Startups need an ESG strategy

Over the last five years, the corporate world has focused increasingly on implementing stakeholder capitalism through Environmental, Social and Governance principles (ESG). However, is ESG a distraction to cash-strapped talent and time constrained startups? Should founders build their business first and worry about ESG later?

Quite the contrary: start-ups have an advantage over larger companies whose “installed base” of assets, products and culture often needs to be undone to be consistent with ESG principles. Startups can build it right from the start, avoiding costly rework later. And they can do this in a way that accelerates the urgent search for product-market fit versus distracting from it.

Here is a novel approach for founders to launch their ESG journey.

Start with purpose

Purpose crystallizes the unmet need a startup is answering and the unique strengths it brings to do that. Purpose answers: “What would the world lose if the startup disappeared?” Could competitors easily replace it or is there something unique it brings which customers will pay for, which is embedded deeply in its core strengths and value proposition? Purpose is a lot more than branding and PR. When employees feel their personal purpose can be lived at work, they are four times more likely to be engaged. It inspires stakeholders, helps the company focus its efforts, and make trade-offs in moments of truth. Startups often benefit from a strong sense of purpose given their proximity to a founder’s initial passion to solve a problem in the world.

Marry purpose with ESG

ESG is different than Purpose. ESG frameworks suggest how you run your business to deliver your purpose, and strategy, and what exposure you have to certain risks. It provides an implementation framework to guide business decision-making. Purpose without ESG is neither measurable nor strategic. It’s not anchored in the business. On the other hand, ESG without purpose isn’t focused enough on the few crucial topics underpinning the startup’s strategy. It’s just a laundry list. Purpose helps founders identify the few dimensions the startup chooses to “win” on versus just being a good citizen.

Identify material risks

Founders should start by identifying the key risks to avoid and manage. George Serafeim’s seminal 2015 research underlined that efforts should focus first on risks that are material to a startup’s specific sector/business. SASB and other frameworks help identify those material ESG risks. Startups should start there and try not to boil the ocean. Failure can be terminal. For example, data privacy is a material risk in the EdTech space. Dozens of startups risk losing important government contracts as a recent Human Rights Watch report on the EdTech sector exposed that many were selling personal data to advertisers that they had collected from minors using their education apps, falling foul of the most basic privacy expectations under the ‘G’ (Governance) bucket of ESG.

Whatever sector startups are in, our research suggests the following short list of material risks should be prioritized because they can have high financial impact when done wrong and because they have high overlap with “typical” startup priorities.

On E: Startups must have a target on carbon/natural resource footprint.

Only 7% of startups have a net zero plan. And yet it’s a top priority for investors who themselves are under the greatest regulatory pressure for transparency in this area. Investors can’t meet their climate targets unless the companies they invest in do. Startups can easily track basic resource use through utility bills. Building a net zero muscle early enables startups to build sustainability into their supply chains as they scale. This also protects against reputational risk from poor supply chain controls, avoiding what the startup darling Daily Harvest is facing today.

On S: Startups must build a strong social contract with employees; including ‘living’ wages, an inclusive culture, and support for mental health.

In an environment of acute labor scarcity, the war for talent has never been fiercer. Companies paying a living wage have 30% lower attrition during this era of the Great Resignation. Today this is the single most important ESG dimension to employees in the United States. Meanwhile, 40% of the workforce complains of burnout and other mental health challenges. Inclusive cultures counter this. Any successful founder with more than two employees is already promoting diverse viewpoints and a strong sense of belonging. WeWork and Uber’s past challenges are salient reminders of the negative impact of toxic cultures.

On G: Startups need diverse boards and rock-solid data security rules.

Increasingly, investors will demand the startups they invest in have diverse boards. It’s the most publicly visible ESG metric investors can track, so is usually built into their early due diligence processes and included in their own targets. Furthermore, increased board diversity correlates highly with stronger business performance.

Startups must also build in rock solid data security and privacy rules. Startups have blown customer trust most often through negligence on data security/privacy, triggering increased regulatory scrutiny in this area. Note the EdTech example above, and myNurse, a healthcare startup up shuttered in 2022 after a data breach affecting 1.7 million patients.

Companies which outperform on ESG tap into five sources of value: lower risk, cost of capital, and regulatory intervention, and higher growth, talent attraction and retention. Startups develop a competitive advantage from building Purpose and ESG into their DNA from the start.

Purpose helps inform ‘offense’ on a few chosen areas of distinctiveness. ESG helps inform “defense” in material categories. In all cases, startups must cover specific basics including climate targets on E, a strong social contract on S, and diverse governance and strong data processes on G. Optimally, the founder should clarify “who” is accountable for implementation, back priorities with metrics, and report progress to their board alongside other priorities.

This article is also published in Harvard Business Review. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.