Category Archives: Finance

A New Challenge for Sustainable Entrepreneurs: Responsible Fundraising

An integral feature of sustainable entrepreneurship and corporate social responsibility is ensuring that the resources required to establish and operate the business are sourced in a responsible manner that does not impair the integrity and reputation of the company.  While transparency regarding sources of funding is relatively robust among public companies, which are subject to extensive reporting requirements imposed by governments and securities exchanges, the same is far from true in the startup world and the risks for sustainable entrepreneurs are increasing as rogue investors dangle capital in front of them at the same time as employees, customers and other stakeholders demand that founders be able to explain how their businesses are funded.  As explained below, founders need to understand the techniques they can use to conduct due diligence on prospective investors and ask questions to prospective business partners to determine how they are funded and the pressures they may be under from their own investors.

The robust economic conditions during the mid-2010s have encouraged many fledgling venture capitalists to hit the road to attract capital for their initial funds and, as recently reported in The New York Times, they have often been advised to go after so-called “easy money”: billions of dollars available from sovereign wealth funds managed by Middle Eastern countries such as Saudi Arabia and Abu Dhabi looking to become major players in Silicon Valley and other innovation clusters around the US and in Europe.  The strategy seemed to make sense and, in fact, appeared to have been endorsed by major investment players such as SoftBank, an investor in Uber and other high profile Silicon Valley companies that had accepted a commitment of $45 billion from Saudi Arabia’s Public Investment Fund.  However, even before news of additional repressive political tactics in those countries came to light in 2018, fund managers, increasingly sensitive to calls for responsible investment, were hesitant about taking money tied to those countries and were instead focusing their fundraising on wealthy individuals, nonprofit organizations, universities and pension funds committed to conforming to international standards for investing in an environmentally and socially responsible manner.

More and more investors must now contend with questions from founders and executives of their existing portfolio companies, as well as questions during the courting process with prospective funding targets, about where the money they are investing came from.  In particular, founders are asking investors whether they have received money from sources that are connected to foreign governments with poor human rights records or from foreign investors looking to effectively “launder” profits from illegal and unethical business activities in their home countries.  Another concern is funding from government-supported sources in countries such as China and Russia where there are significant risks that one of the purposes of the investment is to gain access to proprietary technology and strategic business information.  Venture capital firms have traditionally been less than forthcoming about their own investors (they are under no legal obligation to disclose the information, often keep it secret for competitive reasons and may actually refuse funding from public pension funds that publish the results of their investments); however, it is becoming clear they may often not have a clear idea about where the money is coming from because they have failed to ask the right questions themselves and/or investors employ sophisticated schemes such as shell companies to mask where the funds are actually controlled.

Some founders, with the support of their investors, have extended their concerns about financial and business support from repressive regimes beyond investors to include partnerships with customers, distributors and suppliers, announcing that they would not do business with companies that have taken money from such regimes and/or conduct significant amounts of business with affiliates of such regimes.  Companies are also concerned about doing business with firms that have board members designated by “questionable” investors since sensitive details of transactions are often distributed and discussed at directors’ meetings.  In addition, lack of clarity about ownership and control of investment vehicles means that a founder may discover that one of its investors has also provide capital to competitors through affiliates as part of a broader scheme to gain access to the details of all proprietary technology relevant to a particularly promising sector regardless of which companies own that technology or whether any specific company will be most successful.

Investors have always conducted extensive due diligence on the founders of prospective portfolio companies and their proposed business models, seeking information on the company’s governance, management and finances and often meeting with customers, distributions, suppliers and other business partners; however, the founders themselves have rarely asked too many questions about potential investors, perhaps fearing that aggressive “reverse due diligence” would cause investors to back away.  However, experts caution founders about being too timid, noting that the relationship with an equity investor is akin to a marriage that cannot easily be undone and thus must be entered into only if and when there is trust on both sides.  Recommendations for reverse due diligence provide by one experienced adviser to founders include getting a perspective from peer investors; personally visiting another startup funded by the investor; doing research on investor visibility via Google and social media; inviting the investor to dinner or a fun-related activity; and conducting a routine credit and background check.  In addition, founders need to be direct and clear about asking investors to explain the source of the funds that are to be invested and not be satisfied with vague and elusive answers.

Investors Beginning to Prefer Companies that Pursue Long-Termism

Interest in CSR and corporate sustainability among institutional investors has logically been accompanied by a sharper focus on whether and how companies are adopting the long-term perspective necessary for committing resources to projects that will likely have the highest value to the business at some point beyond the traditional short-term performance window.  A study published in 2017 by the McKinsey Global Institute claimed to provide systematic evidence that companies that adopted a “long-term approach” outperformed companies that emphasized the short-term strategies typically associated with maximizing shareholder value on a range of key economic and financial metrics including revenue and earnings, investment, market capitalization, and job creation.[1]

Institutional investors have identified long-term corporate strategy and aligning compensation and management incentive to promote long-termism as key topics for engagement with their portfolio companies.  For example, over 100 companies from around the world have signed on to the “Compact for Responsive and Responsible Leadership A Roadmap for Sustainable Long-Term Growth and Opportunity”, which has been sponsored by the International Business Council of the World Economic Forum as a means for corporations, their chief executive officers and boards of directors, as well as leading investors and asset managers to create a corporate governance framework with a focus on the long-term sustainability of corporations and the long-term goals of society.  The Compact calls on companies to commit to[2]:

  • Ensuring the board oversees the definition and implementation of corporate strategies that pursue sustainable long-term value creation.
  • Encouraging periodic review of corporate governance, long-term objectives and strategies at the board level as well as clear communication between corporations, investors and other stakeholders about the outcomes.
  • Promoting meaningful engagement between the board, investors and other stakeholders that builds mutual trust and effective stewardship, and promotes the highest possible standards of corporate conduct.
  • Publicly supporting the adoption of the Compact and implement policies and practices within my organization that drive transformation towards the adherence to long-term strategies and sustainable growth for the benefit of all stakeholders.

