The role of ESG in start-ups

Lip Kian Ang Morrison Foerster

Thomas Chou Morrison Foerster

Alfredo B.D. Silva Morrison Foerster

Consumers are paying increasing attention to a company’s values. They are loyal to brands that align with their own beliefs and are quick to dismiss brands that are perceived to be harmful to society or the environment.

Founders of start-ups might hear “ESG” (environmental, social, governance) or “sustainability” and think those terms are simply buzzwords that are not relevant to their start-ups. However, savvy entrepreneurs, innovators and investors are increasingly considering ESG issues as essential drivers for success in today’s markets.

On the flip side, poor ESG practices can lead to significant drops in customer growth, increased legal expenses, and, in extreme cases, the temporary or permanent loss of a legal license to operate.

A.    ESG + START-UPS

ESG factors describe how a business impacts the world around it. The specific ESG issues relevant to one’s start-up will differ depending on the industry and business model, but may include the ones described below.

1.  Environmental

Environmental factors will vary based on the type of start-up. For example, relevant environmental factors for an e-commerce start-up may include composition of packaging and carbon emissions across the supply chain. For manufacturing businesses, relevant environmental issues may include ingredient/material sourcing, energy efficiency and waste disposal.

Companies that do not comply with environmental standards risk heavy regulatory penalties and alienation of customers and stakeholders. For example, following the news in 2015 that Volkswagen had tampered with emissions testing software to make its cars appear greener than they actually were, the carmaker was charged with fraud and conspiracy in the US and levied a fine of US$2.8bn and its CEO resigned. Most importantly, the news resulted in profound damage to the reputation for fine engineering and reliability that Volkswagen had painstakingly cultivated.

2.  Social

Social factors relevant to nearly all start-ups include data protection and cybersecurity. As evidenced by high profile incidents in recent years, businesses that fail to institute and implement proper systems for the protection and proper handling of consumers’ personal data will face an increasing risk of consumer backlash, regulatory penalties and loss of enterprise value.

Community relations and social inclusion also fall under the “S” in ESG. For example, businesses that sell ethically or sustainably sourced products, employ persons with disabilities, or engage in philanthropy tend to be viewed more favorably among an increasing proportion of consumers in Singapore, particularly the youth. Conversely, there have been instances of businesses running ill-advised advertising campaigns that inadvertently carried racially insensitive messages, resulting in backlash from an increasingly vocal public.

3.  Governance

The “G” in ESG can refer to aspects of a company’s culture, structure, policies and procedures. Investors often examine a company’s culture as an indicator of business resilience and reputational risk. Signs of a toxic company culture such as high employee turnover and complaints about workplace bullying or harassment are red flags to investors. Keen start-up leaders not only champion healthy company cultures, they are also able to articulate to investors exactly how they foster a positive office culture and monitor company morale.

For example, high employee engagement and satisfaction in a company suggests that it has a strong governance framework. Employee engagement and satisfaction can be measured through data on employee absences and/or turnover and results from a company satisfaction survey.

Executive and employee compensation also falls under governance. For example, a short vesting period for an executive’s compensation may incentivize a short-term perspective that de-prioritises consideration of the social and environmental impact of the business. For other employees, salaries at or above industry standard as well as equitable pay for men and women would indicate strong governance.

Overall, corporate governance is the responsibility of the board of the directors of a company. A well-functioning board can steer the company and management through difficult decisions, promote transparency, and help to safeguard the interests of the company and its stakeholders.

Conversely, a board – even one populated by senior industry figures and experts – that fails to carry out its duty to guide and oversee the management team is often a sign of a dysfunctional company. For example, Theranos, a biomedical start-up once valued at US$9bn, had a board of directors comprising former US defence secretaries, former US senators, an admiral, a military general and a former bank chairman. However, upon investigation, the board members admitted that they considered themselves more as advisors and rarely questioned or voted on any strategic decision, giving the chairman and founder virtually free rein in the running of the company. The company’s claims that it had achieved hundreds of millions in revenue and a revolutionary breakthrough in blood testing technology were later found to be fraudulent, and the company’s stock was rendered totally worthless.

B.    BENEFITS OF BEING ESG CONSCIOUS

1.  Attracting investors

Investors are increasingly integrating ESG factors into investment decisions – along with financial performance and market benchmarks – due to risk analyses and pressure from their own investors[ES1]. Simply put, failing to anticipate and address ESG factors in the planning and execution of the business can materially and adversely impact the bottom line, if a business’s practices result in social backlash, civil litigation, or fines from government agencies, or if a business is unprepared for the impact of climate change or changes in regulation and consumer preferences.

Additionally, development finance institutions (“DFIs”) require the funds in which they invest to conform to prescribed ESG standards such as the United Nations Sustainable Development Goals. DFIs like the International Finance Corporation (“IFC”) require their fund managers to conduct due diligence on and continuous assessment of their investments to ensure that ESG values are not compromised.

Further, dedicated “impact” investors are only interested in businesses with strong ESG performance. Thus, maintaining focus on ESG factors broadens a start-up’s potential investor base.

2.  Competitive edge

ESG might be underappreciated as a source of competitive advantage, despite numerous studies showing that companies prioritising ESG issues perform better across several financial metrics.

