Why startups should be wary of payment defaults

A lot has been written about the unfortunate arrest of a startup’s co-founder over the non-payment of dues to a service provider and to the owner of the property that housed the startup’s offices. The main area of concern centres around the fact that the criminal justice system is used to assist in the recovery of money in what appears as a civil dispute. There are several reasons why this phenomenon is not new, and I’ll delve into these a bit more.

1. Access to formal, as opposed to informal lines of credit, usually determines the recourse for defaults. Approach a bank for a credit line for a new business, and it will insist on collateral either by securing business assets or through personal guarantees of the founders, third party guarantees, lien on personal FDs, etc. Default with the bank and it will sell assets that are mortgaged or hypothecated, cash in the FDs, call on the guarantors to make good any payment, and if there is still money that is due, recourse to civil court is available. Compare this with defaulting on informal lines of credit. Examples of informal lines of credit could be an advertising agency, the property-owner and even the newspaper or milk delivery agency – essentially anyone who provides a service and to whom money is due. Default on these lines of credit which are essentially unsecured and it usually leads to more serious consequences, such as a police complaint alleging cheating, criminal breach of trust, etc. From a practitioner’s perspective, it is common knowledge that the criminal justice system in India does sometimes provide an effective and cost-effective remedy, especially in cases where recovery of money is involved. Even the state provides for recourse to the criminal justice system for non-payment of dues. Default on depositing provident fund for employees, and the state authorises criminal action against a defaulting employer. Civil prison is the ‘end-game’ for all defaulters on income taxes that are legitimately due and remain unpaid.

Chetan Nagendra, Partner, AZB & Partners
2. Doing business in India is generally about relationships and references. This fact has not changed in millennia – whether one gets credit from the neighbourhood kirana store or approaches a bank manager for a loan, it is all about maintaining relationships. However, some new businesses tend to view this cultural phenomenon of relationships and being responsible for one’s fiscal activities from a purely transactional perspective. Culturally, it is not acceptable to break relationships and cite limited corporate liability to escape monetary liabilities. But, debtors often cite poor levels of service as a response to not paying bills. While this may be true in some instances, this is mostly used as a negotiating tool to pay less or nothing at all and usually serves as a warning sign to creditors that a relationship is on the fringes. Such responses will typically elicit stronger responses from creditors, before opting for a formal legal recourse. Creditors too will need to be wary of the cardinal rule of not overextending credit or pay money on behalf of defaulting clients.

3. Failing is fine but will need to be negotiated. Can’t pay bills because cash-flows are tight? Negotiate with the provider to come up with a payment plan or defer payments. Most startups often choose to close shop and disappear – the reputational risk far outweighs all. Startups also need to be constantly reminded that if they buy goods and services from third parties in support of their businesses, they will need to pay for these.

The eco-system will also need to mature so that startups and service providers are able to take a judicious view of the other to partake in services.

For instance, company credit reports that are a record of a firm’s credit history are only limited to data supplied by lending institutions across India (formal lines of credit). Perhaps there needs to be an evolved system of reporting of informal lines of credit so that both startups and service providers make informed lending decisions or negotiate better credit terms while doing business.

Payment lapses by startups serve as a warning sign to investors that a startup is faltering. Investors, who also sometimes play a role on the boards of startups they have invested in, would need to be wary of such defaults and attempts may need to be made to arrive at a fair settlement with creditors. Perhaps a good starting point would be for investors to choose nominating a financial officer to ensure fiscal responsibility in mature investee startups.

Chetan Nagendra is a partner at AZB & Partners. Views expressed are personal.

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