Price Entrepreneurs, Investors Pay For Growth-at-all-costs And How To Avoid It

In the recent past, many incidents of investors being misled by fake revenue numbers from startups have been coming to the fore. Frauds at GoMechanic, BharatPe and Zilingo particularly shook up the startup industry.

The after-sales service startup GoMechanic’s cofounder Amit Bhasin, in fact, publicly admitted to committing “errors in judgment”. “Our passion to survive the intrinsic challenges of this sector, and manage capital, took the better of us and we made errors in judgment as we followed growth at all costs, including in regard to financial reporting, which we deeply regret,” Bhasin said in a post on LinkedIn.

Why do entrepreneurs paint the wrong picture by inflating their financials to investors?

Chasing growth at all costs

Startup success has today become a game of chasing investors’ attention, even if that sometimes means an exaggerated projection of numbers. While early-stage startups have to convince the investors about their business model by demonstrating certain traction, late-stage companies have to showcase solid revenue growth and profitability in terms of numbers.

“Some entrepreneurs may misrepresent these numbers to show their companies in the best possible light operationally and financially. A typical example of this is consumer startups showcasing their Gross Merchandise Value (GMV), which is, in fact, the value of goods transacting on the marketplace, as their earned revenues,” said Aparna Pittie, principal, Artha India Ventures.

Certain investors’ growth-at-all-costs ideology could also feed into a vicious circle of whitewashing for supposed value creation, she added.

Entrepreneurs also try to preserve their ownership by any means. They are thus constantly striving to reduce this dilution as they raise rounds, which is based on valuation. “The enterprise valuation is assessed on the basis of various financial parameters apart from a qualitative assessment of the founders, product, sales & execution status & capability. Hence entrepreneurs, in the interest of conserving their ownership, they present their financials or revenues or user base in an optimistic (sometimes hugely over-optimistic) light in the interest of positioning the valuation of the company,” said Padmaja Ruparel, co-founder, IAN and founding partner, IAN Fund.

Sometimes, entrepreneurs project a strong valuation to avail of bank debts as well. “However, without condoning the act, sometimes in startups the revenue recognition isn’t defined and they show revenue numbers in all earnestness but those that don’t comply with the conventional accounting standards,” said Bhaskar Majumdar, managing partner, Unicorn India Ventures.

What can investors do about it?

Detailed pre investment diligence is critical for investors. “Apart from business diligence, it’s critical to deep dive into the financials, balance sheet and P&L, contracts, etc. And it is best to work with quality diligence service providers. In some cases, it is good to bring in a domain expert to understand how the current & future business stacks up against competition,” said Ruparel.

Experts feel that the investors have to be mindful of their role and the expectation setting as well. “Investors provide capital and then look forward to revenue guidance and progress. When the mandate is given for growth only direction, the misallocation of capital and adventurism comes into account,” said Brijesh Damodaran, chief investment officer and co-founder, Auxano Capital.

Artha’s Pittie shares the following pre-investment and post-investment due diligence methods.

• Pre-investment: Rigorous due diligence (‘DD’) forms the foundation for investors to evaluate the viability of a business and reduces (not eliminates) the chances of investors being misled. Diligence may vary depending on the investment stage and industry in which a startup operates. The traditional approach of performing DD covers the operational, financial, and legal aspects of the investee. It is typically performed by appointing third parties who are experts in that respective field.
• Post-investment: Having a Board seat, regular catch-ups with the founding team, and an operator mindset of being a partner rather than a mere financier, one can help identify and anticipate, if not avoid, such situations. The appointment of experienced auditors, both internal and statutory, is of significant importance, who can review the accounting frameworks and report inconsistencies with generally accepted accounting principles. In the event of a misrepresentation, the option to conduct a forensic investigation is also available.

Scrutiny without interference

While investors should be aware of the functioning of their portfolio companies, where should they draw the line between scrutiny and the freedom that founders should be given to innovate?

“Investors only back founders when they trust that the founder will execute the vision for the business. Similarly, founders can choose to allow certain investors to share the cap table; and are more likely to share it with experienced investors whose vision aligns with their own. While balancing freedom and accountability, one cannot lose sight of good governance processes. Any compromise would risk the business and have long-term reputational repercussions,” said Pittie.

Experts also say that a simple way to stay clear of such mishaps is to be sure that if cash doesn’t tie up, then there is something amiss and needs digging into.

“For a business to grow and prosper, the founders should be given a free hand . This free hand can have checks and balances, in terms of reporting timelines, transparency and communication lines with the stakeholders,” said Damodaran.

Honest and clear communication between founders and investors can go a long way in ensuring it is a win-win for both. Even if the time is tough, investors can leverage their expertise and networks to help out the startups, provided they are kept in the loop. “Tough times do not undermine investor confidence; lack of honesty and transparency does. When faced with situations of compromised integrity, we will be forced to ask more questions, re-assess governance frameworks, and take a stringent view of the business and the founding team. Our fiduciary accountability to our LPs means we will assess any reputational risks with utmost seriousness,” said Pittie.

Overall, investors and experts feel that short-sightedness is not sustainable for the ecosystem and an increased focus on corporate governance placed at the heart of growth and profitability is the only sustainable way to boost investor confidence and startup success.