Similarly, the corporate governance principles for US listed companies endorsed by the Investor Stewardship Group include guidance that boards should develop management incentive structures that are aligned with the long-term strategy of the company.[3]

One interesting approach to instilling long-termism into mainstream corporate governance is the call for the creation of a “Long-Term Stock Exchange” which would supplement existing requirements imposed by the Securities and Exchange Commission and other exchange regulators with additional conditions such as tenured shareholder voting power (i.e., permitting shareholder voting to be proportionately weighted by the length of time the shares have been held), mandated ties between executive pay and long-term business performance and disclosure requirements informing companies who their long-term shareholders are and informing investors of what companies’ long-term investments are.[4]

While sentiment for encouraging long-termism and promoting a broader range of stakeholder interests has been around in some form for decades, the attacks on the primacy of shareholder value creation have never been as strident and are likely to accelerate in the future and become a permanent fixture among governance issues.  Politicians in more than 30 states and the District of Columbia have formalized the constituency theory by adopting statutes that permit the formation of “benefit corporations”, a new form of for-profit corporation that explicitly expands the fiduciary duties of directors beyond maximizing shareholder value, which is still one of the primary goals of a corporation, to include consideration of whether or not the corporation’s activities have an overall positive impact on society, their workers, the communities in which they operate and the environment.  While the rate of adoption of benefit corporation status has been slow, particularly among public companies, the recognition of benefit corporations has contributed to sharpened focus on the separate interests of non-shareholder stakeholders and created a host of new issues and challenges for directors of all types of corporations such as ­­how to measure and compare non-financial performance aspects of corporate activities; how to hold corporations accountable to stakeholders who do not have the rights to vote that are held by shareholders; and how to structure incentive packages for executives and managers tied to complex multi-stakeholder goals and commitments.

This article is part of the Sustainable Entrepreneurship Project’s extensive materials on Sustainability and Corporate Governance.

[1] Discussion Paper: Measuring the Economic Impact of Short-Termism (McKinsey Global Institute, February 2017), available at file:///C:/Users/Alan/Downloads/MGI-Measuring-the-economic-impact-of-short-termism.pdf

[2]http://www3.weforum.org/docs/Media/AM17/The_Compact_for_Responsive_and_Responsible_Leadership_09.01.2017.pdf

[3] https://www.isgframework.org/corporate-governance-principles/

[4] M. Lipton, S. Rosenblum, K. Cain, S. Niles, V. Chanani and K. Iannone, “Some Thoughts for Boards of Directors in 2018” (Wachtell, Lipton, Rosen & Katz, November 30, 2017), 7, accessible at http://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.25823.17.pdf.

Investor Interest in CSR and Sustainability

Customers, employees and corporate activists, including socially conscious investors, have been focusing on issues now commonly associated with CSR and corporate sustainability for several decades, particularly in the areas of environmental protection and human rights; however, CSR has taken on a new urgency for corporate directors and managers as institutional investors, including large public pension funds, have become more interested in, and concerned about, environmental protection, human rights, health and safety and diversity and have shown greater appreciation for the benefits of pursuing corporate sustainability as opposed to only rewarding short-term profitability.  The submission by the BT Governance Advisory Service to the Australian Parliamentary Joint Committee on Corporations and Financial Services in 2006 provided an illustration of how and why institutional investors seek out companies that understand the need for a longer term approach to risk:

“Long term investors expect organizational decision makers to have a regard for the interests of stakeholders other than shareowners when those stakeholder interests have the capacity to influence shareowners’ interests. We believe that companies that manage their stakeholders’ interests are managing their shareowners’ interests, especially over the long-term. This arises from the fact that risks to companies arise not just from typical financial risks but also from regulatory, community and litigation risks.”[1]

Sustainability has become an important issue for the major institutional investors and asset managers and the marketplace is seeing an increase in smaller, more specialized investment funds that are primarily oriented toward providing capital to companies that excel in their environmental, social and governance (“ESG”) practices and which focus on ESG-oriented activities such as climate change and impact investing.  The goal of investors is to encourage their portfolio companies to contribute to the successful pursuit of environmental and social outcomes which continuing to provide investors with a suitable financial return.

A number of factors have contributed to the surge in the interest of investors in corporate sustainability and the ESG practices of their portfolio companies[2]:

  • Recognition in the financial community that ESG factors play a material role in determining risk and return;
  • Understanding and acceptance that incorporating ESG factors is part of investors’ fiduciary duty to their clients and beneficiaries;
  • Concern about the impact of short-termism on company performance, investment returns and market behavior;
  • Increased legal requirements protecting the long-term interests of beneficiaries and the wider financial system;
  • Pressure from competitors seeking to differentiate themselves by offering responsible investment services as a competitive advantage;
  • Increasing activism of beneficiaries who are demanding transparency about where and how their money is being invested; and
  • Concern regarding value-destroying reputational risk associated with environmental and social issues such as climate change, pollution, working conditions, employee diversity, corruption and aggressive tax strategies in a world of globalization and social media.

A reported prepared by The Conference Board in November 2017 highlighted several important market and regulatory drivers of increased ESG activism among institutional investors.[3]  First, there seems to be a clear shift in expectations among institutional investors’ own shareholders with respect to ESG voting and engagement and institutional investors must now contend with the demands of their shareholders to support environmental and social proposals in line with their fiduciary duties.  Second, in 2015 the US Department of Labor amended its guidelines interpreting the “prudent investor” standard for Employee Retirement Income Security Act (“ERISA”) fiduciaries to affirm that although ERISA does not allow fiduciaries to sacrifice the economic interests of their beneficiaries to promote public policy goals, fiduciary duties do permit consideration of ESG factors in investment analysis and voting practices when necessary to advance beneficiaries’ economic interests.[4]  The DOL’s change in position aligned the US with guidelines that had already been approved in a growing number of other countries that directly endorsed or encouraged public pension funds and other investment fiduciaries’ incorporation of ESG considerations in investment analysis.[5]  Third, consortiums of investors are being formed to exert influence on their peers to promote better oversight of ESG risk.  One example is the voluntary Framework of US Stewardship and Governance formed in 2017 by a group of institutional investors representing over $20 trillion in US equity investments to encourage investors “to continue to engage directly with companies and to make their proxy voting and engagement practices and policies more transparent as part of a balanced approach to corporate and shareholder accountability”.[6]

The consensus today among institutional investors is that “corporate sustainability” is no longer limited to the environmental practices of the company, but should be broadly construed to include all of the challenges that should be overcome–economic, environmental and social–and all of the actions that should be taken in order for the corporation’s business model to survive and thrive currently and into the future.  The President and CEO of State Street Global Advisors (“SSGA”) has informed the directors of SSGA’s portfolio companies that SSGA defines sustainability “as encompassing a broad range of environmental, social and governance issues that include, for example, effective independent board leadership and board composition, diversity and talent development, safety issues, and climate change.”[7]

The potential benefits to institutional investors have been highlighted by the Conference Board, which has argued that CSR enhances market and accounting performance, lowers the cost of capital, improves business reputation, and fosters new revenue growth when it is channeled toward product innovation.[8]  Similarly, the Chairman and CEO of BlackRock, Inc., the largest asset manager in the world, wrote in his 2016 Annual Letter to the CEOs of BlackRock’s portfolio companies that “[o]ver the long-term, environmental, social and governance (ESG) issues—ranging from climate change to diversity to board effectiveness—have real and quantifiable financial impacts”.[9]  While many investors argue that focusing on corporate sustainability is necessary in order for companies to identify and mitigate the risks to current operations due to climate change, shortages of natural resources and ignoring basic human rights issues, investors also believe that developing and implementing innovating solutions to environmental problems, improving workplace conditions and forging strong relationships with local communities will lead to better economic performance for the business.

