Startups Collapsing Because Capital Is Chasing Unsustainable Business Models Driven By Hype

Corporate governance issues at Gensol Engineering have rocked the Indian markets. Diversion of funds by promoters for personal uses, related party transactions and several other lapses have cropped up. This has again raised questions over effectiveness of checks and balances in new age companies. In a conversation with the Bizz Buzz, Shriram Subramanian, Founder & MD of proxy advisory firm, InGovern Research Services said that current regulations by the market regulator SEBI are enough for effective control within a company but should be implemented properly. He also said that greed of investors like PE & VC funds, has pushed many promoters to raise capital without a proper unit economics. Investors should also study the financials of a company, and know about their promoters before taking exposure to a company.

What is your initial reading into the issue of corporate governance lapses in Gensol Engineering? Can you provide some perspective into the matter?

SEBI has found out that promoters have used company funds as personal funds. They have used it for personal uses. The investigation has also found out evidence of channelising the funds through multi-layered companies for personal affairs. There also have been related party transactions through diversion of funds from Gensol Engineering to BluSmart.

When there is an intention to defraud, there are high chances that people will do fraudulent activities. In this case, there has been forged letters of PFC and IRDEA (regarding loan repayment). It is difficult to prevent such gross fraudulent activities. There are, of course, in place some structures to prevent such activities. Independent directors, auditors and others can find out such actions.

Do you feel that all the checks and balances within Gensol Engineering were not able to prevent such a fraud by promoters? Were there red flags earlier?

There have been some concerns regarding corporate governance issues earlier when two CFOs (Chief Financial Officers) were changed at Gensol Engineering. Even, pledging of shares by promoters was also seen as a red flag. (Around 81 per cent of promoters’ share in Gensol has been pledged). Use of social media and hiring of influencers by promoters were another area of concerns.

India has seen several lapses of corporate governance over the years. What will be your prescription to mitigate or at least reduce, such risks for investors?

There is no full-proof mechanism to mitigate such risks. Such events are happening worldwide. However, investors need to aware about these things. For instance, investors should understand how social media is being used to build promoter’s profile; how influencers are being used? Of course, SEBI has cracked down on influencers and come up with guidelines now.

Investors should evaluate company carefully. In many instances, investors’ greed has fuelled such behaviour of promoters. So, there are several regulations and these should be implemented properly.

India equity markets have seen listing of SMEs with irrational investors’ interest. With market correction, many of these companies have witnessed steep correction in their stock prices. Do you think, investors’ awareness should be increased in India to protect retail investors?

Investors should do slightly deeper analysis of a company. They shouldn’t think of it (IPO) as a lottery. They should evaluate the long-term prospect of the company with good knowledge about the promoters. Of course, when the equity market is on a bull run, investors’ caution level goes down. That is happening since Tulip mania. That is the nature of human beings. When the party is on, everyone wants to participate.

What kind of measures should be taken to put effective checks and balances in the startup ecosystem? Can you provide a perspective in this matter?

If the startup has enough control, then corporate governance is not a problem. There are also instances of greed of investors seen in the startup ecosystem. PE funds fuel the greed of promoters. Without proper unit economics, PE funds push promoters to raise next round of funding. This has led to downfall of many marquee startups. The company grows in a measured manner, there is enough opportunity for all. But if the growth is greed-fuelled, then that will not be sustainable.

One school of thought is of the opinion that startups should not be flushed with capital as that leads to financial indiscipline. What is your opinion about this matter? Does scarcity of capital lead to frugal innovation?

Momentarily, scarcity of capital is good. Measured scarcity of capital is good. Too much capital surplus was seen when the US interest rates went down. That led to investors pushing for bad behaviour among promoters. There were many instances wherein fishy businesses were promoted. This happened because too much of capital was chasing lesser number of businesses. So, the availability of capital should be optimum.

Valuations of startups have always been a contentious issue. Have valuations gone down to realistic level in last two years owing to funding winter?

There is no matrix for valuation. So, there will never be one way of valuing a company. Valuation is both arts and science. There is not a single right answer on valuation. But only chasing growth for pushing valuations without regard for profitability is not a good thing. Moreover, good governance practices are critical.

It has been seen that some startups are reporting profits in lieu of good income from treasury operations than operating income. What the investors should do in such cases?

During initial years, if the operational cashflow is negative, that is fine. If a company is building a software product, then operational cashflow may be negative for initial years. But, sustained negative cashflow will lead to death of the company.

With the advent of AI & GenAI, some experts are predicting that it may pose threat to traditional business models of Indian IT services firms. Will such factors be considered at the time of valuing Indian IT firms now?

Of course, generative AI is transforming many businesses across the world. It has to be seen how this new technology impacts Indian IT services companies. In long-term, these companies may get more business due to this technology. But it has to be seen how this plays out for Indian IT firms in the short-term. For SaaS companies, they will integrate GenAI applications.

How GenAI is transforming the corporate governance space? Can you provide a perspective in this matter?

GenAI gives access to more data regarding companies. So, the new technology will be used for repetitive tasks. More data will lead to more insights. But corporate governance also deals with human nature like greed. So, it will be a combination of technology and human factors.