Founders Versus Funders

The discovery that GoMechanic – an auto services startup that has raised $62 million (Rs 510 crore) in venture capital and private equity funding since it was founded in 2016 and had a valuation of $350 million (Rs 2,900 crore) – cooked its books follows on the heels of several other startups accused of financial fraud, including Singapore-based fashion ecommerce tech firm Zilingo.

What do these cases mean for the future relationship between founders and funders? First and foremost, due diligence will sharpen. GoMechanic’s accounting malpractice was spotted only when Japan’s SoftBank Vision Fund vetted its balance sheet ahead of a fresh round of funding. It was set to lead a $75 million (Rs 640 crore) round. EY is now doing a forensic audit of GoMechanic’s books while the founders go on a forced leave of absence.

But financial fraud is not the only worry for both founders and funders of startups in India and globally where accounting frauds have spiked, especially in crypto firms like FTX. The other concern is the basic business model of startups.

Bouyed by surplus cash looking for investment opportunities when interest rates in the West were near-zero till a year ago, startups often received large cheques on the basis of a business plan. Due diligence was light. Masayoshi Son, founder of SoftBank Vision Fund, famously said he invested on intuition. The fables, often apocryphal, of startup entrepreneurs clinching funding over dinner with investors after scribbling their business blueprint on tissue paper, got a whiff of credibility as money poured into startups mired in losses. Its founders though had a good story to tell.

Traditional companies have a straightforward revenue model: sales of their products or services are greater than their overheads and all other costs. Startups turned this business model on its head. A significant part of their “revenue” comes from private equity and VC funding.

The idea is to accept losses in order to build volume which in future will attract genuine revenue. Amazon made a loss for the first 20 years of its existence, say Indian startup entrepreneurs to justify their business strategy. Why not us?

But in the end a business model based on financing expenditure with equity capital, not real revenue, will implode. That is why Indian startups have begun cutting costs with large layoffs. They include big players like Swiggy and Byju’s.

The problem though remains. In the scramble to rightsize, companies risk losing market share. For VC and PE investors that signals trouble. With interest rates high in the US and Europe and likely to stay firm for a while, global fund managers are reworking investment options with their funding partners.

As The Economist noted recently: “Venture capitalists periodically raise money from limited partners, such as endowments and pension funds. Many of these now want to reduce their exposure to venture capital, since public markets have taken a hit and they seek to keep allocations to different asset classes in rough proportion. As a result, a handful are calling up venture capital funds to say things to the effect of ‘don’t rush back’ for more money, says an investor in several venture capital funds. 

“Venture capitalists have other reasons to be concerned about relations with limited partners. During the recent boom, funds started to poke their noses far beyond their usual concerns. Sequoia Capital, a famous outfit in Silicon Valley, launched a ‘superfund’ which includes investments ranging from traditional venture capital interests to public-market shares. Some limited partners thought these sorts of funds were absurdly broad, but opted to buy in anyway in order to gain access to specialist funds.”

With limited partners who fund VC and PE firms becoming increasingly wary of where their money is being invested, Indian startup entrepreneurs will have to rewrite their business models. The stock market performance of the few listed startups shows how ruthless public markets can be. Paytm, PolicyBazaar and Nykaa have fallen to less than half their IPO price.

The other fundamental question is: who actually decides a startup’s strategy? Funders aren’t yet breathing down founders’ necks, but most have increased their active involvement. Boards are filled with their nominated directors. Independent board directors come with a health warning. Many are not conversant with the company’s business. Undue interference can demoralise founders who work 24/7 to make their companies successful. They complain that board directors nominated by a PE/VC firm often overstep their brief and force entrepreneurs to make decisions outside the investors’ domain competence.

The ideal funder is hands-off on operational matters and hands-on on financial diligence. Founders can learn a lesson from large tech companies on how board vigilance can set things right. Cognizant, one of the world’s leading information technology companies, last month sacked its CEO Brian Humphries. The saga played out over nearly a year during which Cognizant’s underperformance on Humphries’ watch compared to rivals like Infosys forced the board to fire Humphries. 

His replacement, Ravi Kumar, was president of Infosys for 20 years. According to Mint, this is how the story unfolded: “The straw that broke the proverbial camel’s back was Humphries’ briefing to the company’s board in the first week of January. Humphries shared with the board that Cognizant would grow in ‘low single-digits’ in 2023. Further, he wanted the board to lower the earnings per share (EPS) outlook for 2022. These two developments sealed the fate of the incumbent at Cognizant and paved the way for the dawn of the Ravi Kumar era at the technology services firm. The compensation for the role gives a sense of the high stakes for the board. Humphries made $19.7 million in 2021.”

The standards startups adopt are not as rigorous as Cognizant or Infosys. Nor are their boards as proactive. But Cognizant, co-founded by Indian-American Francisco D’Souza, and Infosys, co-founded by N. R. Narayana Murthy, Nandan Nilekani and others, are both former startups themselves. They relied on real revenue and real profits to make it to the top, reward shareholders and create an enabling environment for employees.

They offer a valuable lesson in good business practice for both Indian founders and funders.