Investors are embracing “responsible investment”, which has been described in the Principles for Responsible Investment (https://www.unpri.org/about/the-six-principles) backed by the United Nations (“PRI”) as “an approach to investing that aims to incorporate environmental, social and governance (“ESG”) factors into investment decisions, to better manage risk and generate sustainable, long-term returns”.  Investors that have committed to adherence to the PRI have undertaken to incorporate ESG issues into their investment analysis and decision making processes, be “active owners” of the companies in which they invest, incorporate ESG issues into their own ownership policies and practices, seek appropriate disclosure on ESG issues from their portfolio companies and report on their own activities and progress toward implementing the Principles.  The PRI are based on the assumption that institutional investor have a fiduciary duty to act in the best long-term interests of their beneficiaries and that ESG issues can affect the performance of investment portfolios and must be attended to in order for the investors, and their portfolio companies, to improve their risk management and generate sustainable, long-term returns.  In other words, attention to ESG not only helps investors achieve better long-range investment returns, thereby meeting the goals of their beneficiaries, but also aligns investor priorities with broader societal goals.

The Principles for Responsible Investment

The Principles for Responsible Investment (“PRI”), which is supported by, but not part of, the United Nations, considers itself to be the world’s leading proponent of responsible investment.  The PRI has explained its work as understanding the investment implications of environmental, social and governance (“ESG”) factors and supporting its international network of investor signatories in incorporating these factors into their investment and ownership decisions.  Signatories to the PRI commit to the following six principles and the accompanying possible actions for incorporating ESG issues into their investment analysis and decision making processes and their relationships with portfolio companies:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Possible actions:

·         Address ESG issues in investment policy statements.

·         Support development of ESG-related tools, metrics, and analyses.

·         Assess the capabilities of internal investment managers to incorporate ESG issues.

·         Assess the capabilities of external investment managers to incorporate ESG issues.

·         Ask investment service providers (such as financial analysts, consultants, brokers, research firms, or rating companies) to integrate ESG factors into evolving research and analysis.

·         Encourage academic and other research on this theme.

·         Advocate ESG training for investment professionals.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Possible actions:

·         Develop and disclose an active ownership policy consistent with the Principles.

·         Exercise voting rights or monitor compliance with voting policy (if outsourced).

·         Develop an engagement capability (either directly or through outsourcing).

·         Participate in the development of policy, regulation, and standard setting (such as promoting and protecting shareholder rights).

·         File shareholder resolutions consistent with long-term ESG considerations.

·         Engage with companies on ESG issues.

·         Participate in collaborative engagement initiatives.

·         Ask investment managers to undertake and report on ESG-related engagement.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Possible actions:

·         Ask for standardized reporting on ESG issues (using tools such as the Global Reporting Initiative).

·         Ask for ESG issues to be integrated within annual financial reports.

·         Ask for information from companies regarding adoption of/adherence to relevant norms, standards, codes of conduct or international initiatives (such as the UN Global Compact).

·         Support shareholder initiatives and resolutions promoting ESG disclosure.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Possible actions:

·         Include Principles-related requirements in requests for proposals (RFPs).

·         Align investment mandates, monitoring procedures, performance indicators and incentive structures accordingly (for example, ensure investment management processes reflect long-term time horizons when appropriate).

·         Communicate ESG expectations to investment service providers.

·         Revisit relationships with service providers that fail to meet ESG expectations.

·         Support the development of tools for benchmarking ESG integration.

·         Support regulatory or policy developments that enable implementation of the Principles.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Possible actions:

·         Support/participate in networks and information platforms to share tools, pool resources, and make use of investor reporting as a source of learning.

·         Collectively address relevant emerging issues.

·         Develop or support appropriate collaborative initiatives.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Possible actions:

·         Disclose how ESG issues are integrated within investment practices.

·         Disclose active ownership activities (voting, engagement, and/or policy dialogue).

·         Disclose what is required from service providers in relation to the Principles.

·         Communicate with beneficiaries about ESG issues and the Principles.

·         Report on progress and/or achievements relating to the Principles using a comply-or-explain approach.

·         Seek to determine the impact of the Principles.

·         Make use of reporting to raise awareness among a broader group of stakeholders.

Source: https://www.unpri.org/about/the-six-principles 

Pronouncements regarding the importance of CSR by institutional investors are tremendously impactful on the decisions made by management since those investors are among the largest shareholders of the companies they follow.  CEOs must be mindful of surveys showing that CSR issues play a pivotal role in investment decisions for 90% of investors.[10]  The BlackRock Chairman’s 2017 Annual Letter to CEOs put the executive leaders of BlackRock’s portfolio companies on notice that they would be expected to consider sustainability of operations, environmental factors that affect the business, and the company’s role as a member of the community.[11]  State Street Global Advisors (“SSGA”), in a letter from its President and CEO to the directors of its portfolio companies, has made it clear that SSGA believes that CSR issues can have a material impact on a company’s ability to generate revenues over the long term and that whether the companies “clearly [communicate] their approach to sustainability and its influence on strategy” impacts how they will be classified by SSGA.[12]  A few days earlier, SSGA announced that it would consider the following issues when evaluating companies’ CSR and corporate sustainability efforts and the actions of board members in overseeing and management and setting long-term strategy[13]:

  • The company has identified the sustainability issues material to the business.
  • The company has analyzed and incorporated sustainability issues, where relevant, into its long-term strategy.
  • The company considers long-term sustainability trends in capital allocation decisions.
  • The board is equipped to adequately evaluate and oversee the sustainability aspects of the company’s long-term strategy.
  • The company’s reporting clearly articulates the influence of sustainability issues on strategy.
  • The board incorporates key sustainability drivers into performance evaluation and compensation programs.

