As you probably heard ESG (environmental, social and governance) movement has become more present in the investment decisions. It’s not some catchy phrase anymore – ESG is real and your company has to adjust in order to succeed. “ESG has been integrated into our investment process for several years. There have been times when we have given up investing in a company due to the company's inability to improve this issue.” - said Magdalena Pasecka from Innova Capital.
In this article we will try to present you with some strategies related to ESG due diligence i.e. how to integrate them into your investment round and how it may help you to develop a sustainable company in the future.
ESG Catch-up
To make sure we are all on the same page let me remind you with some ESG basics. ESG stands for (E) environment, (S) social and (G) governance. When talking about the environment, it is impossible to ignore energy consumption or waste management. Social criteria are related to business relationships inside and outside the company - here we are talking about human rights, equality in employment and non-discrimination. And when it comes to corporate governance, issues related to board structure, shareholder rights, or corruption are important.
EU has already prepared a set of regulations like SFDR – Sustainable Finance Disclosure Regulation, CSRD – Corporate Sustainability Reporting Directive, Taxonomy or a new proposal for a Directive on corporate sustainability due diligence. It’s all for creating transparent rules for every country to follow and make a real impact. EU by making companies obliged to reveal their secrets publicly via non-financial reporting actually doesn’t need any other punishment system. Investors, customers and consumers care about sustainable development – that is why the companies that do not follow ESG principles will not only be valued lower but also lose their reputation.
ESG Due Diligence
Most of you are familiar with the due diligence process before financing. Financial, tax or legal due diligence has been present in almost each investment round. Although nowadays with startups we do see a trend of limited due diligence standards tailored to every business, the companies will have to be prepared for something new – ESG due diligence.
This happens mainly due to the lack of possibility of transferring the liability from the investor to the company. It is no longer enough for the investor to include in the agreement clause that the company is ESG compliant. A simple checkbox or questionnaire won’t suffice to ensure due diligence while EU regulations are written in such a broad (and smart) way that investment funds will be obliged to examine not only the target but also the entire value chain.
Speaking from a startup perspective, it’s not just another inconvenient duty. We have to remember that most early-stage companies are subject to a high risk of failure. ESG due diligence may actually help them overcome these risks and create an investable, sustainable company with prospects to turn into a unicorn in the future. It’s just important to perceive it as an opportunity for a company to grow and become more conscious.
ESG Report
ESG principles have to be tailored to each business individually. That’s why, ESG due diligence is not some additional process, it has to be integrated into the whole investment round from the very beginning. Each company is different and may have diverse impact on environmental, social and governance issues. For example, the company that produces pipes will more likely be exposed to risks associated with waste segregation or water use in production. Unlike an IT company, whose main risk may be cyber security. In both case scenarios, we have to examine what stays behind the company's revenue and what constitutes its competitive advantage - whether the company uses employment contracts, whether it employs cheap labor from third countries, how it processes personal data or even manages energy.
With startups we have to find the root cause – what is behind the revenues of such an early company? What risks this type of company may be exposed to in the future and how, at this early stage, we can mitigate or completely eliminate them? ESG may actually help to create a business structure that is transparent and make sure that the startups’ principles and dreams becomes reality in a sustainable way.
ESG Before Business Diligence
We recommend starting ESG due diligence even before the business one and then integrating ESG principles in the next steps. So, before checking the company’s financials and commercial past start with ESG analyses of risks and opportunities that a given business model faces and how the materialization of such risks affects the future viability of the company. Targets will be asked to provide some policies and procedures that refer to E, S and G. For example, environmental policy or waste management policy (E); employee’s contracts, code of conduct, remuneration policy (S); anti-bribery and corruption policies, data protection policy (G).
However, the investors will be also obliged to actually talk to founders because such documents (or lack of them) don’t prove if the company is sustainable or not. Thus, ESG due diligence won’t be an easy process. It will involve numerous stakeholders, financiers, tax professionals, lawyers and much more - everybody will have to work together to find some root causes related to ESG principles and then try to mitigate those risks to make sure the company is sustainable and ready for future investments.
ESG due diligence shouldn’t be a separate report detached from the other aspects of the transaction. What the report looks like will depend largely on what the company does and what its competitive advantage is, while the level of risk verification will depend on the business model. Policies will then be adapted to the materiality analysis or new procedures will be created, which will then have to be integrated into the company's real operations.
Startup and Investor Perspective on ESG Due Diligence
ESG due diligence will be a daunting process – but a necessary one. Once done thoroughly it will serve the company for years. It is from ESG principles that investors should explore the possibility of providing financing. Especially S and G will tell them how the company operates and point out some risks it may face in the future. ESG supports good governance, transparency and equality. E on the other hand, tells a lot about sustainability and prioritizing the environment over shareholders’ money.
For startups, ESG due diligence gives an opportunity to grow – to figure out the future plan of development using ESG principles and to create sustainable revenue company. Understanding how the business works from the very begging and what possible risks it may face in the future with regards to E, S and G is crucial for further development and funding.
So, don’t be afraid to start your ESG due diligence analysis regardless of your future investment round – it’s a win for the long run and definitely a marketing advantage as well!
Related Posts:
ESG Investment Strategy (by Aleksandra Polak, Partner, B2RLaw)
Your Startup Needs To Be ESG-aligned To Be Investible (by Aleksandra Polak, Partner, B2RLaw)
How ESG Will Affect VC Funds And Startups? (by Ewa Chronowska, Partner, Next Road Ventures)
