reflecting the consequences of poor governance on fundraising efforts and valuations.
  • Regulatory Scrutiny: A lack of proper governance frameworks invited investigations from regulatory bodies and led to potential legal actions for breaches of fiduciary duties and financial misreporting.
  • Brand Value Destruction: Poor governance affects a startup's financial health and reputation, making recovery more difficult for consumers, employees, and investors.

III. CG Challenges for Startups in India

  • Lack of formalized Governance Structures: Startup founders are often part of close-knit teams, and the decision-making process is generally informal. The powers of the board are often concentrated and centralized. A transition from founder-led decision-making to a structured board with independent oversight is required to ensure that the interests of shareholders are considered.
  • Absence of clearly defined roles: Startups may sometimes need help to define the board's roles and powers clearly, which can lead to confusion in management decisions. It is imperative to clearly define the board's powers to ensure compliance with s. 166 of the CA2013.
  • Financial Constraints and Limited Resources: Startups generally struggle with the availability of funds, impacting their ability to hire experienced board members and establish robust internal controls. Due to a lack of internal audits and segregation of duties, startups may be exposed to legal risks, such as those arising from the provisions of the CA2013, which mandate the preservation of books of accounts for eight years.
  • Conflict of Interest and Founder Dominance: The dominance of founders and potential conflicts of interest often result in disputes between investors and founders. Founders may prioritize short-term growth or personal financial gain over long-term stability. Without adequate oversight, these conflicts can lead to breaches of fiduciary duties and attract shareholder lawsuits.
  • Inadequate Disclosure and Reporting Practices: Private startups often neglect regulatory disclosure practices that are compulsory for listed entities, which can negatively affect investor confidence and the cost of capital. Furthermore, in the absence of adequate disclosure, startups may face challenges in attracting institutional investors.
  • Regulatory and Compliance Hurdles: Startup founders typically manage everything on their own, often with little to no knowledge of the ever-evolving regulatory landscape. This lack of expertise can expose the startup to legal violations, attracting fines, penalties, or, in worst-case scenarios, winding up.

IV. Adaptations of CG Models for Startups

Lean Governance Frameworks

The lean governance model for startups ensures that the right decisions are made while incurring less overhead. It focuses on streamlining procedures to fulfill the interests of various stakeholders and enables everyone to work together harmoniously and effectively. The charter documents, agreements, and relationships between the company and its stakeholders should be structured in a manner that balances the flexibility required by startups with the accountability of management to shareholders.

Airbnb leveraged the principle of lean governance to expand its operations globally. The founders launched their business via a simple website that was continuously upgraded. The business model was validated at each stage, thereby minimizing risks and reducing overhead costs.

Founder-Centric Governance and Mitigating Risks

A founder-centric governance model is one where decision-making powers are concentrated in the hands of the founders during the initial years. While investors may be offered a seat on the board during early funding rounds, the founder retains control over the day-to-day functioning of the business, which provides greater flexibility. There is no legal infirmity in this model. However, the investors may seek affirmative voting rights to ensure that their interests are safeguarded.

A founder-centric governance model requires oversight of management functions to prevent conflicts of interest and protect shareholder interests. The shareholder agreement between the company and the investors should clearly outline the rights and responsibilities of both the board and the investors and include a dispute resolution mechanism to address potential conflicts between founders and shareholders.

Agile Governance Frameworks

Agile governance frameworks provide iterative approaches that enhance flexibility and responsiveness in CG models. This ensures that the decision-making is streamlined while addressing statutory and regulatory obligations.

V. Case Studies: Successes and Failures in CG

A. Successful Implementation

  • Airbnb – Airbnb's lean governance policies, along with a robust whistleblowing policy, have resulted in the expansion of the company from a single bed and breakfast to thousands of listings around the world.
  • Warby Parker – Warby Parker provides prescription glasses via its online platform, allowing buyers to try multiple styles before committing to one. For every successful sale of a frame, Warby donates a frame to an underprivileged person in need of prescription glasses. Thus, Warby has demonstrated its commitment to society while building a successful business.

