Beyond The Pitch Deck: Legal And Ethical Failures In Start-Up Fundraising And The Crisis Of Accountability In India’s Venture Ecosystem

I.         INTRODUCTION

India’s startup ecosystem has evolved from nascent digital ventures in the early 2010s to a high-growth engine with over 110 unicorns and more than 159,000 Department for Promotion of Industry and Internal Trade (“DPIIT”)- recognised startups as of January 2025, positioning India as the third-largest startup ecosystem globally. Bolstered by venture capital (“VC”) and foreign institutional investments, startups have unlocked new markets, created millions of jobs, and shaped India’s global innovation profile. The ecosystem was further catalysed by the launch of the Startup India initiative in 2016, alongside eased incorporation norms and improved capital access. Driving sectors include fintech, edtech, health-tech, logistics, and direct-to-consumer (“D2C”) brands, alongside rapidly growing fintech innovation supported by India’s Digital Public Infrastructure. ¹

II.         THE LEGAL FRAMEWORK GOVERNING STARTUPS IN INDIA

India’s start-up ecosystem, though informally characterised, operates within a rigorous legal framework governed by the Companies Act (“CA”), Securities and Exchange Board of India regulations (“SEBI”), and Foreign Exchange Management Act (“FEMA”). All private limited companies are subject to statutory compliance, including financial disclosures (Sections 92 and 137), governance obligations, and fiduciary duties under Section 166, with fraudulent conduct punishable under Section 447 of CA. SEBI assumes jurisdiction where startups raise capital via Alternative Investment Funds (“AIFs”), Initial Public Offerings (“IPOs”), or crowd platforms, particularly in cases involving insider trading or misrepresentation under the 2003 Regulations. Foreign investment and External Commercial Borrowings (“ECBs”) must comply with FEMA and Reserve Bank of India (“RBI”) directives, with violations attracting penalties under Section 13. While DPIIT recognition under Start-Up India offers regulatory benefits, it does not exempt startups from legal compliance, nor does it provide a mechanism to oversee fund utilisation or governance failures.

III.         FUNDRAISING COMPLIANCE: WHAT STARTUPS MUST DO

Fundraising by startups is a legally significant act that gives rise to binding contractual and fiduciary obligations, requiring strict compliance with regulatory and corporate norms from the seed stage through institutional investment. Startups must maintain financial transparency, ensure clean governance records, and adhere to shareholder agreements that define rights, protections, and exit terms. Failure to disclose material facts, such as litigation, related-party transactions, or founder exits, may attract liability under Section 447 of CA the Companies Act or Section 17 of the Indian Contract Act (“ICA”). Improper structuring of Employee Stock Option Plans (“ESOPs”) or deviation from agreed terms may also result in labour claims, contractual breaches, and regulatory penalties.

IV.         ANATOMY OF FUNDRAISING FAILURES

Despite the existence of a robust legal and regulatory framework, several startups routinely deviate from prescribed norms during fundraising, leading to significant legal exposure, investor disputes, and regulatory scrutiny. These failures may be categorised as pre-funding misconduct, post-funding abuse, and structural governance lapses, each carrying distinct legal consequences.

• Suppression of Material Disclosures- Founders may conceal critical facts such as ESOP liabilities, pending litigation, founder exits, or related-party Due diligence is often compromised due to unaudited financials, redacted MIS reports, or absence of forensic verification, especially in early-stage rounds.
• Misuse of SPVs and Complex Ownership Structures- Special Purpose Vehicles (“SPVs”), although intended to isolate risk, are frequently misused to divert funds, obscure beneficial ownership, and bypass board oversight. Promoters often retain effective control over such entities, compromising transparency and enforceability of shareholder rights.
• Post-Funding Diversion of Investor Capital- Startups may divert funds towards unrelated or personal expenses, including affiliated vendor payments and unjustified reimbursements. Lack of board approvals for such transactions constitutes a breach of CA particularly contravening Sections 179 and 166 and may also amount to criminal breach of trust under Section 405 of the Indian Penal Code (“IPC”) and corporate fraud under Section 447 of CA.
• Financial Manipulation and Valuation Distortion- Techniques such as round tripping or fictitious invoicing are used to inflate revenues and justify inflated valuations. These actions can result in civil and criminal liability for fraud, misrepresentation, and accounting irregularities.
• ESOP Mismanagement- Common violations include backdating of grants, denial of vested options, and lack of disclosure regarding valuation or tax Such practices may constitute breach of contract, employee misclassification, and fraud under Section 447 of the CA.
• Breach of SHA/SSA Obligations- Startups often fail to comply with reporting obligations, suppress board-level information, or ignore investor veto rights. In some instances, founders retain IP in personal names or affiliated entities, violating fiduciary duties              under               Section              166               of                        the                   CA.
• Securities-Like Promises and Regulatory Breach- Founders, especially in fintech and crypto ventures, may offer fixed returns, effectively creating unregistered securities. Such conduct exposes the entity and its promoters to regulatory action by SEBI under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market Regulations, 2003), (“PFUTP”).
• Poorly Structured or Absent Exit Mechanisms- Investor exits are often undefined or unenforceable due to the absence of buyback triggers, drag-along/tag-along rights, or valuation clarity. Disputes frequently arise during down-rounds or liquidation events, exacerbated by    stale    or    manipulated    financial   
• Strategic Consequences- These failures demonstrate that legal compliance must be treated as a foundational element of fundraising, not a procedural The role of legal advisors is crucial in structuring enforceable documentation, conducting forensic diligence, and preserving investor protection from inception.

