5 steps to building an ESG-responsible software startup

Many startups around the world will want to play their part in creating a more responsible business. But it can seem like an unattainable goal, with many regarding it as something to worry about after the business has reached a certain size. This is a mistake.

Startups have every opportunity to take action now and build a long-term strategy in this area, tackling not just environmental issues, but the full range of ESG (Environmental, Social & Governance) areas that go into building a sustainable, responsible, and long-lasting business.

The best way for a startup to begin the ESG journey and ensure its success is to embed ESG as part of its growth journey at the earliest possible stage. If ESG considerations are factored into a startup’s offering from the outset, it won’t come as a shock later down the line when pressure for ESG credentials is mounting from customers, partners, and investors.

Failing to establish a well-defined ESG strategy early on can lead to repercussions in the future: any company seeking to go public or be acquired will be required to demonstrate robust ESG credentials. Even raising capital for early-stage companies will become tricky without having an understanding and plan for ESG. 

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It is my understanding that a majority of European VCs are expected to be an Article 8 fund under the EU’s Sustainable Finance Disclosure Regulations (SFDR), which requires VCs to track certain ESG metrics from their portfolio companies. This further means that ESG metrics are asked about and measured by the portfolio companies; VCs expect this as the norm from startups to know and adopt ESG criteria. Given this background, startups need to be proactive in making ESG part of their operations, from the very beginning. 

1. Laying the ESG foundation at the emergence of a startup life 

Startups that implement sound ESG practices early on can benefit from a multitude of value-enhancing aspects, from employee attraction to higher revenue, to improved stakeholder management, and a higher probability of a successful exit. This last point is a critical, often forgotten, detail. ESG-compliant startups have a higher exit multiplier and can demand a higher exit value than non-ESG-compliant companies, avoiding costly mistakes and keeping government interference to a minimum.

ESG in the beginning of a company’s life is nothing more than the beliefs and values of the founders and the early employees. Founders normally do not recognize that the choices and values they build into the company, in the beginning, lay the ESG foundations, particularly among S and G factors, but also E. This can be related to the company culture that is set in the beginning, the way the company operates and manages itself, and product decisions that become rooted in the core product. 

2. Value is driven from early work

Startups that implement ESG factors from the beginning gain a significant advantage compared to companies that decide to do it further down the road. Implementing ESG aspects early helps to ensure that the startup can easily track important metrics along the growth journey, instead of having to go back in time to collect a metric needed for a subsequent exit. 

The foundation of any company is its employees, and ESG initiatives should start with them. Employees are more and more recognizing and selecting their work environment based on the employer’s ESG practices. 

Especially in software companies, human capital creates business value; thus, building a solid ESG reputation helps to attract and retain top talent. Increasing employee well-being at work will inevitably lead to increased productivity, better quality of work, and lower staff turnover. 

This starts with ensuring all employees have a clear, comprehensive contract, including a well-defined intellectual property (IP) clause. This not only provides legal protection but also sets clear expectations for everyone involved. 

Startups can improve employee well-being with initiatives such as introducing an employee Net Promoter Score (e-NPS) survey and instituting a robust health and safety policy. Gallup research of a wide range of companies (varied by size and sector) found those with engaged employees have profits 23% higher than those with unhappy employees.

Implementing ESG practices early on helps early-stage startups recruit a broad set of talent. Recent studies by McKinsey found a direct correlation between a diverse workforce and higher profits, showing that ESG is not just an empty checklist but a dynamic way to boost profits and attract investment. 

Improving diversity in the recruitment phase can be achieved by crafting inclusive job descriptions and involving a diverse group of people in the recruitment process to ensure a well-rounded, unbiased evaluation of candidates. Booksy, for example, was selected as one of the best tech startups globally for diversity.

From the beginning, startups must recognise that investors view ESG credentials as a key factor in decisions regarding whether to invest in a company. In part, this is because investors must think about their own ESG credentials, and in the EU, stay compliant with regulation. 

The EU’s Sustainable Finance Disclosure Regulation (SFDR) means investors in the EU have obligations to disclose and report the sustainability of their portfolios. And longer term, investors are aware that any firm will need to have a fully developed ESG strategy in place if they hope to ever be listed or acquired.

