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What is the ESG debt of startups, this "invisible weight"?

Ludovic Cailluet , Professor, Associate Dean
Yasmine Machwate , EDHEC Centre for Responsible Entrepreneurship
Justine Soudier , Deputy Director of the Centre for Responsible Entrepreneurship and Director of EDHEC Entrepreneurs

In this article, originally published in Harvard Business Review (HBR) France, Ludovic Cailluet - Professor at EDHEC and Associate Dean of the EDHEC Centre for Responsible Entrepreneurship, Yasmine Machwate - Head of Responsible Entrepreneurship at EDHEC CRE, and Justine Soudier, Director of EDHEC Entrepreneurs and Deputy Director of EDHEC CRE, analyse the ESG debt that represents an invisible challenge for early-stage startups.

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11 Dec 2023
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During their launch phase, startups face a number of obstacles. One of these is still little-known: ESG debt, or all the environmental, social and governance compromises made by young companies in their early days. Yet the consequences can be serious in the medium and short term. Various studies and initiatives at EDHEC are shedding light on this issue and proposing a new approach called "Responsible Entrepreneurship by Design" (1).

 

For startups, the quest for product-market fit is an absolute priority. It's when a product or service meets its target that the company's growth accelerates.

To achieve this goal, founders race against time, aware that any slowdown could jeopardise the survival of their project. This quest for product-market fit tends to justify operational choices that are sometimes questionable. Over time, however, these shortcuts accumulate and can lead to the building up of a debt that increases in line with the company's growth and can endanger its future.

So wouldn't it be useful for companies in their startup phase to integrate ESG (environmental, social and governance) issues into their strategy as early as possible, to prevent their "ESG debt" from exploding?

 

 

ESG debt, an invisible but important issue for start-ups

Technical debt is a concept coined by software developer Ward Cunningham in 1992. It refers to a situation where the speed of a project has taken precedence over quality, and decisions have not been fully thought through (2). As a result, additional effort is then required to correct the shortcomings.

This concept is now well known, and its risks well studied. One example is Facebook, which in 2014 changed its motto from Move fast and break things to Move fast with stable infra (3). A real paradigm shift.

 

But startups face a major problem: they lack resources. Or to be more precise: their ambitions far outstrip the resources at their disposal. This situation can force them into what is known as "path dependence", which consists of persisting with previously adopted choices, even when better alternatives exist. These constraints, combined with other factors such as the lack of tools, the cost of virtuous solutions, the absence of alternative suppliers, etc., potentially fuel ESG debt. - potentially fuel ESG debt.

This ESG debt encompasses all the compromises made, consciously or through negligence, on environmental, social and governance issues, in order to guarantee a startup's initial survival. When poorly managed, this debt can not only generate significant external problems, but can also hinder the viability of a promising project by limiting its potential for economic growth.

 

Concerned entrepreneurs ready to make a commitment

The EDHEC Entrepreneurs / Station F 2022 survey (4) of 205 French startups of different sizes and in different sectors highlights three important points:

  1. Taking responsibility issues into account is vital for the long-term survival of companies.
  2. Startups need to integrate ESG issues from the outset.
  3. Integrating these issues from the outset offers a host of benefits that go far beyond meeting compliance obligations.

Startups are aware of this issue: over 90% of the startups questioned in this study say they are convinced of the importance of adopting an ESG approach. Indeed, over the long term, the financial costs of companies with good ESG practices tend to be lower than those of other companies (5).

Extra-financial ratings, developed over the last few decades, are based on the principle that a company's performance will be better if its behaviour is responsible (6) . In this respect, the study carried out by EDHEC Entrepreneurs and Station F shows that nearly one startup in three that has raised funds has been questioned by investors about its ESG practices.

But although the desire to act is there, ESG issues are often perceived as complex. When asked about the obstacles they face, 58% of start-ups cited a lack of resources. One startup in two mentions a lack of time and/or the difficulty of taking the first steps.

 

The solution: integrate ESG issues into your business strategy as early as possible

Companies in their growth phase need to learn to integrate responsibility into the heart of their business model, right from the start. This is the purpose of the "Responsible Entrepreneurship by Design" (1) initiative launched by EDHEC in 2023.

The complexity of adopting a responsible approach increases as a business grows. The startup phase is therefore one of the most promising for integrating responsibility into its strategy. This phase is characterized by relative flexibility, unlike large companies which are often constrained by rigid processes and well-established habits.

In their early stages, startups have all the freedom they need to forge their own responsible path, and thus limit their negative externalities. For example, a startup may decide to favour local suppliers (which it can also promote to its customers), an initiative that will be more difficult to put in place once the company has established commercial partnerships.

