Why ESG Standards Matter to Privately Held Companies

By John Leemhuis, Esquire

Just last week the SEC proposed far reaching and much anticipated rules intended to enhance and standardize climate related disclosure requirements for public companies. However, if you believe that these rules won’t affect privately held companies, you may want to think again. Privately held companies should be aware of these new regulations because compliance may:

• Improve their position to sell or obtain financing.

• Be scrutinized if the company is in a public company’s value chain.

• Represent best practices.

• Improve their bottom line.

Positioning for Sale or Financing

I recall working with a privately held company in the health care industry to help it get ready for sale. I worked with accountants and other professionals over six months to make sure the house was in order while the business broker shopped the company. The buyer that eventually emerged was a publicly traded company that dwarfed my client in size. When the buyer’s due diligence team arrived, I was surprised by the level of detail and thoroughness of their review. This deal was under $10 million dollars. Why the fuss? It turns out that by this point the buyer had a fair idea of the quality of the seller’s assets. Now it was looking for hidden liabilities that could kill the deal, effect the purchase price, or come back to haunt the buyer down the road. For this buyer, the downside risk had as much, if not greater, weight as the upside potential.

 The level of regulatory oversight and scrutiny by shareholders is quite different for a public reporting company than it is for a privately held one. The buyer of my privately held client was viewing this private business through a very different lens of compliance because, once acquired, it would be integrated with the public company and subject to much more rigorous standards. As more legislation is enacted, the regulatory gap between public and private companies widens.

 A privately held company looking for a buyer or financing (debt or equity) would do well to understand these proposed regulations and use them for guidance on how to operate in the regulated areas. To ignore compliance, or at least an understanding of how the rules may apply to one’s business, creates the risk that your company gets passed over when the time comes to sell or obtain financing. Hey, there’s a lot of competition out there, and potential buyers may look at hundreds of deals before finding one that not only has the upside it needs, but also avoids the downside that comes with noncompliance with these rules - whether intentional or due to benign neglect.

Public Company Value Chain

 The newly proposed climate related disclosure regulations require disclosure of indirect emissions from upstream and downstream activities in a company’s value chain (Scope 3) under certain circumstances. Scope 3 emissions are the result of activities from assets not owned or controlled by the reporting organization, but that the organization indirectly impacts in its value chain. Reporting companies for each identified risk must then disclose the actual and potential impacts of such risks on its strategy, business model and outlook, including impacts on, and significant changes made to, its business operations (including types of operations and location), products or services, suppliers and other parties in the value chain, activities to mitigate or adapt to climate related risks, R&D expenditures, and any other significant impacts or changes.

 Private companies doing business with public companies, in particular those in their value chain, will be caught up in these new rules. Does your company supply parts to the automotive industry? Aerospace? Oil and Gas? Energy? Under the proposed rules, public companies, under certain circumstances, will need to consider and report on activity in its value chain. This is both a threat and an opportunity for private companies in the value chain of public companies. Good emission grades will open doors. Bad grades may result in a loss of business.

Best Practices

 A growing number of businesses are moving toward a constituent-based model and away from a shareholder primacy model. These businesses – benefit companies, B Corps, and the like – are structured to consider how their organizational decisions effect not only shareholder value, but also how they effect the global and local environment, the community where they do business, their employees, customers, and their supply chain. They are operating for a greater social purpose. For these private, purpose driven business, these new ESG rules represent best practices that can inform how they can improve operations that touch all of their constituents.

Improved Bottom Line

As businesses began looking at constituent-based models of operation rather than shareholder primacy models, the prevailing thought was that taking action to advance a social purpose, or to consider a business decision in light of factors other than enhancing shareholder value, would result in a loss of profits. Measured performance over time has shown that this is not necessarily true, and that consideration of factors beyond enhancing shareholder value is not a zero-sum game. In fact, moving to a constituent-based model may lead to an improved bottom line. Over an 18-month period measured from November 2019 to March 2021, the MSCI World ESG Leaders Index outperformed the traditional MSCI World Index by +1.84%, and during that same period the JP Morgan ESG EMBI Global Diversity Index outperformed the equivalent non-ESG by +1.94%. In some instances these results are intuitive. Finding ways to reduce energy consumption and lower a company’s carbon footprint can logically lead to reduced operational expenses. Other activities may not be as intuitive, but these new performance metrics certainly call into question the idea that acting in a socially responsible way inevitably results in lower profits.

Conclusion

 At first glance the SEC’s proposed rules regarding standardized climate related disclosure requirements for public companies may not seem related to the business activities of private companies. However, for a number of reasons that I have discussed, that does not appear to be the case. Understanding how, and if, these proposed rules apply to the business of a private company may help that business (1) prepare for sale or financing, (2) improve or retain business relations with public companies within their value chain, (3) identify best practices, and (4) improve the profitability of the business.

If you would like to learn more about ESG standards and how they may affect your business, how to best position your business for sale or its next round of financing, or how to move toward a more constituent based model of doing business, please contact me at john@leemhuislegal.com.

John Leemhuis is an impact lawyer and owner of Leemhuis Legal, PLLC with over 30 years of business law experience including mergers & acquisitions, raising capital through the sale of securities, business formation and governance, and work with purpose driven businesses and leaders.