Environmental, Social, and Governance (ESG) measures are here to stay, and from the regulatory side, the EU has shown they mean business. First, with the introduction of the taxonomy for sustainable activities, with last year’s long-awaited implementation of the Sustainable Finance Disclosure Regulation (SFDR) following, investors are under increasing pressure to justify their image as sustainable by proving it.
Being listed as a light or dark green fund gives credibility in a market previously dominated by accusations of greenwashing and minimum-effort sustainability measures.
While not all investors are required to report under SFDR, ESG assessment has become a formalised part of any prospecting or due diligence process. Most European VCs now follow EU definitions, meaning new pressure has been placed on startups to match investor expectations.
That’s why it has never been more important to set up a startup sustainably from day one, even if it requires more work and additional capital. Here are three reasons why and what startups can do to meet expectations during funding discussions.
ESG impacts investability and valuation
Whereas investment decisions previously have been solely based on factors like IPRs, product-market fit, market size, business model, scalability, and the founding team’s ability to execute ideas, ESG is now a critical part of any investor’s assessment of a company. ESG risks are now carefully considered before funding a company, and red flags can make investors pull out of a deal. In less severe cases, ESG issues can affect terms, as VCs can demand higher equity or offer less funding than the startup was expecting.
For example, at Metsä Spring, we have stopped talks with startups that were not aligned with Metsä Group’s 2030 sustainability objectives. It is essential for us that the startups we invest in are committed to the same ESG goals and enable the use of Metsä Group’s products and side streams sustainably and efficiently.
Many VCs refuse to work with startups that do not have a dedicated person responsible for sustainability in place. Startups are also required to set up policies ranging from diversity and inclusion to supply chain and procurement and agree to periodic ESG assessments.
Even before SFDR was introduced, 75 percent of general partners (GPs) stated that companies should address ESG issues, even if it would impact their short-term profitability.
As an industrial CVC, we assess things like how much water and energy the process uses, what raw materials are used and where they are sourced from, how much waste is created, and how it is utilised or processed. VC funds now focus on the same topics when assessing the SFDR Principle Adverse Indicators.
In addition, we need to understand how social and governance matters are accounted for. How is the company aligning with health and safety regulations, and creating a safe, diverse, and inclusive work environment?
In short, sustainability is no longer optional if a startup wants the broadest possible access to funds. The only way to secure a place at the negotiation table and get the highest possible valuation, even from the pre-seed or seed stage, is to ensure that ESG matters are accounted for, and potential investors can be certain that their sustainability reporting will not be negatively affected by their newest investment.
ESG impacts access to public funding
Many, if not most, European startups have non-equity grants or loans as part of their funding structure. Meeting specific sustainability criteria is often an absolute requirement for access to these funds. Many startups, especially in the deep tech field, cannot get off the ground without them.
The checkbox nature of such funding applications means that you are either eligible or not. So, having sustainability as your guide when designing a startup’s business model and production concept and getting ESG processes in place from the get-go can be critical.
In addition to public grants, most EU countries have state-funded investment companies co-investing with private GPs. For example, the Finnish state investment fund, Tesi, has introduced sustainability metrics in their investment assessments and continues to develop these further to make sure investments made with public money go towards companies that follow ESG regulations.
ESG takes time and resources — but pays off in the end
Time and resources are things a startup typically does not have. Trying to create sustainability plans or set up ESG measures at the last minute if the business model or production concept were not designed to be sustainable in the first place will inevitably come up as a red flag for an investor.
When a company starts out, there generally won’t be any reliable LCA or GHG calculations, so early-stage investors must understand that the startup is taking concrete steps in the right direction and is genuinely committed to ESG. Some examples include having an ESG strategy and ESG KPIs, which are tracked with relevant metrics and identification of material ESG risks.
The additional planning and data gathering bind up funds and valuable time, but sustainability is critical for long-term investability and profitability. Studies by McKinsey and BCG have shown that startups that outperform on ESG can, for example, generate higher growth rates, attract and retain talent, reduce costs, minimize legal and regulatory inventions, optimize investment expenditures, and obtain funding more easily.
ESG should not just be considered a separate function or reporting obligation but ingrained in the company’s strategy and purpose. Startups will face challenges that seem unsurpassable. The only way to overcome these is by finding and retaining top talent who is motivated and identifies with the company’s purpose.
So, while investors are interested in ESG for ethical reasons and now also because of regulatory requirements, there are concrete financial justifications for why investing in ESG-focused startups makes sense.
With SFDR and new government requirements for co-funding, most investors will keep increasing their ESG focus. Startups who set up for this development from the get-go will be far ahead of competitors that put sustainability at the bottom of their priority list.
Lead image: Photo by Braden Jarvis