The Business Times' Column | Due Diligence: The role of venture capital in managing startups

*This column was first published on *The Business Times

Recent turmoil at venture capital-backed startups has rattled the ecosystem across South and South-east Asia, leaving founders in hot water with investors for reasons ranging from mismanagement of the business to bringing on reputational risks for the investors. In the first of this new column “Due Diligence”, we would like to share our thoughts on the role of VCs in managing and guiding portfolio companies, specifically in matters of enforcing corporate governance to avoid such painful scenarios.

In startups, which are small-scale and high-growth businesses, most investors understand that there is a delicate balance between performance and conformance. If we require founders to do a huge amount of reporting, it will take their time away from running the business and generating profits. Furthermore, reporting to investors is far less exciting and energising than developing a new revenue stream. However, as VCs, we are accountable to our limited partners, who invest their money into our fund. Over the years, we see that the most sustainable approach is for VCs to work as a close partner and advisor to founders, implement basic check-and-balance systems like a board of directors and a set of effective reserved matters, and be on an active lookout for telltale signs of trouble.

VCs lead sustained “due diligence” efforts

Before any VC invests in a start-up, they would carry out due diligence – which is known as the process of gathering and making sense of information from various sources, to verify that what founders are presenting is true and accurate.

However, our experience informs us that the “due diligence” shouldn’t stop at the initial stage. There is a need for investors (especially with large shareholding in the company such as 10 per cent or more) to continue to have good oversight over the startup’s business and even create a simple yet reliable system around the data gathering and checking process.

As a startup grows and attracts new customers, investors and stakeholders, the business evolves. It is important for VCs to stay abreast of these changes in order to root out or anticipate challenges which may plague the startup. This will help the VC decide whether to participate in the next fundraising round. Even if the VC may not lead or participate in the next round of fundraising, it is still important for them to be aware and informed of who their co-investors in the company are, how their goals may be aligned or misaligned, any changes in reserved matters and any other potential issues arising from the startup expanding and diversifying.

Having worked in the VC space for a while, I would say our fund collaborates with founders in a unique manner – we invest extremely selectively, and truly believe that beyond providing capital and connections, we prefer to be an active, involved and close partner to the founders. In doing so, we are able to help them foresee issues in the business through our regular conversations before they arise, and help equip the founders to respond to them adequately.

As most would agree, cashflow is the lifeblood of any business. Hence, one area we discuss often is the cash flow situation and statements to gain insight into the state of the business, during our regular catch-ups with founders. We recommend having at least nine months of runway to ensure that the business does not run out of cash. From past experience, it may take the founders as long as six months to raise a new round, leaving the startup and existing investors in a lurch if funds are not gathered in time. Apart from that, for startups that are operating in more than one market, it may be challenging for them to get a clear picture of the cashflow. This is where we would also advise that they create processes and have a reliable system around capturing their revenue and cash positions.

Participate as an active board member or observer

In addition to having a close relationship with founders, participating in the board is an important part of a VC’s role in management of portfolio companies.

In Singapore, private businesses whose revenue is less than S$10 million do not need to be audited, so most startups are not subjected to audits. This means that there is no audit committee which is charged with the governance responsibility of ensuring the integrity of financial statements and announcements. Hence, the board plays a vital role in private companies.

When a VC leads a priced round of a startup company, they typically appoint one of their partners to sit on the board of the startup. The board is an entity which is entrusted with fiduciary duties – meaning they are obliged to work in the company’s best interests.

The board serves to guide a company through critical junctures of its growth such as by creating an overarching business strategy, hiring or firing senior management and most importantly, providing oversight on the company’s internal governance matters. Mindfully and strategically selected boards are able to use their sharp, eagle-eyed view from the top (or even from the ground if they are common shareholders!) to help the startup navigate or entirely avoid legal and compliance-related issues which may crop up with time. And beyond helping out during times of crisis, the presence of a board sends a strong signal to investors and external stakeholders that the startup is in responsible hands and is capable of making big decisions in a sound manner.

Even if we are not a board director or observer, we would also encourage the startup to record board minutes and share them with us so that we can review and anticipate issues that may arise in future.

Constantly make sure that the terms and reserved matters in new investment rounds still make sense

Whenever a VC makes an investment, the partner will make sure that they set up adequate safeguards through the terms stipulated in the reserved matters. The obvious terms include seeking our approval when committing or spending or borrowing or lending out capital exceeding a certain threshold, issuing any instrument that is convertible into equity, making any merger or acquisition decisions, setting up a joint venture and appointment or dismissal of Key Persons. Key Persons refer to the chief executive officer (CEO), chief operating officer (COO) and other senior positions. If terms set out in the agreements are breached, there will be consequences such as dismissal.

When the founders raise the next round, even when we are not leading the round, we will still examine the terms and reserved matters, making sure that there are enough safeguards in place. These safeguards are not fool-proof, but they provide a framework to guide our founders and ensure that they are prudent and accountable in their decision-making process.

Recognise red flags in founders

Finally, corporate governance is hard to enforce or police in startups, even when there is a safeguard in the form of board members or independent directors. Compounding this issue is that VCs normally invest in a large number of companies and paying close attention to each of them may not be feasible.

For us, we invest selectively (over 70 portfolio companies across our funds of US$1 billion in assets under management) so that the appointed board director will have time to work with the portfolio company to embrace governance expectations. As the saying goes, “prevention is better than cure”. We want to anticipate issues and nip them in the bud before they escalate. From our long and established history of investing in many startups across the region including six unicorns, here are the common tell-tale signs when things are not going well in the company:

• Unkempt physical appearance (that is out of ordinary for the founder) at meetings
• Prolonged delay in arranging meetings with investors
• Prolonged delay or failure to file annual financial statements (this can result in a fine of up to S$600 in Singapore)
• High resignation rates, especially of employees in executive positions or cofounders
• Refusal to hire a professional chief financial officer (CFO) or doesn’t hire a new CFO after the former is proven incompetent
• No or little justification for expansions to markets that are not relevant to the business
• Refusal to let investors to visit the venue of operations

Some of these red flags have consequences as they are in breach of statutory obligations, but we don’t think that a penalty of SS$600 would act as sufficient deterrence for “bad players”. It is still critical for VCs to be observant and detect undercurrents.

With a never ending list of things to do, yet with limited resources, startup founders can find it extremely difficult to put aside time for matters relating to corporate governance. This is where the VC and investors come in as a partner, to advise, guide and prevent issues on the onset.

Thanks for reading, watch out for our next Column coming out third Monday of each month on the The Business Times.

Edited by Elise Tan, Director, Vertex Ventures Southeast Asia & India.

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