The Corporate Governance Tussle

2022 has not started well for a large part of the start-up world. The global economic slowdown has dried up the once overflowing liquidity tap. In this desert of funding, skeletons of impropriety and fraud that were buried under the water are rising up to the surface.

A well-known factor in assessing companies, corporate governance forms a critical component of the diligence into a start-up. Advisors such as corporate lawyers and financial consultants are usually tasked with identifying issues in the corporate management practices of companies (especially those run by first-time entrepreneurs or in earlier rounds of funding), primarily to ascertain that all company transactions are legally sound. However, any diligence exercise is only as good as the information (and its completeness and accuracy) that a company provides to the investor (think the Daiichi/Ranbaxy dispute - a case that (for everyone involved) introduced the contours of what effective risk management and diligence ought to reflect.)

Against this backdrop, we'll look at the issues plaguing Zilingo and how investors and founders can protect themselves from the adverse impact of corporate governance issues.

Background

Without taking too much writing real estate, the summary version of the dispute (at least as reported by the media) goes something like this: In April 2022, Sequoia-backed B2B marketplace Zilingo suspended its co-founder and CEO, Ankiti Bose, pending investigations into the company's accounting practices and financials. Apparently, these issues were highlighted during a diligence exercise. Surprisingly, this was the fourth public instance of a Sequoia-backed start-up facing scrutiny for alleged financial irregularities (the others being BharatPe, Zetwerk, and Trell). Reports suggest that the signs of a potential issue were evident during disagreements between the CEO of Zilingo and Sequoia regarding the direction of the company, as well as simmering tensions (that could escalate into legal issues) between the two co-founders of Zilingo. However, for this article, the focus is on the allegations of financial fraud perpetrated in a company that raised almost USD 300 million and was backed by some large names in the VC world, some of whom also occupied board positions in the company.

Risk mitigation

A standard investment document (usually an Investment Agreement or a Share Subscription Agreement) provides investors with certain checks and balances over the corporate governance of the target entity and obligates its founders to ensure that certain minimum thresholds and standards are maintained during the discharge of normal business. These checks include information rights, veto rights, processes to approve certain related party transactions, etc. A breach of these conditions triggers serious ramifications for the founders and the start-up. Thus these conditions act as measures that theoretically protect investors from downside risks of fraudulent practices. However, as I stated earlier, oversight and information rights are only as effective as the volume, accuracy, and regularity of information that the company provides. A director (or for that matter, even a shareholder) under the law (and even under the investment agreement) does not have unlimited authority over the daily operations of the company. Thus, internal audits, oversight committees managed by investor representatives, and third-party risk assessment entities, etc. play a key role in maintaining corporate governance standards, especially in industries where financial data can be manipulated. Although such obligations are not common, the spotlight on the increasing instances of allegations of fraud in such cases (which casts a doubt on the efficacy and relevance of diligence and oversight mechanisms), investors should now start considering methods to strengthen their visibility over a company's business. At the same time, balancing downside risk protection with investor zealousness (that may sometime stifle growth) is key.

Another method to ensure financial discipline is adherence to the business plan. Although it is generally acknowledged and agreed that a business plan is only a guiding document, important thresholds, especially those pertaining to deviations from budgeted expenses should have sufficient safeguards to control any financial irregularities.

Conclusion

As a founder, one should be very careful about accepting terms that suggest an investor overreach in the regular functioning of the company. While concerns of financial propriety are legitimate in most instances, there have been instances (at least one in the knowledge of this writer) where investors had pushed for excessive oversight that hampered the growth of the start-up and resulted in a bitter dispute between the investors and some founders on one side, and some founders on another. This provides a perfect segue into founder disputes, a topic that is important enough to merit an individual post.