V.         WHERE THE SYSTEM FAILS: COMMON LEGAL AND ETHICAL VIOLATIONS

Despite the presence of a comprehensive statutory framework, several Indian startups persistently breach their legal obligations, driven by inadequate oversight, founder dominance, and superficial compliance cultures. The most common violations are detailed below.

• Fabrication of Performance Metrics- Startups frequently inflate key performance indicators such as Gross Merchandise Value (“GMV”), Monthly Active Users (“MAU”), and projected revenue run rates to attract higher valuations or subsequent funding. In the case of GoMechanic, founders admitted to fabricating financial data presented to investors. Such conduct constitutes fraud under Section 447 of the CA, false statement liability under Section 448, and may also give rise to claims for negligent misrepresentation under contract and tort law, particularly where investors rely on such data to enter into binding funding arrangements.²
• Round-Tripping and Valuation Manipulation- To create the illusion of financial strength or scale, startups often route funds through shell entities or related-party vendors to fabricate expenses or inflate turnover. This practice was suspected in Trell, where vendors were allegedly affiliated with Such actions violate Section 188 of the CA, which regulates related-party transactions, and may attract disallowance under Section 40A (2) of the Income Tax Act (“IT Act”) ³ where expenses are deemed excessive or bogus. In more severe cases, where fund flow structures lack economic substance, the conduct may trigger proceedings under the Prevention of Money Laundering Act (“PMLA”).
• Lack of Effective Board Oversight- Founders often sideline independent directors, suppress material disclosures from the board, and bypass audit committees—diluting the checks and balances envisioned under company law. The Zilingo matter brought these failures to light, where internal irregularities were allegedly concealed from the board, culminating in the CEO’s ⁴ These practices contravene Section 166 of the CA, which mandates that directors act in good faith and in the best interest of the company. Persistent failures in governance may also attract disqualification of directors under Section 164(2) of CA.
• Mismanagement of ESOPs- ESOPs while designed to align employee interests with long-term company performance, are frequently misused. Common irregularities include backdated grant letters, unjustified denial of vested options, and lack of transparency in valuation or tax Such practices may violate Section 62(1)(b) of the CA governing share issuance, breach ESOP valuation norms under Rule 11UA of the IT Act and expose the company to class-action suits under Section 245 of CA where a   collective   group   of   employees   suffer   prejudice.
• Misuse of Investor Funds- Investor capital is often misappropriated post-funding through fictitious vendor payments or unauthorised reimbursements that lack board sanction. In BharatPe, internal governance reviews revealed financial improprieties of this Such conduct amounts to criminal breach of trust under Section 405 of IPC, cheating under Section 420, and corporate fraud under Section 447 of CA.⁵ It also constitutes a material breach of the shareholders’ agreement and investor covenants, potentially enabling legal recourse including civil recovery and regulatory intervention.
• Undisclosed Conflicts of Interest- Founders frequently engage in undisclosed transactions with entities controlled by themselves or close affiliates. These arrangements often involve awarding contracts or transferring value to family-run vendors without board disclosure or approval. Such conduct breaches Section 184 of CA, which mandates disclosure of interest by directors, and Section 188, which requires prior approval for related-party transactions. The suppression of such information also violates the general fiduciary duties of directors under Section 166, giving rise to liability for conflict of interest and self-dealing.

