Is Your Startup ESG Investment Ready

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If your reading this page you are most likely either a Startup or an investor in a startup. Both play a vital role in driving innovation and growth in the economy, in recent times there has been more of a focus on business and investment that drives sustainable impact. In this article, we will explore the basics of ESG, trends in the market and what VC’s are starting to expect from Startups specifically relating to ESG.

The outcome of the article should provide you with insight into some simple ways you can future proof your startup for investment.

What is ESG?

ESG stands for Environmental, Social, and Governance. ESG factors are used to evaluate a company’s sustainability and ethical impact on society and the environment. These factors include, but are not limited to, climate change, carbon emissions, water and waste management, human rights, employee diversity and rights, executive compensation, board diversity, and shareholder rights.

Photo by Maranda Vandergriff on Unsplash

ESG Trends in Start-Ups 

Start-ups are adopting various ESG practices to ensure that their businesses are sustainable and ethical. Some of the common ESG trends among start-ups include: 

Sustainability 

Start-ups are taking proactive steps to reduce their carbon footprint and promote sustainability. They are adopting renewable energy sources, implementing energy-efficient technologies, reducing waste, and promoting recycling. 

Diversity, Equity, and Inclusion 

Start-ups are also prioritizing diversity, equity, and inclusion in their hiring and workplace practices. They are striving to create a culture that values and respects diversity in all its forms, including gender, race, ethnicity, and sexual orientation. 

Social Impact 

Start-ups are increasingly focused on creating a positive social impact. They are working on projects that address social issues, such as poverty, inequality, and access to education and healthcare. 

Governance 

Good governance is critical to the success of any organization, and start-ups are no exception. Start-ups are adopting governance practices that ensure transparency, accountability, and ethical behavior. They are also working on improving their board diversity, executive compensation, and shareholder engagement. 

Why ESG matters to Start-Ups 

ESG practices are no longer just a “nice-to-have” for start-ups; they are becoming an essential component of their business strategy. Start-ups that prioritize ESG practices are more likely to attract investors, customers, and top talent. A recent study by McKinsey & Company found that companies with strong ESG performance outperformed their peers in terms of financial returns and share price performance. Moreover, investors are increasingly interested in ESG performance and are willing to pay a premium for companies that prioritize sustainability. 

Photo by Ian Schneider on Unsplash

Why ESG is Important for VC Firms 

There are a growing number of VC firms that are turning focus toward ‘Impact Investing’ this can sometimes be dismissed as a founder, but as a founder if you are looking to raise capital and cannot demonstrate how your business aligns to the values of the VC firm, you will seriously limit your available options for capital.  

What is impact investing?  

Impact investing is an investment approach that aims to generate a positive social or environmental impact alongside a financial return. It involves investing in companies, organizations, or funds that seek to make a positive difference in areas such as sustainability, social justice, and community development. 

Impact investors evaluate investment opportunities based on both their financial potential and their potential to create positive social or environmental outcomes. They seek to align their investments with their values and contribute to a better world through their financial decisions. 

What VC Firms look for 

VC firms are looking beyond just financial returns when making investment decisions. They also want to invest in companies that are socially and environmentally responsible and that operate with a high level of corporate governance. This is because these factors can play a critical role in a company’s long-term success. For example, a company that doesn’t consider its impact on the environment may face significant regulatory and reputational risks in the future. Similarly, a company that doesn’t prioritize ethical business practices may face legal or financial consequences down the line. 

Investors, are increasingly looking to invest in companies that are committed to responsible business practices. One way is by including ESG clauses in their investment agreements, and term sheets. VC firms can help ensure that the companies they invest in are well-positioned to succeed both financially and socially. 

