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Startups in distress: Navigating legal complexities

In the dynamic world of startups, where innovation and risk-taking are paramount, allegations of misconduct, financial irregularities, and inflated valuation can emerge as formidable challenges. This demands a comprehensive approach to defense that combines business insight, legal proficiency, litigation tactics, and advisory experience.

Startups operate within intricate ecosystems where innovation, financial transactions, intellectual property, and corporate governance intertwine. More often than earlier, we are seeing allegations raised against startups and their founders claiming criminal misconduct, cheating, financial irregularities, and inflated valuations committed on investors, vendors, and other external and internal stakeholders. These allegations often have the effect of putting a complete stop to the business, sending the founders into a cocoon, scared and disoriented, and resulting in an economic and reputational loss to all stakeholders.

The allegations are, almost always, having legal consequences and the remedy lies in law as well as prudence. Of course, the remedy has to be initiated in a timely manner and hence legal advice has to be immediately sought and lawyers brought on board. This piece pens down some notes on key points to be kept in mind while approaching these legal complexities and endeavoring to reemerge unscathed.

1. Commit no fresh mistakes

Since times are tough, it is common to react emotionally and imprudently to situations, resulting in undesirable and costly mistakes. Some examples of 'fresh mistakes', in the context of a distressed startup, would include:

Fresh Mistakes - Data destruction or tampering, misleading communication, improper asset transfer, misreporting financial information, employee mistreatment, breach of confidentiality, ignoring compliance and tax obligations, misallocation of funds, unilateral agreements, ignoring IPRs

Whatever has happened, is a thing of the past. At times it is harder to rectify or defend the fresh mistakes than the original allegations. Also, discovery of these mistakes gives credibility to the original allegations and demonstrates that they had substance.

Bringing lawyers on board should immediately implement a 'No-Fresh-Mistakes' policy. Legal experts bring in knowledge and experience and a dispassionate approach to situation-salvaging, offering invaluable insights to steer the company in the right direction. Legal handholding is not just about addressing past missteps but also about fortifying the startup's foundation to prevent new pitfalls.

2. Do a comprehensive legal assessment

The situation-assessment involves understanding the startup's financial status, contractual obligations, intellectual property assets, regulatory compliance, and potential criminal, civil, tax, and other regulatory liabilities. By gaining a clear picture of the company's circumstances, lawyers can provide founders with accurate advice and strategic recommendations.

The outcome of this exercise is manifold. First is to separate real issues from mythical fears - it is surprising at times that people are fearing criminal consequences in purely civil or contractual matters - myths need to be busted and energies refocused on what really matters. Second is to ensure that the lawyers are all geared up for the problem solving - something like the 'reading' exercise for a court case - and unless the lawyers are having the entire and accurate background knowledge, the representation they'll be able to offer would be sub-perfect. Also, a comprehensive assessment would force an early document or evidence collation, prioritize the to-dos, and ensure that resources are allocated properly to routine and non-routine tasks.

3. Understand each other's languages, and adopt a holistic approach

While the lawyers may know law and business in general, the founders know their startups the best. Crafting the most robust defense for a distressed startup hinges on a collaborative synergy where lawyers gain insights into the unique intricacies of the startup, and founders gain a nuanced understanding of the legal landscape. This way, a dynamic partnership emerges. Through this symbiotic exchange, lawyers and founders collaboratively shape a defense strategy that leverages their collective expertise, resulting in an exceptionally tailored approach to safeguarding the startup's and founders' interests and charting a path towards resurgence.

Next, it's of utmost importance that the defense is built using a holistic approach combining business and legal explanations. Law and courts are well-versed with the twofold bifurcation of questions that they address - (i) Law, and (ii) Facts. The entire legal procedure is built on this classification premise. While law is important and crucial, it is open to interpretation. Facts, on the other hand, are easy to discover and generally unalterable.

