BY ADAM COHEN
Research now suggests that there is measurable financial reward for companies heeding the rising demand for the business world to account for the environmental, social, and governance (ESG) impact of its operations. Those that choose to embrace this opportunity will want to immediately set up and implement sustainable practices. However, before they can do so, they first need to settle on what ESG goals they should be striving to achieve.
While many are working towards a common goal of promoting a more sustainable world and business environment, not every company’s ESG policies should be identical. Rather, they should be as diverse as the business world itself. Companies with shared goals can, and should, collaborate to maximize their positive impact, but the broader systemic improvements we seek can only be achieved by each business working to better its own corner of the globe as well.
The Materiality Imperative
Setting your sights on the right ESG goals can make the difference between success and failure—and competitive edge. The financial benefits of pursuing an ESG strategy are also more likely to manifest when tailored to the most “material” issues in a company’s specific niche, those impact challenges and opportunities that naturally arise out of a company’s industry, its place within its local community. The disclosure of information on material ESG factors created the strongest edge for sustainable companies because they best demonstrate how the commitment to impact delivers a strategic edge against industry competition. In comparison, those that did not narrow their ESG goals to the most material saw very little benefit.
This materiality approach matches the ongoing development of disclosure standards by the Securities and Exchange Commission and other regulatory agencies. It is widely understood that one of the cardinal sins of public disclosure is to include material misstatements and omissions about the company that could be the fulcrum of a reasonable person’s decision whether to purchase its shares. As the SEC adopts impact disclosure rules, we expect it to require companies to report accurately on materially relevant impact-based metrics as well.
The need to report on materially relevant ESG factors could be applied to impact reporting by private companies. While such reports are required for public benefit companies (PBCs) currently, they make for great fundraising tools when engaging sustainability-minded investors. Courts may begin laying down precedent establishing materiality and accuracy standards for private impact-related disclosures as well, in order to protect investors. This creates legal repercussions for purpose-washing or greenwashing, but also for failing to report on the ESG metrics that matter.
Materiality Assessments
Identifying the right, material ESG goals is therefore the first step in creating an effective sustainable business strategy.
Companies that are incorporated as or converted into PBCs may find that they have a head start. To operate as a statutory PBC, the company must include a statement of its specific public purpose or purposes in its Certificate of Incorporation. This is typically included as a short provision defining the unique public good or goods the company seeks to bring into the world. Naturally, developing programs and tracking progress on these specific public purposes will be material to the company business.
But a PBC’s materiality assessment does not end there. Sustainability encompasses the company’s general impact on the environment and people its operations touch. The Delaware General Corporation Law requires PBCs “to operate in a responsible and sustainable manner.” A PBC that is committed to providing a product offering a specific benefit must still consider the environmental impact of creating that product, the conditions of its workforce all along the supply chain, and whether the use of the product has any unintended negative consequences within the communities that use it.
When considering the materiality of a business holistically, the prevailing wisdom is that companies should first consider their industry. The sustainability challenges and opportunities within their vertical will likely be material to them and need to be included when designing their sustainability policies. SASB Standards, a non-profit organization existing under the IFRS Foundation, publishes a Materiality Finder that provides breakdowns of materiality factors on an industry-by-industry basis. Other organizations, such as the Global Reporting Initiative, provide similar resources.
Another valuable resource is the input of the company’s stakeholders. Building an inclusive process for determining which goals to pursue can be an exercise in sustainable governance itself that promotes internal cohesion around a common purpose-driven approach.
For early-stage solo founders and co-founders, the circle of internal stakeholders to engage may be very limited. They may not have anyone else working at the company, any other investors, or provide any products or services just yet. For now, they might focus on developing a mission statement, or a statement of values to be approved by the board that affirms the company’s commitment to growing sustainably and lays the all-important groundwork for a culture that takes impact seriously. The company’s roster of stakeholders will increase and become better defined as it grows; at which point the company should revisit the notion of materiality and its ESG goals.
