While entrepreneurs enjoy lavish lives, their startups are being investigated for suspected financial misconduct. If the current restrictions imposed by VC investors are any indication, such indulgences would be difficult for founders facing probes for excessive and unexplained spending.

Soon, startup CEOs will face the prospect of having their luxurious toys and other personal possessions confiscated by VCs who have lost money by funding their businesses.

Following many claims of fraud that prompted investor-led queries, VC companies are establishing a series of pre-emptive restrictions before transmitting money.

Asset liability is one of the most special terms that have found their way into startup funding term sheets. This points that in the case of fraud or default, the founder will bear full responsibility and may be forced to liquidate his assets, including his home and automobiles, to repay the investors’ money.

Founders used to sign term sheets for equity transactions that excluded their assets until recently. This may seem comparable to firms pledging their properties to raise loans from banks. So why wouldn’t the creator take on debt himself?

Banks often lend to revenue-generating enterprises while investing in startups as they prepare their product for market fit. Without a consistent revenue flow, how would they repay the debt at a minimum 18% rate to the banks? Enquires the Mumbai-based investor, who adds that he has invested in at least seven startups with the abovementioned provision in the past six months.

His most recent investment was in a fashion marketplace, where two leading industry owners also invested as angels on the same terms.

According to Karan Kalra, founder of Bombay Law Chambers, indemnification provisions in India included limitless responsibility for fraud-like scenarios and breaches of basic guarantees in the early days.

With the growth of the startup ecosystem and the influence of Western markets, founders began requesting more founder-friendly provisions, like limiting their liability to the value of their shares in the company and exempting their assets from attachment. However, times are changing, and the conservative approach to investment contract structuring is increasingly gaining traction in the private capital market.

Kalra says that these initial conditions in equity agreements reappear with the advent of the fundraising winter and the backdrop of certain terrible experiences that funds have had. He believes this is fair at some level since there should be no free rides if intent is a problem.

Founders flaunting their wealth as their well-funded firm faces capital constraints and, worse, an inquiry for financial violations has not gone over well with the greater PE-VC investor community.

The BharatPe-Ashneer saga resulted from this divergence of vision and aim. The company’s board publicly accused Grover and his family of theft.

The Grover family & their relatives engaged in significant misappropriation of firm funds, including, but not limited to, creating fake vendors through which they syphoned money away from the company’s account & grossly abusing strong expense accounts to enrich themselves and fund their lavish lifestyles, according to a statement issued by BharatPe’s BODs at the time.

Grover’s fame as a reality TV star was unaffected by BharatPe’s conduct. Mr Grover frequently appears on television entertainment shows. His riches are highlighted in the leisure sections of print magazines and television networks.

Grover has three expensive vehicles, a Porsche, a Mercedes and an Audi. He also has a luxurious home in South Delhi, one of the city’s most affluent neighbourhoods.

Another founder, Rahul Yadav, whose firm 4B Networks is being examined by investors for financial violations after spending USD 35 million, is under scrutiny for his extravagant lifestyle.

Yadav also stated that he believed his staff were becoming angry by seeing him drive his Maybach when they had not been paid for months.

Investors do not desire such an open show of wealth. At the very least, not at their expense. They don’t want the founders to get too wealthy too quickly.

At least three investors said they included lock-in clauses in their term sheets. The lock-in prevents founders from leaving the firm and from taking secondary exits.

According to an investor, there is a three-year lock-in period during which the founders cannot seek a secondary exit. They limited it to 5% of their ownership over the next 24 months. If three founders have a combined investment of 30% in the firm, they can sell 5% of that stake, resulting in a 1.5% stake in the company.

Sometimes, the investor continues that not one of those factors mattered, but today they recognise that if founders take too many exits too early, they have no skin in the game. Lock-in provisions have always existed, but they were never this strict. They would only be for a year or so at most.

This would irritate people like Grover. Grover states in his book Doglapan that founders should be bold in liquidating the equity at any secondary sale opportunity. He believes entrepreneurs should not be martyrs for their cause and should prioritise their stocks’ liquidation. Having money in the bank can only make you more daring. In succeeding rounds, do not optimise for greater values. According to the book, at least 80% of the earnings from any secondary sale should go to the founders.

