Governance in start-ups: buck stops with investors

G. Sabarinathan

Business Line, May 1, 2017

For the past two years, start-ups have been beset with bad press about their governance. A question that has been often asked in that context is whether equity funds that invested in them should be expected to ensure good governance at the enterprise.

To answer this question, it is necessary to look deeper into the business and legal basis of the relationship between the investor and the investee enterprise.

As a business, early-stage funding has a limited number of investors who are well networked. So, preserving good reputation is an important goal for the investor and the entrepreneur. Bad reputation spreads fast and imposes an economic cost: High quality entrepreneurs hesitate to raise capital from investors with a reputation for being unreasonable. Prudent investors decline to fund dodgy entrepreneurs.

Two levels of laws

The legal basis of the relationship operates at two levels. Right at the top are the general laws of the land. In the Indian context, the law of contracts and the law governing the functioning of companies are the most important among them, giving the investor certain rights and protection.

At the next level, to further fortify the protection under the general laws, investors demand a set of contracts that are known by different names, which we shall simply refer to as investment contracts.

Rights under these investment contracts provide the investor a seat on the board of directors of the funded enterprise and the right to veto decisions, major as well as minor.

Examples of such decisions are the starting of new businesses, the purchase and sale of assets of the enterprise, raising or retirement of various forms of capital such as debt and equity, the declaration of dividends, composition of the board itself and the recruitment and termination of key employees. These rights are in addition to other standard ones such as access to periodic accounting and other information relating to the enterprise, audit of books and the right to visit the facilities of the enterprise.

The most significant of these provisions are two which allow the investor to impose a cost on the entrepreneur if he/she were to fall out of line. One allows the investor to demand that the enterprise find a way for the investor to dispose of his investment, if the entrepreneur violates the investment contract. The other stipulates that the founder can increase his shareholding in the enterprise in return for predefined performance, good conduct or the sheer passage of time, through a process called vesting.

What follows from the discussion above is that the investor has several levers of legal and other controls over the entrepreneur’s conduct. Further, he has the flexibility to customise these controls to the context of individual investments.

Role of fund managers

That leads us to the enforceability of these contractual provisions. Do fund managers have the professional competence and the financial incentive to wield the power of these contracts sensibly?

Most generally, venture capital (VC) and private equity (PE) fund managers receive two per cent of the funds under management as annual management fee and 20 per cent of capital appreciation, making them one of the most expensive managers of money. Thus one would imagine there is no shortage of incentives.

But do managers have the competence to exercise the powers under the contracts? That is a hundred and twenty five billion dollar question for the Indian VC and PE industry, remaining largely unanswered.

A common peeve among fund managers is that they can hardly enforce any of these rights because of the slow speed of disposal of cases in Indian courts and the limited understanding of these complex contracts that exists among the Indian judiciary. That argument would cut ice only if fund managers had invoked these rights often enough, but failed to enforce them in a court of law.

All things considered, the balance of arguments would suggest that VC and PE fund managers have enough in their legal and contractual arsenal to ensure that their investee enterprises are well-governed. No matter whether the enterprise invited hostile legal action from its supplier or incurred the wrath of the enforcement directorate or simply fudged its books to hoodwink its investors, fund managers should receive a significant share of the rap for the lapse in governance.

Isn’t that the minimum that investors in funds should expect from fund managers as performance for a generous pay?

That would of course assume that the fund manager exercised adequate diligence to ensure that he selected the right enterprise and the entrepreneur for funding, to begin with.


Academic institutions: The new players in venture capital?

G. Sabarinathan

The Mint, February 14, 2017

A less well-known event in the history of the respected Boston University is its not-so-successful entry into venture capital investing, decades ago. More recently, the University of Minnesota and others reportedly decided to move out of early-stage investing.

I was reminded of these examples when I read about a leading Indian academic institution launching a large early-stage investment fund. I began to wonder if managing venture capital was for all and sundry.

Conceptually, managing early-stage investments is straightforward financial intermediation.

Investment professionals, referred to in trade speak as general partners (GP for short), raise money from investors, known as limited partners (LPs for short) who have the capacity to wait for a long time to realize highly iffy returns.

GPs are paid a flat percentage of the funds they manage for their services. They are incentivized to maximize returns for the LPs through a share of the capital appreciation they generate.

The trouble of course lies in implementing this model. Notwithstanding the incentive compensation, fund managers can short-change their investors or simply perform poorly.

So what does it take for a venture fund to perform well?

First, the GP has to pull in a seriously large flow of quality investment opportunities. That is not as easy as one might think because savvy entrepreneurs are bound to ask themselves if they would like to have a public academic institution as an equity shareholder in their enterprise.

Second, the GP needs to bring in exceptional deal evaluation skills because entrepreneurs may not disclose credible information about their business, either out of sheer optimism or out of bad intent. The periodic stories in the Indian business press about investments that go up in smoke due to poor disclosure and deal evaluation are just the tip of the proverbial iceberg of failed investments.

