If venture capital-backed funds lose money because of their inability to check for misappropriation of funds by a founder, should the government care?
The Print28 February 2024
Some of India’s most promising startups are in the process of falling from grace. A few days ago, Byju’s CEO Byju Raveendran had a public spat with shareholders who wanted him ousted from his position. Byju’s current valuation, at less than $2 billion, is 90 per cent lower than its $22 billion valuation in late 2022. The Ministry of Corporate Affairs has also decided to expedite the inspection report on Byju’s. Similarly, Paytm Payments Bank is under regulatory scrutiny for alleged violations in its business. This, of course, is not just an Indian scenario. A few months ago, in November 2023, Sam Bankman-Fried was convicted of defrauding customers of his cryptocurrency exchange. Earlier, in May 2023, Elizabeth Holmes began her prison sentence for defrauding investors in her biotech startup, Theranos. These and other similar events in the last few years raise questions about governance in private markets. We’ve not yet discovered the answers, but this is a good time to revisit some of the questions.
Consumer protection vs investor protection
The narrative around startups seems familiar. There is a superstar genius who thinks out of the box and is not afraid to push boundaries. But these daring strategies can often border on the illegal, either in the form of misappropriation of investor funds, or outright lying to and intimidating customers. The day of reckoning comes soon enough, and everyone is left wondering, what was the board doing? Why were large institutional investors sleeping at the wheel?
At the outset, it is useful to distinguish between two types of misdemeanours.
The first is where the startup defrauds its investors (shareholders), which are typically large VC funds. In a startup ecosystem, there is no “public shareholding” that needs to be protected, unlike in a public market. The firm may have an excellent product offering, but the founder may be inflating the company’s books, or embezzling funds. Private capital has the ability and the levers to inspect the company and demand higher standards. It also has the legal means to sue the startup founder for breach of contract.
The second type of misdemeanour is where the startup defrauds customers by lying to them about the product or engaging in unethical sales practices. The firm’s books may be very sound, and the shareholders may be getting excellent returns on their capital. This is no different from a large financial firm mis-selling products to unsophisticated consumers. The issue of consumer protection is distinct from that of shareholder protection, and will have a different diagnosis and subsequent response.
Complications of shareholder protection
The first thing to realise about startups is that most will fail. Their very objective is to try outrageous new ideas that have a high chance of failure. Venture capital firms invest in these ‘mad’ ideas knowing that about eight out of ten will fail, but the two that succeed will make up for the failures. In this environment, where a ‘genius’ founder pursues a blue-skies idea backed by generous venture capital, the board is often seen as an ally for the company’s growth, not a bulwark against potentially fraudulent practices. In a traditional firm, the board plays a “control” function. But in a startup, the board often focuses on developing the product or increasing scale.
Additionally, VCs also negotiate a seat on the board to monitor how their money is being spent, and to potentially add value to the firm. A startup has several funders, who often join at different stages and may have different motives. An investor who funds the firm in its early stages may be looking to exit, while someone who has come in later, might have an interest in letting the startup remain private. Each investor may negotiate a seat on the board with different voting rights. As a result, there may be large differences between board members themselves. This leads to a much more complicated relationship between the founders and the board, compared to that of a large publicly listed mature firm.
Finally, the promise of scale and the charisma of a ‘genius’ founder can often cloud judgement. Since funding is closely tied to revenues, the incentive is to show growth. A complicated shareholding structure with conflicting interests between board members may make it worse. At the same time, it’s important to understand that spats resulting in the ousting of a founder may actually be a reflection of the board working.
The response
If VC- backed funds lose money because of their inability to check for misappropriation of funds by a founder, should the government care? After all, it is someone’s private capital at stake, with no public shareholding. Besides, investors in such firms are willing to take risks and capable of hiring the best talent to understand accounting statements.
Those investing in VC funds should be the ones asking questions, and as funding becomes tighter, tougher oversight will surface. The sky-high valuations of startups will begin to adjust and reflect the company’s true value. The puzzle is, why is it taking so long for the disciplining force of the market to work?
Imposing public market restrictions on private markets comes at a cost and should not be done blindly. If this is done, we may lose the upside potential that comes with a startup ecosystem without any gains to minority shareholders, as there are none in this context. VCs should be able to take founders to court for fudging of books or other such misdemeanours.
Issues of consumer protection, meanwhile, should be dealt with by improving the overall framework for this in the country. The functioning of consumer courts needs to be improved, as does the framework of tort law. Class action suits should also be made possible. It is important to diagnose the problem correctly before we ask for the application of state coercion.