SSGA has also opined: “Today’s investors are looking for ways to put their capital to work in a more sustainable way, one focused on long-term value creation that enables them to address their financial goals and responsible investing needs.  So, for a growing number of institutional investors, the environmental, social and governance (ESG) characteristics of their portfolio are key to their investment strategy.”[14]  In the same vein, an article distributed by the consulting firm PwC in October 2016 noted that “[m]ore and more, stakeholders are considering environmental, social and governance (ESG) factors when they evaluate a company’s strategy, risk profile, and ultimately, its plan for creating long-term value”.[15] The Forum for Responsible and Sustainable Investment (www.ussif.org) provided further insights on changing investor motivations leading to the surging interest in sustainable, responsible and impact (“SRI”) investment:

“There are several motivations for sustainable, responsible and impact investing, including personal values and goals, institutional mission, and the demands of clients, constituents or plan participants. Sustainable investors aim for strong financial performance, but also believe that these investments should be used to contribute to advancements in social, environmental and governance practices. They may actively seek out investments—such as community development loan funds or clean tech portfolios—that are likely to provide important societal or environmental benefits. Some investors embrace SRI strategies to manage risk and fulfill fiduciary duties; they review ESG criteria to assess the quality of management and the likely resilience of their portfolio companies in dealing with future challenges. Some are seeking financial outperformance over the long term; a growing body of academic research shows a strong link between ESG and financial performance.”[16]

As for the specific CSR and corporate sustainability issues that are most important to investors, and which should therefore be priorities for directors and members of the executive team, reference can be made to surveys of CSR-related shareholder proposals compiled by organizations such as the Institutional Shareholder Services Inc. (“ISS”) Governance Analytics Database.  In 2016 and early 2017, for example, the most popular topics among shareholder activists included lobbying disclosure, climate change reporting, political contributions disclosure, gender pay gap disclosure and sustainability reporting, a list that highlighted a decided shift in shareholder engagement toward sustainability and away from some of the issues that had dominated in previous years such as proxy access.[17]  A little more than half of the CSR-related shareholder proposals submitted to companies in 2016 were actually voted upon since some did not meet the criteria for voting established by the company and others were removed from the ballot before the meeting based on undertakings by the company following engagement with the proponents of the proposal to voluntarily provide expanded CSR-related disclosures.  Average support for those proposals that were voted upon was around 20%; however, nine proposals focusing on the following topics received majority support: board diversity, political contributions disclosure, methane emissions management, sustainability reporting, animal welfare, prohibition of sexual orientation and gender identity discrimination and gender pay gap disclosure.  Companies can gather further insights by closely reviewing the proxy materials of other firms in their industry and the published voting records and pronouncements of their major institutional investors.

In the 2017 proxy season, shareholders at ExxonMobil, Occidental Petroleum, and PPL Corp. voted by overwhelming majorities in favor of proposals urging these boards to assess and report on the financial risks their companies face as a result of climate-related regulation. These proposals passed with the support of BlackRock, State Street Global Advisors, and Vanguard, all of whom have voting and investment policies that include environmental, social, and governance (“ESG”) considerations and risk assessment. In 2017, Fidelity followed suit and revised its proxy voting guidelines to state that it “may support shareholder proposals calling for reports on sustainability, renewable energy and environmental impact issues” as well as proposals on board and workplace diversity.[18]

The published voting guidelines of ISS for the 2017 proxy season reflected the growing support among institutional investors for ESG-related proposals.  Among other things, the guidelines called for generally supporting resolutions requesting that a company disclose information on the risks related to climate change on its operations and investments, such as financial, physical, or regulatory risks; generally voting for proposals requesting that a company report on its policies, initiatives, and oversight mechanisms related to social, economic, and environmental sustainability; and supporting proposals seeking reports of company’s efforts to respond on a range of ESG issues, including climate impact mitigation, board and workplace diversity.  Proposals that called for the adoption of GHG reduction goals from products and operations were to be considered on a case-by-case basis and proposals seeking a company’s endorsement of social/environmental issue principles that support a particular public policy position were opposed.[19]

Institutional investors are themselves under increasing pressure from their own investors, as well as peers, activist groups and non-governmental organizations, to proactively embrace CSR and corporate sustainability.  For example, in 2006 investors with over $2 trillion in assets under management pledged to commit to the UN Principles for Responsible Investment (“PRI”), which require that environmental, social and governance issues be incorporated into investment analysis and decision making and that shareholders committed to the Principles proactively engage their portfolio companies regarding CSR and corporate sustainability issues and goals.  At the time the Principles were first announced, the then-UN Secretary General observed:

“In signing on to these principles, you are publicly committing yourselves to adopt and live up to them. And you are expressing your intent to channel finance in ways that encourage companies and other assets to demonstrate corporate responsibility and sustainability. In short, you have given a vote of confidence to corporate responsibility – not as a luxury, not as an afterthought, not as a goal to be achieved someday, but as an essential practice today.”[20]

By 2016, more than half of all publicly traded debt and equity worldwide was held by investors who were signatories to the PRI, and US signatories accounted for nearly 20% of the total participation and included both traditional backers of environmental and social proposals and mainstream investment companies like BlackRock, Fidelity, State Street and Vanguard.[21]  Not to be forgotten is that in addition to the assets managed by these well-known mainstream investors, more than 20% of all assets under management in the US were invested based on sustainable, responsible or impact investing strategies.[22]

A survey of whether institutional investors affected a firm’s commitment to CSR for a large sample of firms from 41 countries over the period 2004 through 2013 found that institutional ownership was positively associated with firm-level environmental and social commitments.[23] A July 2017 report issued by US SIF Foundation indicated that managers of $8.72 trillion of the overall total of $40 trillion assets under management in the US, about 22%, included sustainability in their investment decision making.[24]  A November 2017 reported by The Conference Board stated that surveys of institutional investors by major consulting firms since at least 2014 have found, on average, that 70% to 80% saw ESG information as important or essential to their investment analysis.

This article is part of the Sustainable Entrepreneurship Project’s extensive materials on Sustainability and Corporate Governance.

[1] Parliamentary Joint Committee on Corporations and Financial Services, Corporate responsibility: Managing risk and creating value (2006), 68.

[2] https://www.unpri.org/about/what-is-responsible-investment

[3] V. Harper Ho, Director Notes: Sustainability in the Mainstream–Why Investors Care and What It Means for Corporate Boards (The Conference Board, November 2017), 10-12, electronic copy available at: https://ssrn.com/abstract=3080033 (based on information available at UNPRI, Signatories, https://www.unpri.org/signatory-directory/).

[4] Interpretive Bulletin Relating to the Fiduciary Standard under ERISA in Considering Economically Targeted Investments, 29 C.F.R. § 2509.15-01 (October 26, 2015).  The guidance in effect prior to October 26, 2015, which had been in place since 2008, generally prohibited ERISA from selecting investments on the basis of any non-economic factors. Interpretive Bulletin Relating to Investing in Economically Targeted Investments, 73 Fed. Reg. 61,734 (October 17, 2008).

[5] According to the Report, many jurisdictions in the midst of changing their conceptions of fiduciary duty to permit, or even impose a positive duty on, investors to incorporate financially material ESG factors into their investment decision making.  Sources cited included UNEP-FI, A legal framework for the integration of environmental, social, and governance issues into institutional investment (2005), http://www.unepfi.org/fileadmin/documents/freshfields_legal_resp_20051123.pdf; UNEP-FI, Fiduciary Duty in the 21st Century (2015), http://www.unepfi.org/fileadmin/documents/fiduciary_duty_21st_century.pdf; and OECD, Investment governance and the integration of environmental, social, and governance factors, (2017), 48-50.