Sustainability-minded companies avoid short-term solutions and invest in cost-effective and sustainable innovations that deliver long-term returns.

Consumers are paying increasing attention to a company’s values. They are loyal to brands that align with their own beliefs and are quick to dismiss brands that are perceived to be harmful to society or the environment.

Thus, an ESG-centric business can drive profitable growth through developing sustainable business practices and cultivating a devoted customer base.

3.  Improved reputation

For a B2C startup, a focus on ESG can help build trust with consumers and distinguish it from its competitors. This distinction will not only improve a start-up’s reputation, it can also lead to positive press.

4.  Recruiting and retaining employees

Having a strong ESG focus may help a start-up to attract top talent. Millennials, now the largest generation in the workforce, are increasingly seeking more purposeful employment opportunities.

For example, nearly 40% of millennials in the US have chosen a job because of company sustainability and more than 70% would take a pay cut to work at a company with a strong environmental mission.

Having a company mission that aligns with employees’ personal values can foster stronger employee engagement, which can, in turn, reduce employee turnover and boost productivity, all of which feed into higher profitability.

C.    INTEGRATING ESG INTO START-UP BUSINESSES

A few ways of embedding ESG into a start-up business are set out below.

1.  Identify relevant ESG factors for company and industry

The first step to focusing on ESG factors is determining which factors apply to the business.

An entrepreneur may consider mapping the ecosystem of stakeholders tied to the company and analysing their incentives, values and viewpoints. This likely includes customers, employees, suppliers, regulators, shareholders and the public.

The Sustainable Accounting Standards Board (“SASB”) is a widely accepted organisation that assists businesses around the world in identifying and reporting on sustainability topics. The SASB Materiality Map is an interactive online tool that identifies relevant ESG factors for a variety of industries and is a useful resource for businesses seeking to identify the ESG factors relevant to their industry and business model.

By identifying relevant ESG factors, a business can evaluate the current performance and associated risk(s) in each area.

2.  Develop ESG measurement and reporting strategy

Once the ESG factors relevant to the start-up have been identified, it will be necessary to determine how the company will measure those factors and report on performance to investors.

Tracking a company’s ESG metrics not only provides a clear picture of the environmental and social impact of the company, it can also improve its relationship with existing investors and simplify the diligence process for future investors.

There is no universal set of ESG standards, but there are a few widely adopted frameworks. The SASB Materiality Map provides examples of applicable accounting metrics for each of its ESG topics.

For example, e-commerce businesses are asked to describe policies and practices relating to behavioral advertising and user privacy, as well as provide the number of users whose information is used for secondary practices.

The Global Reporting Initiative (“GRI”) is another international organisation focused on sustainability reporting. The GRI Standards are used by some of the world’s largest corporations to report on sustainability performance.

3.  “B Corp” certification

Some companies promote themselves as “B Corps” while mentioning a social or environmental mission. Promoting one’s business as a “B Corp” signals a commitment to ESG that can attract customers and investors.

The term “B Corp” does not refer to a form of legal entity; B Corp is a third-party certification administered by the nonprofit B Lab. Many companies around the world have undergone the certification process with B Lab, which entails completing a self-audit, applying for certification and entering a licensing agreement with B Lab to use the “B Corp” label.

4.  Integrate ESG into governance and investment documents

Many companies that are serious about ESG choose to embed social and environmental goals in various governing documents.

For example, compensation plans can be crafted so that salaries, bonuses and promotions are contingent upon ESG factors. This requires identifying factors that are clear and easy to measure.

Companies can also include mission-oriented shareholder rights and carefully drafted provisions into shareholder agreements and subscription agreements.

Start-ups can also consider populating their boards with one or more members who support a social or environmental mission.

AUTHORS

Lip Kian Ang Lip Kian Ang is a partner in the Corporate Department of Morrison & Foerster LLP, and is resident in the firm's Singapore office. Mr. Ang represents international funds, financial institutions and multinational corporations in cross-border transactions, as well as assists clients on a wide range of general corporate advisory and regulatory matters.

Thomas Chou Thomas Chou is a partner in Morrison & Foerster LLP’s Hong Kong office and co-head of our Asia Private Equity Practice. Highly ranked as a leading individual in China for Corporate/M&A and Private Equity: Buyouts & Venture Capital Investment by Chambers Asia Pacific and Legal 500, Thomas’s practice focuses on cross–border mergers and acquisitions (inbound and outbound), joint ventures as well as private equity and venture capital financings. With over two decades of experience, he is particularly known for his global expertise in private equity and venture capital investments, especially in US and Asia.

Alfredo B.D. Silva Alfredo B.D. Silva is a partner in Morrison & Foerster LLP’s Corporate Department, co-chair of the firm's Social Enterprise and Impact Investing Group, and a member of the firm’s Pro Bono Committee. Mr. Silva advises clients on a broad range of corporate and securities law matters, including late stage financings, cross-border investments, and issues in corporate social responsibility.

Disclaimer: This article is intended for your general information only. It is not intended to be nor should it be regarded as or relied upon as legal advice. You should consult a qualified legal professional before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising.

 

Published 29 May 2020