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.

Link: http://www.thehindubusinessline.com/specials/emerging-entrepreneurs/governance-in-startups-buck-stops-with-investors/article9675525.ece