[6] Investor Stewardship Group, “Framework for U.S. Stewardship and Governance”, https://www.isgframework.org/. Stewardship codes have also been introduced in a number of foreign countries as a means for encouraging or requiring institutional investors as asset owners or managers to disclose how their investment strategy contributes to the medium and long-term performance of the investor’s assets.

[7] Letter from Ronald P. O’Hanley, President and CEO, SSGA, to Board Members, 1-2 (January 26, 2017), available at ssga.com.

[8] M. Tonello, Corporate Investment in ESG Practices (The Conference Board, Inc.: August 5, 2015).

[9] Annual Letter from Larry Fink, Chairman and CEO, BlackRock, to CEOs (February 1, 2016), available at blackrock.com.

[10] Tomorrow’s Investment Rules: Global Survey of Institutional Investors on Non-Financial Performance, 5 (Ernst & Young, 2014).

[11] Annual Letter from Larry Fink, Chairman and CEO, BlackRock, to CEOs (January 24, 2017), available at blackrock.com.

[12] Letter from Ronald P. O’Hanley, President and CEO, SSGA, to Board Members, 1-2 (January 26, 2017), available at ssga.com.

[13] SSGA, Incorporating Sustainability Into Long-Term Strategy (January 23, 2017), available at ssga.com.

[14] SSGA, Performing for the Future: ESGs Place in Investment Portfolios Today and Tomorrow (2017), available at ssga.com.

[15]http://www.pwc.com/us/ne/governance-insights-center/publications/esg-environmental-socai-governance-reporting.html,

[16] https://www.ussif.org/sribasics.  The Forum for Responsible and Sustainable Investment is a valuable online resource with information and educational materials on sustainable and responsible investing trends, performance and sustainable investment, proxy voting, shareholder proposals and community investing.

[17] H. Gregory, “Corporate Social Responsibility, Corporate Sustainability and the Role of the Board”, Practical Law Company (July 1, 2017), 5-6 (citing Institutional Shareholder Services Inc., United States 2016: Proxy Season Review—Environmental and Social Issues (October 26, 2016), available at isscorporatesolutions.com (subscription required)).

[18] V. Harper Ho, Director Notes: Sustainability in the Mainstream–Why Investors Care and What It Means for Corporate Boards (The Conference Board, November 2017), 2, electronic copy available at: https://ssrn.com/abstract=3080033. See also V. Harper Ho, “’Comply or Explain’ and the Future of Nonfinancial Reporting”, Lewis & Clark Law Review, 21 (2017), 318; and V. Harper Ho, “Risk-Related Activism: The Business Case for Monitoring Nonfinancial Risk”, Journal of Corporate Law, 41 (2016), 648.

[19] https://www.issgovernance.com/file/policy/2017-us-summary-voting-guidelines.pdf, 57-63.

[20] Ban Ki Moon, UN Secretary General Speech at the NYSE announcing the UN Principles for Responsible Investment (April 26, 2006).

[21] V. Harper Ho, Director Notes: Sustainability in the Mainstream–Why Investors Care and What It Means for Corporate Boards (The Conference Board, November 2017), 3 and Table 1, electronic copy available at: https://ssrn.com/abstract=3080033 (based on information available at UNPRI, Signatories, https://www.unpri.org/signatory-directory/).

[22] Id.

[23] A. Dyck, K. Lins, L. Roth and H. Bocconi, “Do Institutional Investors Drive Corporate Social Responsibility? International Evidence” (November 18, 2015).  Interestingly, the researchers found that while domestic institutional investors and non-U.S. foreign investors accounted for the identified positive associations, U.S. institutional investors’ holdings are not related to environmental and social scores. Similarly, higher scores are associated with long-term investors such as pension funds but not with hedge funds.

[24] http://www.ussif.org/files/Infographics/Overview%20Infographic.pdf

Sustainable Finance: A Primer for Sustainable Entrepreneurs

Sustainable finance has been described as the interrelationships that exist between environmental, social and governance (“ESG”) issues on the one hand, and financing, lending and investment decisions, on the other.  Sustainable finance has also been explained to be a long-term approach to finance and investing, emphasizing long-term thinking, long-term decision-making and long-term value creation.  Companies now operate in an environment in which more and more capital providers are taking sustainability issues into consideration when deciding whether to fund a particular company or project and this means that the finance committee, as well as the entire board of directors, need to understand how the company’s ESG-related strategies, principles and practices can impact its access to capital and the stability of its relationship with investors and bankers.  An additional consideration is measurement and reporting of ESG-related performance, a topic that the finance committee must consider in collaboration with other board-level committees such as the audit and corporate social responsibility committees.  Measurement and reporting techniques are evolving and differ across jurisdictions; however, there are emerging standards that need to be understood as more investors and lenders rely on sustainability reporting for collecting information necessary for them to make decisions about allocating their capital.

When reviewing and approving the company’s financial strategies and specific capital projects the finance committee needs to be mindful of the various factors that motivate investors and decision makers to incorporate sustainability aspects into their investment and lending decisions:

  • Many investors and lenders take sustainability issues into consideration in order to make better risk management decisions, avoid future financial issues and make better long-term investment and lending decisions. Investors and lenders are increasingly skittish about funding companies and projects that carry high legal and reputational risks due to concerns about compliance with applicable laws and regulations and ESG norms and standards.
  • A growing number of investors and lenders are focusing on sustainability as a means for uncovering promising new business opportunities and undervalued assets. Companies that can offer investors and lenders a path to participate in financing innovative solutions to environmental and/or social problems can tap into new pools of capital.
  • Investor are taking a more values-driven approach to funding decisions and avoiding investment in companies or projects considered to be “unethical” and/or which are likely to cause environmental or social harm. At that same time, these investors are proactively seeking out projects that have a demonstrable positive environmental or social impact.
  • Certain investors, as well as shareholder activists, are interested in applying pressure on companies to change their behavior with respect to operational activities that have adverse environmental and social impacts (e.g., threatening to withhold or withdraw capital unless companies cease to engage in activities considered to be unsustainable).
  • Some investors, like consumers, enjoy being associated with “good causes” and are therefore driven to invest in companies that have a good reputation with respect to ESG matters as a means for embellishing their own social identity.