To avoid accumulating ESG debt while knowing that their level of resources is extremely limited, startups need to be able to prioritise the most concrete actions according to their sector of activity, as well as the actions with the greatest potential impact.

They must also be able to make informed compromises, i.e. assume their potential shortcomings knowing that these will be corrected when a better alternative is found. As with financial debt, it is essential to evaluate these trade-offs on a regular basis. These compromises can, for example, be communicated transparently via a "register of concessions made".

 

Why should startups integrate ESG issues into their strategy without delay?

Integrating ESG into the early stages of the entrepreneurial adventure offers a multitude of advantages. In particular, the following benefits have been observed by EDHEC researchers:

1) Save time and effort

The accumulation of ESG debt potentially multiplies future costs for the company and forces it to slow its pace, as it has to devote part of its resources to 'correcting' this debt. By integrating responsibility into the heart of its initial model, the company adopts a proactive approach and saves time and effort, while preserving its coherence.

Fast-growing startups sometimes realise a little too late that they are only managing to attract a certain type of profile to their teams - they have only hired women, only men, only graduates from the same school, etc. -. This may be due to a recruitment process that is not very inclusive, which will be much more complex to "correct" than if it had been thought through in a comprehensive way from the outset.

2) Easier to grow virtuously

Integrating ESG issues from the outset ensures virtuous, responsible growth and a healthier corporate culture. This is because a virtuous operating model is put in place from the outset, which avoids having to devote additional time and resources several months or years later, when potential shortcomings will have to be compensated for. This is the path-dependency effect mentioned above: even when the importance of change is felt, the weight of choices made in the past is often heavier and contributes to a certain inertia.

For example, a French technology start-up may decide from the outset to choose a French data host. It will be much more complex, time-consuming and costly to migrate to another hosting provider once the entire infrastructure has been set up and is being used by an increasing number of customers.

3) A gain in competitive advantage

This approach is also a very powerful way of differentiating in the long term. A company that has a clear positioning from the outset can more easily distinguish itself from its competitors, while also having the potential to develop the loyalty of a targeted customer base (and team). By launching on a market, it has a competitive advantage.

A startup may choose to emphasise the sustainability of its products at the design stage, in order to meet the long-term needs not only of its customers but also of society and the environment.

 

Towards the need to take ESG debt into account?

Today, there is still a long way to go in assessing, calculating and valuing ESG debt. Still little known, it often remains under the radar, even though it has a considerable influence on young companies. This requires a global approach, as ESG performance assessment is currently fragmented.

To this end, the start-up rating process should diversify the sources on which it relies, in particular by developing a standard based on three pillars: people, the market and governance. A rating based on these three pillars could help to diversify the sources of funding for start-ups in the seed phase, and thus support their growth.

While tools such as Sustainable Entrepreneurship (7), which aims to assess startups on the basis of ESG criteria, using qualitative data (pitches, articles, white papers), are emerging, for the moment neither international standards nor metrics are clear or appropriate for measuring the ESG performance of startups. Research needs to focus on developing simple scoring tools for use by early-stage entrepreneurs and their investors and advisers.

 

References

(1) Le Guide de la responsabilité en startup (2023). Outil en open-source, 100% gratuit. Une initiative portée par EDHEC Entrepreneurs. https://startup-guide-responsibility.edhec.edu/

(2) « An exploration of technical debt », by Edith Tom, Aybüke Aurum and Richard Vidgen, Journal of Systems and Software, Volume 86, Issue 6, 2013. https://doi.org/10.1016/j.jss.2012.12.052

(3) Zuckerberg: 'Move fast and break things' isn't how Facebook operates anymore, CNET, April 2014

(4) Startups et entrepreneuriat responsable en 2022, EDHEC x Station F

(5) « ESG practices and the cost of debt: Evidence from EU countries », de Yasser Eliwa, Ahmed Aboud et Ahmed Saleh, Critical Perspectives on Accounting, Volume 79, 2021. https://doi.org/10.1016/j.cpa.2019.102097

(6) « Les annonces de notations extra financières véhiculent-elles une information au marché ? », par Alexis Cellier, Pierre Chollet et Jean-François Gajewski, Finance Contrôle Stratégie, 2011, volume 14, numéro 3. https://hal.science/hal-00950507/

(7) https://sustainableentrepreneurship.org/

 

Pour lire cet article en français, rendez-vous sur hbrfrance.fr

Photo by Simon Wilkes on Unsplash

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