ESG clause in VC Term Sheets 

More and more ESG clauses are making their way into the term sheets of Startup funding, depending on the commitment and specific portfolio sector the VC operates a startup could see some of the following: 

• Demonstrate specific ESG metrics or targets 
• Reducing carbon emissions 
• Increasing diversity and inclusion 
• Implement specific ESG initiatives, such as establishing an environmental sustainability program or developing a set of ESG policies. 
• Board make up, governance and diversity 

• Annualised sustainability reporting and ESG performance benchmarking   
• ESG reporting and performance to be made public 

The specific ESG clauses in a VC agreement will depend on the VC firm’s priorities and the industry in which the startup operates. However, the overarching goal is to ensure that the company is operating in a socially and environmentally responsible manner and that it’s committed to good governance practices. 

What This Means for Startups 

For startups, ESG clauses in VC agreements can have both positive and negative implications. On the one hand, startups that prioritize ESG are more likely to attract VC funding already on the ESG pathway and typically will already have terms sheets with ESG clauses. This could be an advantage when pitched against other startups, if your company has already established a framework and begun this process it may just tip the funding in your favor. 

Moreover, implementing ESG initiatives can also help startups identify and mitigate risks that could impact their long-term success. For example, a startup that develops an environmental sustainability program can reduce its regulatory and reputational risks, which can translate into cost savings and increased customer loyalty. 

On the other hand, ESG clauses can also place additional burdens on startups. Implementing ESG initiatives can require significant resources and expertise, and meeting specific ESG metrics or targets may be challenging for startups that are still in the early stages of their development. 

How This Trend is Likely to Evolve 

The trend of VC firms including ESG clauses in their investment agreements is likely to continue in the coming years. As responsible business practices become more important to consumers, employees, and investors, VC firms will want to invest in companies that are committed to ESG. Moreover, as ESG reporting requirements become more widespread, VC firms will need to ensure that the companies they invest in are able to comply with these requirements. 

However, it’s important to note that there are potential drawbacks to ESG clauses in VC agreements. For example, startups may feel pressured to prioritize ESG initiatives over other important business activities, such as product development or sales. Additionally ESG metrics can be difficult to measure and compare across different companies, which can make it challenging for VC firms to evaluate the impact of their investments on ESG factors. 

To address these challenges, VC firms will need to develop more sophisticated ESG metrics and reporting frameworks. They may also need to provide startups with more resources and support to help them implement ESG initiatives effectively. Ultimately, the success of ESG implementation will depend on whether they are able to strike a balance between promoting responsible business practices and supporting the growth and development of startups. 

Types of ESG Clauses in Term Sheets 

The following is a brief summary of the types of clauses making their way into the deal term sheets of VC firms 

• Specific Objectives on a time frame  
• Best effort clauses  
• Optional clauses  
• Standardised clauses  

Specific Objectives 

The VC firm and Startup will agree on a specific set of actions and objectives to achieve within the first 12 months of funding. This normally is there to encourage the Startup to commence their ESG journey whilst still meeting the VC firms sustainability requirements.  

Best Effort Clauses  

This normally requires a Startup to agree to do their best to hit a specific target or metric e.g. 1 board member from a minority ethnic group within a given time period, or baseline emissions measurement of the business completed within the first 12 months of funding.  

Optional Clauses  

Can be included where the VC has a commitment but wants to allow for flexibility within their portfolio for high potential founders, the VC will also look to assist the business identify weaknesses and help establish ESG practices.  

Standardised Clauses  

Some VC firms are looking to implement standardised ESG clauses e.g. The British Venture Capital Association ad Berlin non-profit Leaders for Climate Action has already developed some. This does make it easier for both founders and VC’s but will loose veracity and meaning.

What can a Startup do now to be ESG investment ready?  

Simply just starting your company’s ESG framework will go a long way. We have created a simple and basic toolkit that will provide a startup with everything to get their framework in place.  

What does the tool kit look like? 

1. Use the provided ESG Audit tool to get a score and see where you need to improve 

1. Use the table below and customise your templated policies to adopt for your business  

ESG Policy

Environment Policy

Metrics: Carbon footprint, energy efficiency, waste reduction, water usage and resource conservation

Social Policy

Metrics: Employee satisfaction, customer satisfaction, diversity and inclusion within the business, supply chain KPI’s

Governance Policy

Metrics: Board diversity, published compensation in line with market, open reporting.