Sustainable investment can be broken down into several categories, information that is helpful to companies when they attempt to identify the types of sustainable investors that might be interested in providing capital for their operations and new projects:

  • Negative/exclusionary screening: Negative or exclusionary screening consists of avoiding specific assets due to considerations of moral values (e.g., tobacco or gambling), standards and norms (e.g., human rights), ethical convictions (e.g., animal testing), or legal requirements (e.g., controversial armaments such as cluster bombs or land mines, excluded in order to comply with international conventions). Companies engaged in “negative” activities must be prepared to make significant modifications to their business models in order access capital from investors and lenders applying these types of screens.
  • Best-in-class/positive screening: “Best-in-class” (positive) screening contrasts significantly with negative screening and calls for investment and lending decisions to be made based on a company’s demonstrated high ESG performance. Investors can rely on a growing number of reference indexes to select projects that can improve both the risk and return aspects of their portfolio and companies need to be mindful of the criteria applied by the reference indexes and track their performance, although it should be understood that such indexes are not infallible and that it remains difficult to reliably measure ESG performance..
  • ESG integration: ESG integration involves new and emerging methodologies intended to systematically and explicitly include ESG risks and opportunities into traditional financial-based investment analysis. ESG integration differs from ESG indexing in that it does not rely on benchmarking ESG performance vis-à-vis peers.  As with ESG indexing, companies need to understand the how investment analysis taking ESG risks and opportunities into consideration is conducted, not only to gain a better understanding of the expectations of investors but also to potentially improve their own risk-adjusted rate of return on assets and mitigate sustainability-related risks.
  • Impact investing: Impact investing has been described as “investments made in com­panies, organizations, and funds with the intention of generating social and environmental impact (pursuit of positive externalities) alongside a financial return”. So far, impacting investing, which has often focused on microfinance and development investing, has been available mostly through private markets from funds managed by specialized asset managers.  Access to capital from impact investors may be limited for companies that lack scalable high-quality investment projects.
  • Thematic investments: Thematic investments include investment activities focused on specific high profile sustainability themes such as cleantech, infrastructure, energy-effi­cient real estate or sustainable forestry and thematic investments are projected to become increasing important for certain long-term oriented investors such as pension funds, insurance companies and sovereign wealth funds.
  • Active ownership: Active ownership takes a different approach to sustainable finance by focusing on engagement and dialogue with portfolio companies after an initial investment is made in order to influence ESG strategies and actions through exercise of ownership rights and being a visible activist for change.  The growing role of activism can be seen by charting the increasing numbers of proxy votes relating to ESG issues, a trend that has materially impacted how boards and senior executives manage investor relations.

For lenders, as opposed to investors seeking attractive risk-adjusted returns in addition to recovery of their original capital, ESG issues appear in their reluctance to enter into loan transactions that might ultimately involve them in financing controversial activities and/or projects that are overexposed to identifiable environmental or social risks and potential liabilities.  Lenders are not only concerns about the possibility that ESG issues for the parties to whom they lend may impact their ability to repay but also fear reputational damage from being associated with such borrowers and their environmentally harmful and/or unethical practices.  Many lenders follow an approach similar to the negative/exclusionary screening described above.  At the same time, however, lenders are themselves interested in enhancing their sustainability reputations and are adopting various types of positive screening and ESG integration methodologies into their loan analysis and proactively seeking qualified borrowers in the areas of interest to thematic sustainability investors.

The board of directors as a whole, as well as the members of the finance committee, need to understand the role that investors and lenders can play in impacting the future structure of the economy and, in turn, the influence that the priorities of investors and lenders can have on the business and financial strategies of their potential portfolio companies.  This means making various adjustments to the how the finance committee approaches some of its traditional duties and responsibilities.  For example, companies are being urged to move beyond conventional net present value analysis of projects to implement sustainable asset valuation and capital budgeting techniques such as analyzing projects based on “net present sustainable value”, which has been described as estimating “the net present value added across financial, environmental and social dimensions using a required rate of return that considers not only investors’ opportunity cost for their financial capital, but also the opportunity costs of the environmental and social capital inputs”.  With respect to capital budgeting, analysts are beginning to favor in incremental savings of water, energy and waste.  Another transition necessary for companies to take advantage of sustainable financing opportunities is shifting toward reporting and disclosure that includes environmental and social matters, particularly when companies are seeking targeted financing for projects based on renewable energy, climate change action, community and economic development and natural resource conservation and management.  Oversight of insurance matters by finance committees must take into consideration the evolving needs of insurance companies to mitigate their exposure to sustainability-related risks (e.g., natural disasters, ecosystem and community damage from operational activities and litigation costs associated with claims from employees based on hazardous work conditions and/or consumers based on issues with defective and/or hazardous products).

As mentioned above, finance committee strategies with respect to investor relations will need to take into account the surge of activity with respect to the incorporation of ESG issues into investment practice.  The world’s largest institutional investors have signed on global standards such as the United Nations Principles for Responsible Investment developed by an international group of institutional investors through a process convened by the UN Secretary General.  Finance committee members need to understand that investors that have signed on to the Principles for Responsible Investment are committed to incorporating ESG issues into investment analysis and decision-making processes and being activist owners through the exercise of their voting rights and engaging with portfolio companies on ESG matters.  One of the finance committee members, working with the CEO and CFO, should be responsible for engagement with the company’s largest investors to ensure that investor concerns regarding sustainability are addressed.

Sources for this article included A. Krauss, P. Kruger and J. Meyer, Sustainable Finance in Switzerland: Where Do We Stand? (Zurich: Sustainable Finance Institute, September 2016), 15-20 and Ignited: A Brief Overview of Sustainable Finance.

This article is adapted from material in Sustainability and Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedInTwitter and Facebook.

Audit Committee Membership? Expect to be Busy

Members of the audit committee must be prepared to spend a substantial amount of time in discharging their duties and obligations in relation to the company.  For example, commentators are advising that audit committees should schedule full-day meetings on no less than a quarterly basis.  The schedule for the meetings should allow sufficient time to review earnings releases and proposed 10-Q filings.  The chairperson of the audit committee plays a key role in ensuring that the time of the committee members is invested wisely and efficiently and he or she needs to be prepared to work on the committee agenda to make sure that meetings run smoothly and coordinate with other committees, such as the compliance and risk management committee and the disclosure and reporting committee, to avoid unnecessary waste of effort through duplication.  The committee chairperson should also have a good understanding of the business, its risks, and controls; be professionally skeptical and possess integrity and confidence; have strong communication and interpersonal skills; and prepared and willing to set aside large amount of time to overseeing the committee’s agenda and projects and meeting with management, other board members, the independent auditors, members of the internal audit function and representatives of key stakeholders.

At each meeting, members should be prepared to engage in lengthy and detailed discussions with senior management, as well as the company’s internal and external auditors, to understand the financial reporting system of the company and the decisions that are to be made relating to the accounting treatment of various transactions.  Under no circumstances can any of the audit committee members fail to achieve a clear understanding of any transaction, the manner in which it is presented, and the economic effect it will have on the financial position of the company.  Audit committee members should be able to review and evaluate the results that would have been reached if alternative accounting methods had been elected.