VI.         JUDICIAL PRECEDENTS 

1. BharatPe / BluSmart-related ED actions (2025): Although still under investigation, both companies faced allegations of fund diversion and shell transactions, triggering insolvency proceedings and potential criminal recourse under IPC Sections 405, 420, and Section 447 of the Companies Act. ⁶
2. Trell (internal investigations, 2022): Allegations of shell entities and insider-linked vendor transactions that potentially violate Section 188 of the Companies Act and Section 40A (2) of the Income Tax Act, with PMLA implications in cases of fund ⁷
3. Needle Industries India v. Needle Industries Newey Holding Ltd. (SC, 1981Needle Industries Case (Needle Industries (India) Ltd. V. Needle Industries Newey (India) Holding Ltd., (1981) 3 SCC 333): Affirmed director duties to avoid conflicts of interest and operate in good faith, applicable in ESOP disputes and director-controlled issuances under Sections 62 and 166.
4. Tata Sons Case (Cyrus Investments Ltd. V. Tata Sons Ltd., (2019) 4 SCC 534): The Tata Sons case brought to the forefront the complexities of fiduciary duties within the context of corporate governance in large conglomerates. The National Company Law Tribunal (NCLT) and subsequently, the Supreme Court, examined the conduct of directors in relation to the company's interests, setting a precedent on the interpretation of fiduciary obligations in India's corporate landscape.
5. Zilingo Escalation (2022): CEO suspension after board-encountered irregularities; investor scrutiny revealed conflict-of-interest and governance lapses implicating Sections 184 and 188, alongside fiduciary breach under Section 166.⁸

VII.         THE CRISIS OF ACCOUNTABILITY IN INDIA’S VENTURE CAPITAL ECOSYSTEM

India’s venture capital ecosystem, while instrumental in driving innovation and scale, is increasingly marred by a crisis of accountability rooted in asymmetrical power dynamics, founder dominance, and fragmented enforcement. In many cases, capital is deployed with limited scrutiny of governance practices, and post-investment monitoring remains perfunctory. The absence of sector-specific regulatory oversight for early-stage ventures allows misconduct, ranging from financial misstatements to misuse of investor funds to go unchecked until it manifests in litigation or public scandal. While contractual instruments such as shareholder agreements provide a foundation for investor protection, their efficacy is often undermined by information asymmetry, complex holding structures, and delays in enforcement. The current regulatory apparatus, split between the Ministry of Corporate Affairs, SEBI, and other agencies, lacks a unified mandate to oversee the conduct of private startups, especially where fund flows involve offshore SPVs, AIFs, or grey-market intermediaries. As a result, legal recourse often remains reactive, fragmented, and ineffective, allowing egregious governance failures to persist with impunity. insolvency stages.

VIII.         COMBATTING THE CRISIS: LEGAL AND POLICY RECOMMENDATIONS

The proliferation of legal and ethical failures in India's startup ecosystem signals a systemic accountability crisis. Normalising opacity, misgovernance, or fund diversion in the name of innovation not only undermines investor confidence but also corrodes the rule of law and market integrity. While structural reforms and regulatory overhauls are necessary, policy interventions typically require time for stakeholder consultation, legislative vetting, and institutional readiness. In the interim, robust legal strategies, both preventive and corrective constitute the most effective instruments for preserving investor interests and restoring market discipline.

1. Preventive Legal Strategies for Investors and Funds ⁹

At the outset, investors must adopt a legally fortified approach to term sheet negotiation, due diligence, and fund deployment. This includes:

• Enhanced Due Diligence: Legal and financial diligence should go beyond surface-level MIS and unaudited Investors must insist on forensic accounting, verification of vendor and related-party transactions, and confirmation of statutory compliance (including filings under the Companies Act, FEMA, and taxation laws).
• Contractual Safeguards: Shareholder Agreements (“SHA”) and Subscription Agreements (“SSA”) must incorporate detailed representations and warranties, anti-fraud clauses, fund utilisation covenants, reporting obligations, and board participation rights. Exit clauses, including drag-along, tag-along, buybacks, and liquidation preferences, must be clearly articulated and legally enforceable.
• Governance Controls: Investors should negotiate for reserved matters requiring board or investor consent, the right to appoint directors, independent audits, and whistleblower Where possible, investors should avoid structures that allow unilateral fund movement through SPVs or affiliated entities.
• Valuation and ESOP Audits: Investors must periodically validate startup valuations and ensure ESOP allocations are compliant with shareholder approvals, tax regulations, and disclosure A failure to monitor cap table dilution or equity issuance may impair exit rights.
• Fiduciary Training: Investor-nominated directors must be aware of their fiduciary duties under Section 166 of the CA and ensure they are not complicit, passively or actively, in decisions that prejudice minority shareholders or breach statutory norms.