However, investors are sceptical about the founders’ rash share sales. They believe that such fresh money-fueled bravado would lead to irresponsible judgements and, finally, the death of startups.

At least two investors have stated that they may allow the founders to accept secondaries valued up to a million dollars to improve their living level. However, that is the greatest amount of leeway in the early years. And this would be acceptable only once they had established the firm.

Nice property in Bengaluru might cost anywhere between INR 5 and INR 8 crore. They could also get a nice automobile. However, when entrepreneurs make too much money early on, the motivation to work hard diminishes. They then become preachers instead of executioners.

Investors these days are frequently seen citing situations at BharatPe in which both the founder and the investors who contributed were prominent people with strong financial backgrounds. Both parties engaged attorneys to fight each other. On public platforms, there was a lot of tossing of mud.

Grover had employed two law firms and a single legal counsel to battle for his shares, Karanjawala & Co, Meraki Law, and Ritin Rai, respectively. At the same time, BharatPe was advised by Shardul Amarchand Mangaldas.

The owners of the company want to maintain control. They believe that in certain circumstances, the founder became too powerful for them.

The pendulum has shifted to the opposite end of the 2021 flexible deal-making spectrum. The dread of missing out was driving weekend offers back then.

Mistakes owing to sloppy money management systems have made investors wary, in addition to constrained cash flow. Closing a contract now takes significantly longer. In the January-March quarter of this year, startups raised just 1/4th of what they did in the same period last year.

Startups raised USD 2.8 billion in funding in the January-March quarter of 2023, according to Tracxn. This compares to USD 11.9 bn increase over the same period in 2022.

The fundraising boom came to an end in the first quarter of 2022. The year 2021 was exuberant in a different way. Startups then raised a record USD 40 bn in total funding. According to the broad consensus, due diligence was neglected, and appraisals were exaggerated.

There was simply no money to cover up governance or process flaws during the severe financial winter that followed. In the last year, at least a half-dozen cases of financial fraud have been reported.

It was a matter of syphoning off money in certain circumstances. In other cases, it was manipulating revenue figures to deceive investors. There were several cases of large quantities of dubious vendor payments. Other concerns that aroused eyebrows were wasteful expenditures and questionable revenue recognition practices.

In BharatPe, co-founder Grover is accused of stealing INR 81 crore from the company with the help of his family members, who were also employees. The Economic Offences Wing is looking into the matter.

Trell’s founders were accused of engaging in related-party transactions and failing to report financial problems. EY analysed the company’s books.

Zilingo was the most contentious of these instances. When investors discovered inconsistencies, they hired the consulting firm Kroll to undertake a forensic audit of the company. Such instances prompted its principal investor, Sequoia India, now Peak XV Partners, to suspend relations with a law firm with whom it had previously worked closely and to issue a note to its limited partner investors, informing them of suspected misbehaviour in the portfolio business that warranted inquiry.

Some entrepreneurs are accused of enriching themselves by giving themselves large salary packages. According to Inc42, Ankita Bose, the ousted CEO of Zilingo, reportedly awarded herself, co-founder Dhruv Kapoor, and chief operations officer Aadi Vaidya a large compensation raise between 2017 and 2019 without the board’s consent.

According to the study, her pay increased tenfold from SGD5,500 in 2017 to SGD58,900 in 2019. During this time, Kapoor’s and Vaidya’s net worth increased thrice and sevenfold, respectively.

GoMechanic founder Amit Bhasin admits to financial misreporting in a shocking admission. The corporation held a fire sale a little over a month ago. Zilingo’s assets and operations were also sold cheaply after a lengthy process. Zilingo had raised USD 342 million, while Trell had gathered USD 62 million in venture capital from investors who got almost nothing back.

Mojocare, a Series A stage healthcare firm, is the most recent to receive attention for anomalies.

One of their transgressions was gold-plating numerals. Peak XV is said to have invested around USD 200 million in Zilingo, BharatPe, Trell, and Mojocare.