In addition, the audit committee should schedule extra time to allow for discussion of all financial information and other disclosures that are to be made in response to regulatory requirements, including financial statements, press releases and earnings guidance and other financial information given to analysts and rating agencies.  Discussions with the company’s independent auditors are particularly important in this process, especially given the oversight responsibilities now vested in the members of the audit committee.  The auditors should be quizzed about the procedures and decisions that they themselves might have used or made had they been given complete authority over the preparation of the company’s financial statements.  This inquiry is designed to focus on differences from the approach taken by management toward the reporting process.  The auditor should also be asked to put itself in the shoes of senior management and opine as to whether or not the auditor believes the company’s internal controls are sufficient for the auditor to be comfortable in delivering the certifications required of senior managers.  Finally, the auditor should be asked whether it would be satisfied with the financial information provided by the company if it were an investor.

Given the time required by audit committee members to complete the necessary consultations, it is more important than ever that audit committee meetings and activities be carefully scheduled.  This requires proper advance planning for meetings, including timely dissemination of the materials to be discussed at the meeting, and sufficient time during the meetings to accomplish all the work that needs to be done.  In addition, audit committee members must anticipate the need to devote additional time for follow up on questions and issues that arise at the meetings.  All of this means that each prospective audit committee member should evaluate carefully the existing demands on his or her time before accepting this important assignment and the Commentary to the NYSE listing standards actually includes conditions that must be satisfied before an audit committee member will be allowed to simultaneously serve on the audit committees of more than three public companies.  Audit committee members should also expected to be tapped for assignment to other board-level committees that handle topics that overlap with the traditional responsibilities of the audit committee in order to ensure that there is effective coordination and collaboration between those committees.  For example, audit committee members are good candidates for service on the board’s compliance and risk management and disclosure and reporting committees.

Given the broad array of duties and responsibilities that have been vested with the audit committee, and the corresponding need for interpretation of applicable rules and regulations, it is not surprising to find that the audit committee will often require focused advice from independent counsel.  Recognizing this need, SEC rules now provide the audit committee with authority, as discussed above, to engage independent counsel and any other advisers the committee determines may be necessary in order for it to carry out its duties and obligations.  For example, it can be expected that counsel will be consulted for interpretation of basic issues, such as whether a nominee for the audit committee is “independent” or whether a particular service provided by an accounting firm falls within the scope of the audit committee’s approval requirements.  Counsel will also be required to assist the audit committee in the development of rules and procedures, including written charters that must be developed to define the scope of audit committee activities.  Finally, counsel will be required to assist the committee in overseeing and conducting internal investigations that may be brought to the attention of the committee through the professional standards requirements imposed on attorneys..

This article is adapted from material in Sustainability and Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedInTwitter and Facebook.

Compensation Philosophy

The compensation and organizational development committee plays an essential role in setting the overall tone for the company’s philosophy with respect to rewards and incentives generally and executive compensation in particular.  Among other things, the members of the committee are expected to continuously review and assess the company’s executive compensation philosophy and provide counsel and guidance to the CEO and leaders of the human resources function with respect to alternative approaches to rewarding employees for the work they perform on behalf of the company.

When preparing the statement of the company’s executive compensation philosophy the committee should begin with a description of the primary purposes of the executive compensation program, such as attracting, retaining and rewarding talented leaders who can achieve sustainable and profitable growth for the company’s businesses and maximize the long-term value of the company for its shareholders and other stakeholders.  The statement of philosophy is often broken out into several categories, each of which are considered to be important for recruiting and retaining the best people to lead the organization.  For example, realizing that qualified and experienced leaders are highly sought after it is essential that companies be prepared to offer compensation packages that are competitive, which means that the statement of philosophy should incorporate the following activities:

  • Regularly compare the company’s total compensation levels against comparable companies in each of the industries from which the company is likely to draw executive talent, with particular emphasis on salary levels and short and long term incentives, to ensure the ongoing competitiveness of our compensation program
  • Measure the competitiveness of compensation levels in the countries and regions where the company operates, and utilize compensation benchmarks from multiple geographic markets for executives with international responsibilities
  • Use median (50th percentile) compensation values reported by the company’s comparator group companies as a primary reference for establishing target amounts for each element of compensation, and for maintaining competitive total compensation levels
  • Consider factors related to the executive’s potential impact on the company’s results, scope of responsibility and accountability, and reporting structure in determining appropriate compensation levels

It is necessary, but not sufficient, for companies to offer competitive compensation arrangements to their executives.  Compensation plans must also motivate executives to consistently deliver superior performance and this means ensuring that executives have a significant proportion of total annual compensation contingent upon achieving objective measures of financial and operating performance; establishing an appropriate “mix” of compensation elements to ensure an appropriate and balanced focus on short- and long-term results; and preserving a strong and direct relationship between business and individual performance, and the short and long term compensation earned by executives.  Committees should strive to create incentive arrangement that provide executives with opportunities to achieve compensation levels comparable with the highest earners among their peers at other companies; however, incentives should be tailored so that they are aligned with the company’s long-term strategic objectives and not just winning compensation battles with competitors.

Finally, the compensation package should be built in a way that ensure that executives are properly engaged with the pursuit and achievement of the company’s long-term strategic goals and meeting the expectations of the company’s stakeholders.  Engagement provides a foundation for building a deep and committed relationship between the executive and the company and makes the executive a stronger ambassador of the company to both internal and external stakeholders.  In order to achieve engagement, the company’s executive compensation philosophy must include linking a material portion of executive compensation to measures of business performance for which the executive has direct line of sight and accountability; ensuring that the company’s compensation programs and practices encourage appropriate risk taking and discourage inappropriate risk taking; and ensuring that senior executives meaningfully share the risks and rewards of ownership with the company’s shareholders by basing a portion of their total compensation on share price performance.  While compensation arrangements have traditionally emphasized achievement of financial goals, mounting pressure from institutional investors and other stakeholders has driven companies include sustainability issues in their executive compensation philosophies and explicitly provide that sustainability performance and innovation will be tracked and that a significant element of executive rewards will be based on demonstrable success in those areas.

This article is adapted from material in Sustainability and Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedInTwitter and Facebook.

Tired of Chasing Investors? Consider Bootstrapping Your Startup

While it is widely believed that startups need outside capital in order to grow and survive, many of the fastest growing new businesses in the country—60% of the companies on the Inc. 500 list in 2015—have been launched using “bootstrapping” techniques with less than $10,000 in capital.  In contrast, only 7% of the companies on the Inc. 500 list that year were fueled with funding from venture capitalists.  Joel Spolsky, writing in Inc. about his own experiences with bootstrapping, said that “our goal has always been to grow slowly, organically, steadily and profitably”.  This approach contrasts sharply to the “big bang” model that involves rapid growth fueled by significant amounts of capital from outside investors such as venture capitalists.