Third, early-stage investment managers need to stay engaged with their portfolios for five to eight years, through the life of the investment fund. For that to happen, the fund management enterprise requires an organization that will find the best fund managers and keep them motivated to see those risky investments through to successful exits.

This last feature is as important as the other two, if not more so. Ironically, it is also the reason all forms of early-stage investment organizations, except the typical venture capital partnership firm, have often failed. Considerable evidence to this effect has been accumulated over five decades or more of the venture capital industry’s history.

That said, I wonder if any Indian academic institution will be able to create and sustain an organization of talented professionals who will stay with the fund management firm through the life of the fund.

That brings me to the main question: Should Indian academic institutions get into venture capital management?

At the end of the day, academic institutions are expected to produce academic excellence. Management schools have been handing down to generations of their students the wisdom that organizations and institutions should stick to their knitting in order for them to excel.

When it comes to managing money, academicians as well as their institutions have not exactly covered themselves in glory. In a typical academic understatement, professor Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School, who has written extensively on venture capital, summed it up: “It’s very hard to marry these organizational forms.”

In spite of that warning, if Indian academic institutions plan to launch venture funds and do not heed their own wisdom, they could end up being the cause for much costly amusement in future.

G. Sabarinathan teaches at the Indian Institute of Management Bangalore. The views expressed are personal.


Venture capital industry in India is a flourishing one

By G Sabarinathan, Aditya Muralidhar & Ahana Shetty

Economic Times in ET Commentary, March 27, 2017

Popular perception about the Indian venture capital and private equity industry would probably suggest that it is a marginal part of the larger capital market in India. But that may not be true anymore. Assuming that the approximately $120 billion of VC and PE funds deployed in India represent an average equity ownership of 40 per cent, the funded enterprises could be as big as 15 per cent, or more of the market capitalisation on the National Stock Exchage (NSE).

On a different dimension, the 4,000-plus enterprises that have been funded by the industry need to be compared against around 1,847 enterprises that have been listed on the NSE over 23 years and 5,500 on the Bombay Stock Exchange have been added over more than 140 years.

The industry has grown from less than 100 enterprises that it funded annually in the early 2000s, to more than 500 in 2007. The financial crisis brought those numbers down to less than 300 in 2009. But the industry was back to funding over 700 enterprises in 2015.

More striking than the number of enterprises supported is the breadth of the industries supported. The VC industry used to be associated with technology enterprises in the early years and with more visible businesses like ecommerce recently.

Big Support
The reality, on the other hand, is that VC has been supporting enterprises across more than 35 broad categories of industries. VC-funded enterprises today touch nearly every aspect of our lives — from schools to real estate to beauty salons to hospitals of various specialties to transportation companies to fine dining restaurants and retailers of nearly all kinds of goods.

A third feature is that in the past decade or so, the Indian VC industry has supported enterprises by providing them with what is known as ‘follow-on funding’. Some VC-funded enterprises have managed to raise as many as eight rounds of financing before they got acquired or went public. This has to be interpreted as a sign of the growing maturity of the industry.

VC has created a line-up of public offerings and acquisition candidates.

As many as 20 per cent of VC-funded enterprises have gone on to be acquired, or have their shares listed on an Indian stock exchange. The 130 VC-funded enterprises that listed their shares on an Indian stock exchange constitute around 15 per cent of the initial public offerings in the past 17 years.

The venture investment marketplace has seen the entry of around 850 investment funds. As of 2016, close to half of them had stopped making investments for two years or more. Economists would consider this rate of entry and exit of firms as the sign of a competitive marketplace where capital by way of investment funds flows to the most efficient players.

These achievements of the industry are in spite of the absence of a regulatory regime that is supportive of venture investment. The industry continues to operate under the foreign direct investment (FDI) regime, with some added rules thrown on top that restrict the flexibility in structuring deals. It has had to deal with problems relating to poor governance in many of the investee enterprises and dispute resolution mechanisms that deliver too little justice, too late.

Poorly Understood
Notwithstanding its contribution as a source of startup funding, the Indian VC industry remains poorly appreciated and even more poorly understood.

Serious doubts have been cast upon the rates of return realised by these funds. There have also been concerns about lax oversight by VC firms of regulatory compliance on the part of investees, and of relocating valuable Indian enterprises outside the country through a restructuring mechanism, euphemistically known as ‘externalisation’.

To dispel these perceptions, the industry has to engage with independent constituencies by sharing more data that will help a more objective assessment of its contribution. Its North American counterparts have done so in spite of being thought to be notoriously secretive.

The industry has further been accused of funding ideas that are mere copycats of what have been proven in the US. When one looks at the kind of businesses that have been funded, one is led to wonder if there isn’t some merit in that view. Accolades and criticisms aside, one thing that emerges is this: Love them or hate them, you cannot ignore those VCs any more.

(Sabarinathan is professor, IIM-B. Muralidhar and Shetty are students, IIM-B)