How Should Startups Implement

Corporate Governance Mechanisms?

Governance issues are mistakenly presumed to be relevant for companies which are
large or are listed on a stock exchange. However, the foundations of governance are laid
down in the initial stages of a company, and we can’t afford to miss the relevance of
governance there. Sound corporate governance can be a factor in the success of
businesses.

For example, co-founder disputes are one of the key reasons for the failure of startups.
Cofounder disputes can arise on a variety of issues, but we fail to see that having sound
governance principles can reduce the likelihood of such disputes and friction. This can
also go a long way in discouraging unproductive interactions in amongst team members,
‘office politics’ and gossip.

This chapter will discuss the most critical areas around corporate governance that must
be addressed at the startup stage itself. By corporate governance at startups, we are
including governance principles to be followed by partnership firms and LLPs as well.

Questions that must be addressed

Certain questions which need to be answered for each area highlighted below are
common:

- Can i) one founder take a decision on these matters or is ii) all founders’ consent
required or iii) is a majority of founders’ consent is required?

- Is both founders’ consent required on all matters or can each founder take
decisions on the area of his or her expertise?

- How is the interest of any external person to be protected? Do they have a

nominee director or an observer who is up to date with the progress at the
company? Do the founders want to put in additional communication mechanisms
to keep investors updated so that they are not taken by surprise?

Key Areas / Interfaces of Corporate Governance For

Startups

1. Business Restrictions in articles and contracts

Are there any restrictions or ‘reserved matters’ in the articles of association,

investment agreements and loan documents?

For example, if you obtain even the simplest of credit facilities such as a bank
overdraft, you might realize there are restrictions on any amendment to your
articles or LLP agreement, declaration of dividends, change of capital structure,

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 entry into joint ventures, diversification of business model, etc. These clauses
function as governance restrictions for the company. Founders are free to insert
such limitations to ensure sound governance and prevent unilateral action. Most
startups use a vanilla format of articles from the Companies Act or draft a vanilla
LLP Agreement, but they forget that this is the opportunity to define actual
limitations on abuse of co-founder powers.

Similarly, shareholders agreements contain many restrictions and ‘affirmative

voting rights’ in favour of investors, so that founders must obtain their consent
before taking decisions of a certain magnitude or decisions on certain matters.
The intention is not to limit the business judgment of founders but to ‘protect’ the
investment of an investor (although in reality it might really prevent startups from
pivoting their business model and adapting fast to newer realities).

Here, we are suggesting that even startups which are not funded or are otherwise
profitable can have agreed principles laid down in their ​co-founders agreement​,
articles, LLP / partnership agreement or simply as board resolutions. ​Even if these
are orally agreed by the founders, it will make sense if they are recorded in a
partner’s or a board meeting. Some of these terms look similar to the terms in
investment agreements, while some additional terms have been added to stay in
tune with the business reality that early stage startups face. Go through the
discussion below to identify where you should place checks on founder’s powers.

2. Specific issues on which co-founders / partners must mandatorily arrive

at a joint stand

Apart from any business restrictions that you may already notice in the articles or
in investment/loan agreements, we have identified certain issues on which
founders ​must​ arrive at an agreed stance beforehand and listed them below:

- Hiring decisions and authority

Apart from the questions above, also answer this: Where the work of
someone is not directly supervised by a founder, should the opinion of the
head of the team be involved in making a hiring decision? Should the
founder be hands-off or should he or she be present to support through the
decision-making process?

- Firing decisions and authority​ - Same questions as for hiring

- Taking new office space on lease

- Expenditure (see below)

- Change in the manner of utilization of investment funds

- Sale of any company assets (e.g. furniture, computer,etc.)

- Obtaining loans

- Extending loans to employees or anyone else on behalf of the company

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 - Extending credit to vendors or modifying credit terms

- Creation of or investment into new products

- Initiating legal action against someone

- Amendment of company policies or introduction of new company policies

- Execution or amendment of any legal documents such as employment

agreements

- Modification of terms of any standard legal documents or contracts of the

company

- Issuance of equity and stock options, or conclusion of terms of association

with potential advisors

3. Ability to sign contracts and enter into deals / collaborations

Who has the ability to sign and negotiate contracts and undertake joint initiatives
or co-branding activities? Is consent of all co-founders required or is there some
kind of division of roles? These kind of restrictions can be very well-recorded for
future purposes in board resolutions. Founders simply need to email these to each
other and keep signed printouts on the letterhead and stamp of the company to
create a valid document trail.

Read how Eduardo Saverin was ousted from active management of Facebook, and
you will be able to see how much the chances of co-founder disputes can be
reduced if corporate governance mechanisms are implemented at this stage itself.

4. Who has financial authority? What are the caps on spending?

How much expenditure can a single founder undertake on the company’s behalf?
When is approval of all founders required? Can one founder operate the bank
account singly or is a joint signature required for expenses exceeding a certain
amount? In which situation and for which purposes can the company’s finance
team/co-founders decide to use the overdraft facility?

When you open a current account, you will need to specify the mode of operation
of the bank account. You will need to pass a board resolution/partner’s resolution
for the same. It must be consistent with the terms specified in the LLP Agreement
or the Articles. For example, if the articles are silent or if they state that the limit
on financial expenditure / operating a bank account may be specified by a board
resolution, you can specify any limit, say, INR 50,000. If however, the articles
state that there is a financial limit of INR 50,000 per transaction per founder /
partner, then you cannot specify a higher limit without first amending the articles.

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Practical guidelines for reporting and ensuring checks
and balances

1. For financial matters, merely informing the bank about the mode of operation of
your current account will not be sufficient. You will need to observe additional
internal reporting processes and checks to ensure that limits on financial spending
are complied with. Netbanking options of various banks do not automatically
incorporate these restrictions. Similarly, at the startup stage founders often use
their personal credit cards to incur certain business expenses on behalf of the
company. You will need to ensure that credit card expenses and net-banking
expenses also comply with such restrictions on financial expenditure.

2. All decisions, variations or modifications around the above matters must be

recorded. On many occasions, it is important to take a decision on the spot, when
you may need to resort to phone or instant messaging. However, we suggest that
you place all such communication in writing subsequently over email. All such
emails should be put in a folder. Any variation or a new stance on company policy
must also be mandatorily recorded on email.

3. You can also set in a fortnightly/weekly call structure where founders invite each
other to share information about pre-identified governance topics, such as
financial expenditures, business decisions and policy stances (in a safe way), so
that inadvertent errors are not made. Brief written records of this must be
preserved with the other emails (in Google Drive, Dropbox or any method the
company chooses).

4. At the last level, record of the decision on all items from points 1 - 3 must be
aggregated, recorded and ratified by the company on a quarterly basis, in the
board or partner-level meeting.

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