This article is adapted from material in Sources of Capital: A Guide for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Spolsky explained that companies that bootstrap correctly move slowly and four important pillars of organic growth—revenue, head count, public relations (“PR”) and quality—are always synchronized.  In other words, revenue grows only as fast as the company can hire and train skilled employees and awareness of the company’s products never gets ahead of the quality of the goods and services that the company is able to provide to customers.  When the only capital available comes from actual revenues from sales of products or services, as opposed to outside investors, the company must build its workforce slowly, which means there is more time to train new employees and make sure they understand and embrace the desired culture of the company.  Working on a shoestring also means there is no money for big advertising campaigns, which makes the company rely on natural growth of the marketplace and be selective about how it prospects for customers.  Product development is more simplistic for bootstrapped companies; however, while initial product offerings are limited in the scope of their features they generally are enough to convince customers that the company is able to offer quality and value.

Several problems can arise when raising large amounts of outside money causes the company to get out of synch with its pillars of organic growth:

  • When capital is used for advertising that produces a service in revenues from sales to customers, companies often struggle to keep up because they are unable to hire skilled employees and train them fast enough to keep up with the demands of existing customers and the intense interest of prospective customers. Employees become overworked and demoralized and the failure to keep up with prospects means they lose patience and move on to competitors—generally for good.
  • When the company hires employees faster than it can reasonably expect the quality of its product to improve the new employee won’t have a chance to learn and absorb the culture of the company because there simply are not enough experienced mentors available to conduct the necessary training. If this continues for too long, the quality of work and service will begin to decline as more and more of the workforce consists of inexperienced employees who haven’t had the time to learn about the business and their specific roles.
  • When the company uses the money collected from investors to jump start demand through PR campaigns, it often isn’t ready for the explosion of interest in the new product or service, which often still lacks all of the features that prospects believe they have been promised in the marketing blitz. The company may find itself handling more customers, but turning them into paying customers is difficult and they may ultimately decide that the product or service is too simple or lacks the necessary quality and never return, even when the company has substantially increased the quality of its offerings.  A related risk of misalignment is that the time frame for developing high quality technology-based products is generally quite long, which means that quality has a hard time keeping pace with interest generated from high spending on PR.

Spolsky argued that “raising too much money—whether it is venture capital or private equity or from a strategic investor—is often the key deciding factor in whether a company grows at a natural pace or gets misaligned”.  His advice was that sometimes it makes sense, however difficult, to say “no” to investors willing to fund a “great leap forward” if the founders know that it will likely become too difficult to manage growth and satisfy customers to the point where they will forge long-term relationships with the company.  Having too much money may also lead to waste and a lack of discipline about finding smart solutions to problems in the most efficient manner.

The flip side of the argument is that venture capitalists not only provide money that can be used to accelerate growth, they also provide expertise that can be tapped to improve the business model and connections that are not otherwise available to the founders that can be used to find talent for the business and forge key partnerships.  Money from venture capitalists can also be used to make investments ahead of revenues, such as hiring and training employees who are best suited to the particular business and conditioning the market through selective PR campaigns.  Venture capital is also seen as a “Good Housekeeping Seal of Approval” for the company, its management team and proposed business model.  Finally, founders with money in the bank can spend more time on building their product and business rather than continuously looking for and pitching new investors or assuaging the concerns of employees and/or vendors worried about whether they will be paid.  However, venture capitalists are under their own pressures to produce results for their investors and will want to see their invested funds deployed quickly in order to generate value that can be turned into an “exit event” (i.e., a sale of the company or initial public offering) within a relatively short period of time, say five to eight years.  Venture capitalists also want to be involved in the steering the business, something that many founders are not totally prepared for.  In some cases, investors demand that companies move their offices, install elaborate tracking and reporting processes and adhere to tight milestones to ensure that progress, as defined by the investors, is being made.

In an article in The Wall Street Journal, John Roa, the founder and CEO of ÄKTA, observed that bootstrapping wasn’t for everyone or every business and that the answers to the following three questions would provide a founder with insight on whether it makes sense for him or her:

  • How well do you know your business and industry? The founder needs to have a solid understanding of the proposed business and the applicable industry in order to determine the cost structure and price points for the proposed product or service. If launch is not possible without investing in substantial R&D, inventory, etc., the founder may have little choice but to bring in outside investors.  If it looks like the business can be launched without such an investment, the founder must nonetheless be prepared to operate “lean” and make sure that the key functions for the business can be operated and talent can be recruited without substantial cash outlays (e.g., by offering equity).
  • What’s your comfort level with different kinds of risks?  Bootstrapping is risky business and it is likely that the founder will find himself or herself on the edge of a cliff, with a declining bank balance and no reserves, more than once during the time it takes for the company to gain traction. If the founder is uncomfortable with this, and the accompanying stress, seeking a cushion from outside investors may be the preferred route.  Even if the founder is willing to take on such a risk, he or she must have a plan for dealing with unexpected downturns to make sure the business can survive rough patches.
  • Do you want the buck to stop with you?  Founders who want, and enjoy, have full control over the management of the business will be attracted to bootstrapping, since money from outside investors generally comes with demands for sharing in decision making. In many cases, however, founders will benefit from having others who have “skin in the game” and can serve as sounding boards and bring different perspectives and experiences to the table.

Only certain types of companies can realistically look to bootstrapping as a viable strategy: companies that can generate revenue from the very beginning, usually firms that can quickly find a market for their product or service among other businesses.  The inherent ability to generate revenues quickly tends to lower the risk for properly-synched bootstrapped companies and the chances of “success” are enhanced by not having to meet the ambitious valuation goals of outside investors and instead concentrate on methodically building a sustainable business with the right amount of growth and marketing to support building a loyal workforce and customer base impressed by the quality and service offered by the company.

The reality is that “bootstrapping” and “big bang” funding are not necessarily incompatible and the ideal may be to use the two strategies sequentially, an approach that is at the heart of the popular “lean startup” methodology.  This path begins with self-funding until the point where the business model has been validated and profitability has been achieved.  Once that milestone has been reached, outside funding can be used for “company building” and fueling a proven growth model without the founders having to absorb too much dilution to their ownership stake.

Sources: J. Spolsky, “The Four Pillars of Organic Growth: Revenue, head count, PR and quality—if one gets ahead of the others, you’re screwed”, INC. Magazine (January 2008), 69; C. Said, “Bootstrapped Startups go against the VC trend”, San Francisco Chronicle (August 10, 2015), D1; and J. Roa, Weekend Read: Getting Rid of Bootstrapping’s Bad Rap (April 3, 2015)

This article is adapted from material in Sources of Capital: A Guide for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedInTwitter and Facebook.