Not only very active early-stage investors like Peak XV but also Info Edge, famed for funding Zomato and PolicyBazaar, have lately gone bankrupt.

Rahul Yadav pretended to lie when Info Edge, which invested USD 35 million in his firm 4B Networks, realised that the money ran out all too rapidly. The bulk of investors have now begun a forensic audit.

Then there were raids on several well-funded startups by tax officials and other regulatory organisations such as the Enforcement Directorate.

Byju has yet to release FY22 financials after having to restate company financials for FY21 due to auditors pointing out inconsistencies in its accounting practice. Deloitte, the business’s auditor, left around ten days ago, and the corporation is facing a major credibility issue.

A string of similar occurrences appears to have riled up some VC investors. They spare no one from the newly imposed strict terms in their zeal to nip any financial impropriety.

A 30-year-old Gurugram-based businessman was taken aback when possible investors demanded clearance for capital expenditures and compensation increases from the founders and top workers.

Prospective investors were requesting clawback provisions, yearly audits by a Big Four firm, and quarter statutory audits, the expenses of which would be borne by the company in light of the previous events of governance.

In a bad leave situation, the company will have the right. The impugned founder will be obligated to transfer his granted and unvested shares to an employee welfare trust, failing which the company will buy back the said vested and unvested shares at face value, according to a copy of a term sheet just offered to a businessman.

A terrible leaver scenario occurs when a shareholding executive is fired for fraud or serious misbehaviour or when they fail to achieve performance expectations.

Essentially, in this situation, the investor has secured that, in the event of a nasty divorce with the founder, the owner is entitled to transfer his ownership in the firm in the name of an employee ESOPs pooling or an employee welfare trust.

Considering that he is a renowned second-time entrepreneur who sold his first enterprise to a global corporation a few years ago, a slew of strict terms were offered.

It was not just the expense of the auditors but also the cost of the core staff focusing on these demands and devoting time to them. It would have used a significant portion of the company’s bandwidth. But they agreed so that nobody could allege someday that the founder had to hide anything. It would also be a question of business discipline. They asked for too much regarding access to and involvement in operational issues and clawbacks. By any standard, this is different from the norm, according to the entrepreneur.

He discovered this from his own experience. He needed to be explicit about these matters. When events are going well, agreements are struck. When events or arguments go wrong, they are always scrutinised. He recognises that these are merely spillover effects, but it’s not fair to characterise every founder based on a few events, the entrepreneur continues.

Existing investors jumped in for a follow-on round in this entrepreneur’s instance. While attempting to raise USD 20 mn, the entrepreneur shortened the offered size and pursued an internal contest.

However, not every entrepreneur is in the same boat as this second-time creator. Due to a lack of choices during the lengthy fundraising winter, many entrepreneurs would agree to the stringent restrictions imposed by investors.

Following the write-off in GoMechanic, Orios Venture Partners has also established an independent audit unit to do due diligence on firms it invests in. Orios is not alone, according to reports. SomeVC firms consider setting up an internal independent audit arm to minimise future headaches.

The environment has improved due to increased attentiveness and site visits. The requisition list has grown in size as investors request breakups in addition to line items. According to a partner at a renowned corporate law firm, there will be provisions for management calls every six months, and at some level, forensic accountants would be recruited to undertake due diligence before investing.

The private capital boom of 2017-2022 did nothing to aid in developing long-term company models and internal procedures. The startup community was captivated by untested startups quickly raising large sums of money. Several of these firms, while still in their infancy, went on to become famous unicorns.

In India, only a few of the 100 unicorns are expected to survive the next five years without significant cash infusions from their investors. While one-third of India’s unicorns are healthy and profitable, others still rely significantly on tier investors for survival.

Aside from solid company fundamentals, VCs and entrepreneurs acknowledge the need for robust procedures, controls, and governance structures, even if it means sacrificing growth.

And the winter funding season is ideal for such soul-searching and harsh repairs. Nobody is rushing.

Conclusion.

With multiple claims of fraud prompting investor-led probes, venture capital companies are establishing a series of pre-emptive criteria before transmitting the cash. They spare no one, including the second-time founders, in their haste to nip any form of financial oddity in the bud.