Illustration A startup 'XCo' and its founders A and B are alleged with having committed financial misconduct by inflating their sales. The sales are allegedly inflated by selling goods to related parties and receiving the monies back in cash. Here, the 'factual' defense would include things such as: (i) the sales figures are accurately reported in the books of XCo (ii) sales contracts are available on record (iii) sales were made by XCo to companies, even though the directors / shareholders of these companies are known or related to A and B (iv) no money trail of any cash receipt by A or B has been discovered. The 'legal' defense would include, for instance: (a) books of account represent the true state of affairs of the company and hence are reliable (b) availability of sales contracts demonstrates the 'form' of the transaction being proper (c) buyer companies are separate legal entities as per law, distinct from their shareholders / directors and hence the allegation of selling to related parties is baseless (d) there is no evidence to incriminate the founders because they have not made any 'wrongful gain' and hence there is no intention that is evident for having inflated the sales.

A holistic approach, where legal expertise is combined with the business experience and realities, and where the defense is built jointly on legal interpretations as well as factual rebuttals, is the most desirable.

4. Learn from the big, implement processes

While the above allegations might appear daunting, there's a valuable lesson that startups can glean from larger organizations. Large companies, at times 'too big to jail', with their organized approach and extensive operations, possess the capacity to recover from such setbacks and continue their operations. By observing their methods, startups can derive insights into establishing structured responses to allegations, prioritizing thorough investigations, and implementing crisis management strategies. Emulating large companies' emphasis on organizational structure, dedicated legal support, and efficient governance frameworks can equip startups to address allegations while maintaining their momentum towards growth. Lawyers, having experience in dealing with situations in organizations of varied sizes and operations, can assist the startups and founders in adopting this motivation and philosophy.

5. Remember: Merit is of paramount importance

Merit is often overlooked in the quest of short-term, immediate, reactive solutions. For instance, Courts often conclude that initiation of investigation into a matter or a person (say, filing an FIR), does not amount to harassment and hence such person needn't be heard prior to starting the investigation. The underlying philosophy is - if the merit of your case is strong, no amount of investigation can incriminate you.

Now, what constitutes merit? It is all the things that would amount to prove that the allegations are baseless. And these 'things' could be anything - an email communication, a WhatsApp chat, personal profile, educational achievements, company policies, investor intentions, intellectual property ownership - literally, anything. The end result is that when all these things are put together, it should clearly establish the innocence of the business and the people running it. Discovering, collating, and putting these things together, is a comprehensive exercise and should form the core of the endeavor.

Illustration A startup is on the verge of closing down. Amongst other things, an investor alleged a breach of warranty against the founders and invoked indemnity. The breach of warranty was alleged on the basis of a tax notice/demand received after the investment, for a period prior to the investment. In the above, the indemnity would not be enforceable because the tax issue was disclosed to the investor during the due diligence process and hence the warranty stood qualified. In fact, for such prior period indemnity claims (frequently arising during the times of distress), the availability of experts, lawyers, and chartered accountants with the investor at the time of investment and the fact that such issue was not pointed out at the time of due diligence works against the investor. Courts pay much regard to this fact and in many cases the courts have denied any interim relief to investors solely on the ground that their decision was a sound, reasoned decision, and since the investor had gone ahead with the investment despite the knowledge of the issue, he could not cry foul subsequently. Similarly, many a time we see a forensic audit being initiated on the startup's accounts and financials for periods prior to the investment. Legal and tax due diligence is a must-to-be-done exercise for any serious investment. Given that a due diligence was already conducted, and the investment has taken place, a forensic audit throwing up issues which were okayed in due diligence would be strange. Alleging breach of warranties on the basis of such forensic audit findings would be difficult to establish in a legal process.


In conclusion, addressing allegations of misconduct and financial irregularities in distressed startups demands a multifaceted and strategic approach. By heeding the lessons learned from larger corporations, implementing thorough legal assessments, and fostering collaborative partnerships between legal experts and startup founders, a solid defense can be constructed. The imperative 'No-Fresh-Mistakes' policy, guided by legal insights, can prevent further complications and safeguard the startup's interests. A comprehensive legal assessment offers founders a clear roadmap, separating factual issues from myths and enabling efficient resource allocation. The fusion of legal and business perspectives in the defense strategy, combined with a focus on merit and diligent adherence to due processes, lays the groundwork for a robust defense. Ultimately, startups can learn from established methodologies while tailoring their approach to their unique circumstances, ensuring resilience, recovery, and sustainable growth even in the face of adversity.

Authored by Vikas Kumar, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.


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