2. Corrective Legal Mechanisms Post-Funding

Where misgovernance or fraud is detected post-investment, investors must act decisively using available statutory and contractual remedies. These include:

• Invocation of Fraud and Misrepresentation Clauses: Contractual misstatements may be actionable under the Indian Contract Act, and false declarations under the Companies Act may warrant criminal prosecution under Sections 447, 448, and 420 IPC.
• Civil and Regulatory Recourse: Investors may seek remedies under Sections 241–242 of the Companies Act for oppression and mismanagement, initiate arbitration for contractual breach, or invoke indemnity and clawback provisions.
• Regulatory Filings and Complaints: In egregious cases, complaints may be filed with the Registrar of Companies (“RoC”), SEBI, SFIO, or Enforcement Directorate (ED). These bodies are empowered to investigate violations under company law, securities law, FEMA, or money laundering statutes.
• Forensic Audits and Independent Investigations: Investors holding board rights or majority voting rights may commission forensic audits, the findings of which can be used in civil suits or enforcement proceedings.
• Litigation and Interim Reliefs: Where investor agreements are breached or funds siphoned, civil courts or the NCLT may be approached for injunctions, asset freezes, or specific Arbitration may be invoked where the agreement provides for it, including emergency interim relief.

3. Policy Recommendations to Strengthen the Regulatory Architecture

While investor-side legal strategy remains crucial, systemic reforms are essential to curtail misconduct at scale. Policymakers, regulators, and industry associations may consider the following:

• Startup-Specific SEBI Framework: SEBI may consider formulating a regulatory sandbox for high-risk private placements and early-stage capital flows, particularly in fintech, crypto, and AI ventures, which often straddle grey areas of securities law.
• Mandatory Disclosure Regime for DPIIT-Recognised Startups: Recognition under the Startup India initiative should carry with it baseline disclosure requirements, including annual reports, ESOP registers, and fund deployment summaries, auditable by the RoC or an independent regulator.
• SPV and Beneficial Ownership Transparency: Rules must be amended to require disclosure of ultimate beneficial ownership and control structures, especially where offshore entities are involved. This will improve fund traceability and limit abuse.
• Strengthened Role for Investor Associations: Formal investor groups should be permitted standing before regulatory bodies and NCLT to represent collective grievances, especially where misconduct affects multiple investors or classes of
• Capacity Building of Directors and Founders: The government and startup ecosystem bodies (such as Startup India, IVCA, and NASSCOM) should provide training modules on corporate governance, fiduciary duties, and legal compliance to founders and directors of DPIIT-registered entities.

IX.         CONCLUSION

India’s startup ecosystem, while dynamic and fast-growing, is increasingly challenged by recurring legal and governance failures. The prevalence of fund misuse, disclosure lapses, and weak oversight points to a systemic accountability gap. To preserve investor confidence and ensure sustainable growth, startups must integrate legal compliance into their core operations, not treat it as an afterthought. Strengthening regulatory enforcement, enhancing board accountability, and embedding fiduciary discipline are essential to building a trustworthy and resilient venture ecosystem.

Footnotes

¹ https://www.pib.gov.in/PressReleasePage.aspx?PRID=2093125 

²https://www.moneycontrol.com/news/business/startup/fraud-rocks-gomechanic-how-chasing-growth-at-all-

costs-brought-down-one-of-india-incs-rising-startups-9890781.html

³ https://inc42.com/buzz/trells-founders-under-scrutiny-for-financial-irregularities

⁴https://www.entrepreneur.com/en-in/news-and-trends/financial-fraud-rocks-the-indian-startup-boat-

again/443264

⁵ https://www.ndtv.com/india-news/bharatpe-fraud-case-ashneer-grovers-family-member-arrested-6610658 

⁶https://www.reuters.com/world/india/indian-e-cab-provider-blusmart-enters-insolvency-amid-corporate-

governance-2025-07-29/

⁷ https://www.legaltea.in/corporate-governance-in-startups-loopholes-in-the-law

⁸ https://www.legaltea.in/corporate-governance-in-startups-loopholes-in-the-law

⁹ https://www.startup-movers.com/startup-due-diligence-investor-guide

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.