B. Governance Failures

  • Uber – The collapse of governance due to ethical lapses, regulatory conflicts, and allegations of workplace misconduct led to CEO Travis Kalanick's ouster. This underscores the importance of ethical leadership, regulatory compliance, and fostering a positive corporate culture to maintain investor trust and public credibility.
  • Byjus – Once a celebrated unicorn, Byjus faced scrutiny over financial irregularities and poor internal controls. The lack of strong internal controls and inadequate governance oversight led to reputational damage and declining investor confidence. This highlights the critical role of governance in mitigating risks, especially as companies scale rapidly.
  • Bharatpe – Governance issues at BharatPe surfaced when the company's co-founder faced allegations of financial mismanagement and unethical practices, leading to public backlash and executive changes. The case emphasizes the need for startups to have robust internal audit mechanisms and clear lines of accountability to avoid such governance lapses.
  • Zillingo – A prominent fashion-tech startup, Zillingo's governance failures came to light when the company suspended its CEO amid allegations of financial impropriety and irregularities in accounting practices. This not only led to investor exits but also raised questions about the oversight mechanisms in place, underscoring the need for transparency and regulatory compliance, especially for startups dealing with large-scale funding.
  • Trell – The influencer-led social commerce startup faced a major governance crisis due to accusations of financial misconduct and reporting discrepancies. This case illustrates the governance risks involved in scaling startups, especially when internal financial controls are weak or non-existent. The lack of accountability and internal checks damaged Trell's credibility and growth trajectory.

VI. Recommendations and Governance Best Practices for Startups

A. Establishing Formal Governance Structures earlier in the growth cycle

  • It is important to establish CG during the formation and growth process of the company, and it should be incorporated into the charter documents, which will impact the startup's overall growth and value-creation process.
  • The CG principles should be included in the shareholders' agreement or other agreements that define and structure the company's relationships with its stakeholders, ensuring that the company gains the confidence of investors.
  • An independent board with clearly defined roles and powers should be established to ensure that the board does not take actions exceeding the authority of the memorandum.

B. Implementing Robust Financial Controls

  • The company should set up committees of the board, including an audit committee, to ensure that the company's financials are in order and to prevent mismanagement of funds.
  • The shareholders' agreement between the company and the investors may impose certain restrictions on using proceeds, enabling checks on unusually large expenses through robust clauses.
  • The CA2013 mandates companies file financial statements and annual audits. Stakeholders or the public can access these financial statements from the Ministry of Corporate Affairs (MCA) website.

C. Enhancing Transparency and Accountability

  • Management should ensure that adequate disclosure practices are implemented and followed. An internal code of conduct should be established to ensure ethical business practices.
  • Regulatory authorities may recommend reporting standards to enhance transparency and accountability among entities.

D. Aligning Founder Interests with Long-Term Corporate Goals

  • Legal safeguards can be incorporated into the founders' agreement to ensure that the interests of the founders do not clash with the long-term goals of the company and its stakeholders. Such safeguards include anti-dilution clauses, vesting schedules, restrictions on the transfer of shares, founder exits, or anti-competitive clauses.

E. Integrating Risk Management Frameworks

  • Startups should establish governance structures that are responsive to changing regulations to ensure they remain well-adjusted in the ever-evolving legal landscape of the startup industry.
  • Under the CA2013, the formation and implementation of a risk management policy to address operational, financial, and reputational risks are mandatory. This Policy positions the company against any risks that may affect its existence.

VII. Conclusion

It is often believed that CG policies are important only for stakeholders. However, a comprehensive analysis indicates that the formation and implementation of CG guidelines are crucial for the overall growth of startups. Ultimately, the importance of robust CG practices cannot be overstated; they are fundamental not only for stakeholder interests but also for the sustainable success of startups.

Different organizations have established various guidelines; however, they are voluntary in nature, and their importance should not be undermined. The legislature has incorporated CG methods into the CA2013, which every company must follow. Additionally, SEBI and other regulators have framed sector-specific or entity-specific guidelines. Making CG practices mandatory in the Act is a commendable step in the right direction. However, it is essential to develop and enforce a more comprehensive framework to facilitate the interests of various stakeholders and support the overall growth of startup companies.

Footnotes

1.G20/OECD PRINCIPLES OF CORPORATE GOVERNANCE.

2. As of 03.10.2023, Data prepared by Invest India.

3. National Voluntary Guidelines on Social, Environmental & Economic Responsibilities of Business.

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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