The environmental, social and governance (ESG) practices of startups are moving beyond regulatory compliance to become strategic imperatives. While large companies face mandatory business responsibility and sustainability reporting requirements, an increasing number of small and medium enterprises (SME) and early-stage companies have voluntarily adopted ESG frameworks.
For example, the startup Skippi Ice Pops developed an ESG initiative to offer an eco-friendly delivery service that has attracted more customers, thus enhancing its value. Companies positioning themselves as impact enterprises are attracting venture capital (VC) investment. According to the Impact Investors Council, despite the gloomy funding environment, impact enterprises raised USD6 billion of equity investments in 2022 and USD2.9 billion in 2023. Most of the investment was raised from commercial investors, not impact investors. Venture capitalists are thus incorporating ESG into their investment strategies, making it more than a mere checkbox exercise.
ESG factors are now seen at every stage of deals. Several investors have incorporated ESG due diligence into their investment evaluation processes. Others, such as IvyCap, have introduced sustainable development goals to their investments, highlighting an increasing consideration of ESG. Detailed ESG compliance clauses are now found in investment agreements.
ESG clauses usually consist of four parts, the first being the adoption of detailed value creation plans, outlining specific, measurable and time-bound objectives for companies to achieve. The second sets up ESG management systems to monitor progress and assess risk. The third details information rights, by which investors receive periodic performance reports, and inspection rights, allowing investors to engage third-party auditors to identify breaches. The final part of the clause specifies periods to remedy breaches and the acceleration of investors’ exit rights should such breaches become irremediable.
ESG clauses are investor risk mitigation tools, protecting investments from regulatory penalties and reputational damage. Studies have linked robust ESG practices to value creation by facilitating sustainable top-line growth, reducing costs, minimising regulatory intervention and increasing employee productivity. ESG-forward companies offer more exit opportunities and accelerated exit processes, attracting more investors to the ecosystem.
The practical implementation of ESG clauses presents significant challenges, particularly for early-stage companies and SMEs. Some VC investors set a single ESG commitment standard across their portfolios. However, many companies lack the resources to fulfil these obligations meaningfully because they require dedicated personnel to be appointed, capital investments in the short term or time to be spent educating their vendors. ESG commitments can divert vital resources from core business operations and growth initiatives in resource-constrained companies. This creates friction in deal negotiations and post-investment compliance.
To meet such challenges, ESG milestones should be tailored to a company’s industry, size, and growth stage. Parties could include material thresholds specifying which ESG incidents must be reported immediately, what breaches constitute default events and which ESG improvements require board approval. The staggered adoption of ESG practices, such as setting up management systems, enabling checks and balances in adopting and operating enterprise resource planning software for compliance, will lead to better implementation and establish clear enforcement mechanisms. The key is to draft ESG clauses that safeguard investor interests while overcoming the practical constraints inhibiting early-stage companies.
The long-term benefits of well-thought-out ESG integration increasingly outweigh short-term pain. ESG implementation is poised to become central to corporate competitiveness. ESG-forward companies will be better positioned to capitalise on emerging opportunities in developing sustainable markets, attract informed consumers and secure preferential access to capital. Well-structured ESG clauses in VC contracts not only establish clear and objective performance thresholds but also bring many tangible improvements, from operational efficiencies to brand reputation.
Swathi Girimaji is a partner and Nikita Parihar is an associate at Bharucha & Partners.
