Are you an innovative startup looking for funding? At first, you would answer affirmatively right away, as you have a pitch deck and MVP. You also know the underlying drivers of your future financial success, and risk analysis is already behind you. However, have you also considered your business’s environmental and social impact and how ecological and social issues might affect your financial performance?
Environmental, social and governance (ESG) metrics are no longer mission & vision statements on colorful webpages which your marketing team deals with alongside your motto. There is a strong link between being ESG-aligned and obtaining funding, which will intensify each year, as ESG is not only your new obligation but most importantly it is a chance for you to outperform the competition, gain loyal clients, secure funding and become a mature business that shapes your industry.
What is ESG and sustainable business?
The European Union has stressed the importance of green transformation and aims for the EU to become a zero-net economy by 2050. This highly ambitious goal is to be achieved by changing how we perceive the financing of business activity. The EU is pioneering a new investment landscape and telling us that assessment of our business performance should not predominantly focus on financials and overlook environmental, social and governance risks and impact. The business needs to be sustainable in terms of E (Environment), S (Social) and G (Governance) issues (i.e. ESG-aligned) to secure long-term returns.
When it comes to assessing financial performance, we have established a framework and array of tools: balance sheets, P&Ls, EBITDA, gross margins, etc. But how do you assess whether a business is environmentally and socially sustainable in a manner which would be verifiable and comparable? How do you translate smiley faces from a flowery sustainably brochures into qualitative and meaningful data? Again, the EU offered investors a helping hand and in 2020 introduced a new law, known as Taxonomy which is a classification system of environmentally sustainable economic activities.
The Taxonomy establishes 6 environmental objectives:
- Climate change mitigation
- Climate change adaptation
- The sustainable use and protection of water and marine resources
- The transition to a circular economy
- Pollution prevention and control
- The protection and restoration of biodiversity and ecosystems
A business can be qualified as sustainable (ESG-aligned) if it:
- significantly contributes to at least 1 of the environmental objectives;
- also does not harm any of the 6 environmental objectives; and
- complies with minimum social and governance safeguards (i.e. human rights, employment law).
On top of that, the EU has introduced (and keeps on expanding) the list of entities that need to publicly disclose whether and to what extent their business is sustainable (ESG-aligned). Reports for 2023 will need to be audited.
Who is directly affected by the new ESG reporting obligations?
Every entity which provides financing (debt or equity) for business activity already needs to publicly report the percentage of its funds that are used to finance a sustainable (ESG-aligned) business and likewise, the percentage used to finance non-sustainable businesses. As such, this is directed at banks and investment funds.
Moreover, for 2023, all large companies* (it doesn’t matter if they’re listed or not) will be required to produce sustainability reports. From 2026, SMEs with securities listed on EU regulated markets will also need to provide sustainability reporting.
Additionally, the new regulation obliges financial investors to take ESG risks into account and to integrate ESG considerations into their investment strategies.
The EU is constantly expanding the catalog of obliged entities and increasing the number of reporting obligations. Why? The aim is to achieve greater transparency about the integration of sustainability risks. The companies will need to explain, among others, their strategy and business model with an ESG focus, the role of governing bodies, and also provide a description of processes used to identify sustainability risks and opportunities, as well as management policies.
What about ESG in startups?
Startups are not directly required to prepare sustainability reports. EU laws do not prevent funding entities which do not address ESG factors. However, EU funds will only be allocated to environmentally-friendly investments and the EU expects environmental risks to be taken into account in investment decisions. The EU has obliged banks, investment funds and large companies to make ESG disclosures. Further up the chain, investors of your own investors might need to disclose ESG metrics and, as such, they will reach out to you for such data. Therefore, whilst your company may not be directly impacted, ESG will very much touch your business. To comply with their own ESG obligations, funds will be asking ESG-related questions to their portfolio companies and target companies. You can expect ESG questionnaires and ESG due diligence as a part of the funding process. Your pitch deck, value proposing, market strategy, the pricing model will all need to be screened through an ESG lens.
