GoMechanic: Why Are Many Indian Start-Ups Caught In A Financial Mismanagement Mess?

The founder of GoMechanic, an Indian start-up last valued at $300 million, took to LinkedIn to reveal that the company had cooked its books.

The company had every ingredient an ideal start-up could have - strong brand recognition, wide outreach, founders from IIM-A, and top investors on the cap table. Yet, the company will now let go of nearly 70% of its staff. 

The start-up had already struggled with working capital issues resulting in payment delays. Hence, it had been trying to raise funds from Masayoshi Son's Softbank Group. However, the deal was withdrawn after the company failed to qualify on due diligence parameters. The financial misreporting, which came to light during the due diligence, forced the company to come clean. 

The new developments will undoubtedly make investors sceptical of investing in the start-up, making raising capital a difficult task. Reports suggest that the company inflated revenue numbers, added fictitious garages, and around six per cent of its 1,000 garages helped inflate revenue.

Not The First, Not The Last

GoMechanic is not the only start-up that has been pulled up for financial misreporting. 

Byju's, Zilingo, Infra. Market, BharatPe, Bikayi, Trell, and several other prominent start-ups have gotten into trouble over their financial reporting practices or for outright fraud cases. 

Several portfolio companies of venture capital fund Sequoia, have been hit by a spate of financial mismanagement allegations. 

Start-up frauds have rocked mature markets as well, with companies like Frank, FTX, and several others being investigated for fraud. One of the reasons for these sudden revelations of fraud is the increasing cautiousness of investors. 

With central banks tightening credit availability, valuations are falling lower in new rounds. Investors are becoming more cautious about new and existing investments, resulting in increased investor scrutiny. With dynamics changing, investor money is no longer chasing founders, resulting in more careful investments. 

To be sure, this is not a new phenomenon. Across cycles, frauds have usually been unearthed right after a period of the market boom. 

After the dot-com bust, several companies were found to use aggressive accounting practices or indulge in outright fraud. 

Similarly, after the infrastructure boom between 2003 and 2007, several infrastructure companies in the listed and unlisted space ran into trouble with government agencies, banks, shareholders and other stakeholders. There are several reasons why private companies could get away with unethical practices.

Usually, start-ups hire dedicated and qualified chief financial officers after reaching a certain size, resulting in the CEO or founders having a larger degree of control over financials. 

The lack of a CFO and Ashneer Grover's wife's control over finances was one of the key points of contention between investors of BharatPe and Grover. 

A differentiation in roles helps to prevent operational management from influencing accounting practices. 

In several cases, for both listed and unlisted companies, reputed auditors take financials at face value and pass them without qualifications – making it difficult for investors and outsiders to find signs of trouble early on. Similarly, basic accounting checks such as cash flows leading to profits are often futile in start-ups since they are loss-making and cash-burning entities.

 For instance, in the case of Go Mechanic, the financials for the financial year 2021 and financial year 2022 were passed without qualifications from reputed auditors – giving them a stamp of credibility. Unlike listed companies, disclosures aren't stipulated by regulation for private companies, allowing them to have a freer hand.

Growth At All Costs

To justify an investor's valuation and raise a new round, a company needs to demonstrate rapid growth. This becomes especially necessary when the valuations are incredibly frothy, as they were in 2020 and 2021. 

Private markets are more prone to froth than public markets since they aren't as liquid – resulting in a higher chance of asset mispricing. 

The incessant flow of money and limited investing opportunities resulted in high valuations, increased pressure to grow, and quite possibly lenient due diligence. 

In case growth is not forthcoming on the demand side, some founders would have found it easier to fudge numbers to raise money at a higher valuation in the next round. 

One difference between listed and unlisted financial misreporting in the Indian scenario is perhaps that managements of unlisted companies did so out of pressure to sustain valuations, while public market frauds usually involve promoters trying to enrich themselves at the cost of the minority shareholder.

Some of the ousted founders have alleged that there are more to these financial mismanagement allegations than meets the eye. They believe that investors conspired against them to take control of the company and tarnish their reputation. Whether these allegations are true or mere stunts to improve their public perception remains to be seen.