More than that, there is a desire in many VC funds to invest in the future. An increasing number of funds, particularly in Europe, share a mission statement to back technologies that will help make the world a better place. Just look at the huge rounds recently for companies in this space, such as quantum leader IQM’s €128 million Series A to help “combat the climate crisis”.

3. ESG implementation should reflect the stage of the company

Many startups struggle to implement ESG practices due to the overwhelming array of suggestions and a lack of clarity on where to begin. However, the most significant value is generated when startups align their ESG initiatives with the most value-enhancing activities specific to their current growth stage. 

Investors do not expect startups to implement everything simultaneously. Instead, companies should plan ahead, ensuring that specific ESG practices are in place before reaching key milestones such as revenue targets, geographical expansion, or employee headcount.

In the early stages, ESG focuses on employees, product development, and legal compliance. As the company grows past ten employees, it should increase ESG efforts, focusing on employee development, feedback channels, and effective governance. Gender pay gap tracking should start early, but closing the gap may not be feasible until the workforce exceeds 50-100 employees.

Depending on the product offering of the startup, environmental factors need to be considered at different time periods. If there is a physical product offering, particularly in B2C startups, the company should start measuring the environmental footprint early. 

Not only does an understanding of the environmental footprint help the startup to select suppliers, but it can also significantly contribute to higher margins and revenue. A Capgemini report succinctly set out the importance of business leaders making this connection between sustainability and business growth, with sustainability still too often viewed as “​​a cost centre, rather than a value centre.” 

It is worth noting that for pure software companies the environmental footprint, however important, is not paramount in the early days. Most of the emissions stem from Scope 3, such as travel and product usage, e.g. emissions from data centres, which the company has a hard time affecting. 

4. Building out ESG practices for long-term success as the company grows

In the early days of a startup, ESG practices are normally handled by the founders sporadically. As the startup grows, it is paramount to ensure that the company starts to have a coordinated ESG implementation and assigns a dedicated person responsible for ESG-related actions. Most of the time the ESG responsibility is dedicated to the CEO, CFO, HR, or another committed and eager employee. 

The common trait is that none of the people are true ESG experts, or have ESG as their sole responsibility. As the company surpasses 250 employees, it should hire a dedicated ESG employee with adequate knowledge about the field. External consultants can also be used before hiring to further help the company understand its ESG position.

A key responsibility of the person responsible for ESG is ensuring that adequate ESG training and information are readily available to all employees. This knowledge-sharing initiative educates the workforce on ESG principles while empowering them to actively contribute to the company’s sustainability efforts. In doing so, startups can align their values with their actions. 

Regularly discussing ESG factors outside the regular reporting periods, with different parties, significantly strengthens the startup’s own ESG integrations and helps to prepare the company for the subsequent steps in its growth journey. 

Investors possess a lot of knowledge about the field, regularly developing material to help  portfolio companies, and seeing best practices from multiple companies. As such, discussing the topic helps to benchmark your own company to others, learn from best practices, and understand in which areas you should improve further. Putting ESG on the agenda in board meetings is an essential first step to validate that your ESG strategy is relevant and to plan ahead for the future. 

As the company starts planning for a subsequent exit, be it an IPO or acquisition, it becomes important to have a clear view of the current ESG practices and what further needs to be implemented and improved. Having tracked ESG since its inception ensures that the company has all the data and understanding of ESG that will be asked and evaluated at the subsequent exit. 

If you look at any successful IPO, you will see a company with solid ESG foundations in place and clearly communicated to the market. Truecaller, the caller ID app, listed in 2021 with a $2.2 billion market cap, and ESG was right at the heart of its pitch to the market, including its pledge to “make the communication of the future smarter, safer, and more efficient”.

5. Understanding that ESG is a continuous process

ESG should not be something that is evaluated once a year or only considered when asked about by investors or stakeholders. Instead, ESG should be a visible part of the organisation that adapts as the startup enters different phases and challenges. 

Each stage of a startup’s journey requires something different. ESG also needs to evolve to serve its purpose. Startups need to recognise ESG as a central part of any company for it to materialise in real value. 

If it is left out or not regularly updated it faces the risk of not providing any value, and in many cases turns out to be more of a burden than a value-enhancing aspect. Seeing ESG as a continuous process ensures that it stays relevant to employees, customers, investors, and the mission of the company.