Additionally, many startups cooperate or strive to cooperate with blue-chips, which might be directly obliged to undertake ESG reporting. Large companies have already included ESG criteria in their procurement process.
Startups might not directly fall within the scope of ESG-laws but failing to consider it will mean that the issue will come back to bite. A need for a funding or desire to cooperate will make startups indirectly obliged to disclose ESG metrics.
Some might suggest that funds are obliged to disclose ESG metrics, but on the other hand no-one has yet forbidden them to invest in ESG agnostic (not to say non-aligned) companies. The reality proves that funds do not wish to invest in non-sustainable business any longer. Quoting Larry Fink, CEO of BlackRock in a most recent highly anticipated annual letter stated: “The next 1,000 unicorns won't be search engines or social media companies, they'll be sustainable, scalable innovators – startups that help the world decarbonize and make the energy transition affordable for all consumers”. The sustainable (ESG-aligned) business will drive long-term (sustainable) financial results. Techstars CEO Maëlle Gavet in an article for the Fast Company website says: „these principles are fundamentally good business, and will allow us to make more and more profitable investments (…) there is a positive relationship between ESG scores and financial returns”. But we’ve already said that words are qualitative - so let’s look at the quantitative numbers. According to the Global Sustainable Investment Alliance review, sustainable investment in the US, Canada, Japan, Australia and Europe reached USD 35.3 trillion (AUM), representing a 15% growth in two years. According to the study of Mergermarket and HIS Markit “ESG Agenda: Revolution or evolution?” 59% of the surveyed entities said that a negative assessment of ESG factors lowers valuation significantly.
Is ESG a competitive advantage for startups?
Aside from being key to obtaining financing, ESG may actually help you to build a better company i.e. ESG improves collaboration within your company, so it may be a link between different departments. ESG, in fact, covers so many issues from finance, environment, legal, compliance, procurement, that your team will need to exchange data, synchronize and plan together. In consequence, it will improve control over strategic planning, but will also positively influence the company's reputation and transparency in the eyes of investors and counterparties.
Furthermore, ESG might be helpful in determining the financial effectiveness of companies and looking holistically at the value of the company, taking into consideration not only old financial statements and EBITDA. ESG indicators are innovative and may give you a competitive advantage. According to Mergermarket, investors have already recognized ESG opportunities but there are still not enough ESG-aligned targets, thus ESG-aligned companies can expect higher multiples and valuations.
Sustainable management is often about innovation. It is a constant search for modern solutions and keeping up with the constantly changing world. Even consumers are more likely to buy products or use services from a company that cares about the environment. In the era of a growing climate crisis, this is a topic that should not be overlooked when creating a corporate strategy. We encourage you not to look at ESG as another compliance requirement - paradoxically, regulation can often provide a business opportunity and ESG along with the 6 environmental objectives have created a new market for startups to come up with products and services which significantly contribute to their achievement.
Does your startup need to be ESG-aligned?
As a startup, you don’t need to be ESG-aligned but it is definitely a chance for you to grow, to change the world, be seen and stand out. We have to be aware of the constant change around us and the impact that we have on our future, especially as a matter of climate change.That is why ESG was created. Companies need to adjust their business to a changing economy – a green economy. And which entities are more adaptable than startups? That is why we strongly suggest you implement ESG strategies from the very outset by creating sets of transparent rules that govern your business. How do we advise to do this and what are the strategies? Stay tuned for our further articles.
* choose 2 out of 3: revenues > 40m euro; assets > 20m euro; 250 employees
Related Posts:
VC Funding In CEE Report - 4Q 2021 (by Konrad Koncerewicz, Head of VC & Startups, Vestbee)
ESOP For Startups: What is ESOP and how does it benefit startup? (by Marcin Laczynski, Partner, Next Road Ventures)
How ESG Will Affect VC Funds And Startups? (by Ewa Chronowska, Partner, Next Road Ventures)