One stakeholder group to engage is the workforce. Not only do employees have a stake in how the company is run, but they often live within the communities affected by the business. This unique positioning allows them to offer keen insights into the issues and opportunities to make positive contributions on a community level. Employee buy-in and commitment to the company’s mission is a key factor in attracting and retaining top talent; incorporating their views into the company’s values and ESG strategy can be key to retaining the sustainability competitive advantage.
Investors should be considered as well. This is especially true for growth-stage and mature companies transitioning into sustainable business practices. Investor buy-in may be a legal necessity as well as a practical measure. Mature companies may already have a large group of investors whose votes are needed to approve major strategic changes and that have the power to remove directors if they disapprove of the way the board is reshaping the business. They may already have Preferred Directors serving on the board whose support would be required to approve these actions as well.
Startups looking to raise their pre-seed or first preferred equity rounds may want to consider what a potential lead investor might want to see from a new portfolio company. Recently, we saw several venture financing term sheets include new covenants that require companies to develop and implement formal ESG policies. These investors want to be involved at the outset and remain involved in annual reviews and assessments. That these covenants contemplate the creation of ESG policies suggests that the investors do not expect such policies to be in place already, but the investors may expect to be involved in a review and revision of an outstanding policy if one exists after the transaction closes.
Investors as Impact Partners
An investor that wants to be involved in purpose-driven startup ESG initiatives could be an excellent match, but it is not a promise. Just as some venture capital firms are sought after because of their reputations for providing expert contributions to portfolio company marketing or product development, others yet can help startups identify their unique material sustainability goals and put necessary implementation and analytics structures in place.
Investors might reasonably be expected to show interest in and prioritize certain ESG issues over others. Those ESG factors that provide “double materiality” benefits, a direct social and economic impact, are more likely to matter to stakeholders that have an interest in seeing a healthy financial return upon exit. Rejecting the double-materiality framework, others promote the concept of “dynamic materiality,” which considers all ESG factors financially material due to their contribution to long-term economic stability.
Regardless which school one adheres to, it is worth having a conversation with a potential investor about the impact goals the company should pursue to ensure that there is an aligned vision for the future of the business.
Synthesizing Materiality
The number of inputs in the materiality assessment can create confusion. Between industry-specific factors and solicited input from employees, investors and other possible stakeholders, there is a considerable amount of information to synthesize into a coherent ESG policy. With information coming from several different sources, it may be possible to identify an overwhelming number of materiality factors.
A useful strategy for working through the materiality assessment could be to appoint an officer of the company with relevant expertise to lead the operational aspects of this process. This may be any standard corporate officer, or the board could create the position of Chief Impact or Sustainability Officer, increasingly common in today’s c-suites, and delegate to it responsibility for conducting industry-specific research, analyzing relevant reports like SASB’s Materiality Finder, and building feedback tools to gather stakeholder input and synthesize the information with recommendations for board review.
After the materiality factors are selected, the next step is to set tangible goals, to make progress on those factors, and then to develop effective initiatives to make and track progress on those goals. On a regular basis, the board may review the goals set, or even revisit the initial materiality assessment, to make adjustments that will allow the company to be most sustainable and create the greatest impact.
Your Lawyers Can Help Too
Founders hoping to build profitable companies around their commitment to sustainability need to engage in a concerted effort to get clear about which ESG issues are most material to their business. Without that focus, their programs are more likely to be scattershot and lack buy-in from internal and external stakeholders. With it, they can integrate sustainability into their operations, develop strong support from employees, loyalty from local customers, and partnerships with their investors. With that focus, they are best positioned to take advantage of the competitive edge from their commitments to impact.
At Jayaram, our understanding of the legal lens of materiality aids founders and their teams in framing this process with disclosure requirements in mind. We have a deep knowledge of the ESG landscape and can guide you towards the best resources for mapping out the impact areas that are most relevant to you. Further, our familiarity with corporate governance matters ensures that you satisfy your legal compliance obligations as you put into place the bedrock of your ESG policies.
Whether you are just starting out on your startup journey or are seeking to integrate impact into your long-established business, connecting your impact with your business strategy, vision for the company, and personal goals is vital to capturing the sustainability advantage.