Neil Patel

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Integrating ESG principles into mergers and acquisitions has become a crucial facet of the deal. Non-compliance can make or break transactions because of the increasing focus and pressure from regulating agencies.

M&A deals must offer complete transparency on issues like climate risk, sustainability in operations, social justice, and corporate governance. Integrating these principles will ensure that the transaction progresses without any snags and gets the mandatory approvals.

Dealmakers interested in strategic acquisitions and private equity funds should deploy expert teams proficient in ESG laws. They should bring in professionals to conduct the due diligence and affirm that the target company is compliant.

Even if it is not, the next step involves allocating the risk in the transaction agreements. Next, buyers must ensure that the surviving company integrates ESG principles after the deal’s closing. If this is you, and you’ve recently acquired a new company, read ahead for detailed information about ESG integration.

Why is this important? Surveys indicate that 65% of M&A executives expect that their organizations are likely to increase their focus on ESG. They estimate significant transitions over the next three years. Another 11% report that they focus on ESG extensively when considering a targeted company for acquisition.

These statistics indicate that founders intending to exit their companies should make sure to follow ESG regulations. That’s how they can hope to get the best valuation for their startups. And, why integrating ESG principles into mergers and acquisitions is imperative.

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    Regulatory Agencies Require ESG Disclosures

    The U.S. Securities and Exchange Commission (SEC) requires registering companies to include climate-related information in their audited financial statements. This information is about the risks that will likely impact their business operations or financial conditions.

    Businesses must also submit reports of their greenhouse gas emissions, which has now become the common metric to assess risks. Providing this data will allow investors and acquirers to make an informed decision whether or not to back the company. Here’s what the ESG report includes:

    • How does the company monitor its climate-related risks and the steps it takes to identify and manage these risks?
    • Do the climate-related risks affect the business, its activities, and consolidated financial statements over an extended period? This period could be short-term, medium-term, or long-term.
    • How the risks can impact the company’s business model, future prospects, and strategy.
    • The possibility of climate-related events like weather and other natural conditions impacting the company’s operations and consequently, its financial statements.
    • If the climate can affect the company’s financial projections, investors need to know about it. For instance, if the company is agri-based, its products and estimated revenues could rely on ideal weather conditions.
    • Direct and indirect emissions of greenhouse gasses (GHG) from the company’s operations, including purchasing electricity or other energy forms.
    • Any GHG emissions from activities conducted in its value chain, upstream or downstream. That would include vendors and suppliers and customers and consumers of the end products.

    Getting Financing for Companies

    When evaluating a company for acquisition, acquirers focus on its market standing and potential to attract funding and support from investors. They’ll also examine how stakeholders view the startup.

    Companies that have unsatisfactory ESG ratings and performance metrics may find it harder to pitch for and get funding. Institutional investors, lenders, and financiers may be unwilling to offer funding to companies that don’t make ESG a priority.

    Eco-conscious consumers increasingly support brands that adopt green practices in their operations. Any brands that can demonstrate responsible and sustainable manufacturing processes have a better chance of retaining their customer base.

    Spending patterns also trend toward green businesses, and with eco-awareness circulating across the industry, companies must work harder on compliance. Without this compliance with ESG rules, they’ll find it harder to stay competitive and maintain that edge in the market.

    These factors make integrating ESG principles into mergers and acquisitions all the more crucial. That’s because acquirers prefer to purchase brands that have a dedicated customer base and can sustain their market presence.

    They’ll have a better chance of attracting funding for the deal if they pick the right companies for acquisitions.

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    Role of the Board of Directors in ESG

    The targeted company’s management structure and board of directors influence a company’s viability as a potential candidate for acquisition. A strong board complies with its fiduciary duty toward the company’s stakeholders and ensures that all ESG risks are duly addressed.

    That’s how directors make sure to maximize shareholder value in the long term and the company’s commercial standing. Their job is to practice due diligence, utmost care, and professional skills when devising the core strategies for the organization.

    On their part, shareholders are now committed to sustainable and eco-friendly practices. They are not above removing directors and executives if they are not satisfied with their approach to ESG.

    The board of directors must institute policies and processes to develop an understanding of how EGS issues affect the company. Next, it must come up with ESG risk management protocols, which can be done by establishing an appropriate governance structure. Of course, these protocols vary according to the overall culture and mission of the acquirer.

    ESG procedures and policies also depend on the business vertical and type of business. The board must assign roles and responsibilities to the different directors and committees. In this way, they can ensure that each individual is aware of the specific tasks assigned to them.

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    Procedure for Addressing ESG-Related Issues

    The board must follow a step-by-step process for managing ESG risks, such as:

    1. Monitor the company’s operations to identify any material ESG risks as they arise quickly.
    2. To identify risks, the board must develop reporting procedures to compile high-quality and detailed ESG data. Since maintaining consistency in data sets is critical, the company should have a standard process and create reference sets for maintaining ESG data records. Adopting AI and automated processes is advisable when compiling data to eliminate errors in computing and manually adding data.
    3. Implement the appropriate ESG risk management protocols per the company’s business strategies and verticals.
    4. Integrate ESG risk management into the business decision making procedures and devising business strategies.
    5. Maintain documentation about ESG risks and communicate the information to the company’s stakeholders, such as senior executives, shareholders, and workforce.

    Integrating ESG principles into mergers and acquisitions becomes a much more streamlined process when the targeted business demonstrates compliance.

    ESG-Driven Due Diligence

    M&A due diligence should include more than simply evaluating the company’s performance. It should focus on the broad impacts of its operations across the global chain. Buyers assume the liabilities of the acquired company, which is why they must evaluate the long-term ESG impact of the acquisition.

    When planning the integration process, they must ensure that the surviving company has sustainable strategies that are compliant. Due diligence involves examining the target’s assets and reputation on social media platforms and public forums.

    Any red flags that affect the target’s reputation could consequently impact the buyer’s reputation as well. The core areas of focus include social impacts like human rights violations, workplace diversity, workplace misconduct, corruption, and gender inequity.

    Environmental impact includes environmental degradation, greenhouse gas emissions, and previous instances of environmental protection violations. On consumer protection, the target would have to demonstrate that it offers security against privacy breaches and data breaches.

    Integrating ESG principles into mergers and acquisitions is also about assessing the prospect’s level of community engagement and cultural issues, as in the case of cross-border acquisitions. Buyers may also want to demonstrate that their company’s mission and values align with ESG compliance.

    And that applies not just to their regular operations. But also to the way they enter into M&A deals to scale their organization and develop a better market presence. In this way, due diligence influences the target company’s value and pricing and the transaction’s structure.

    Having identified the potential risks and liabilities of the M&A deal, acquirers can choose to back out of the transaction. Or, they can include terms in the transaction agreement requiring the seller to make changes in the company pre-closing.

    If you’re ready for more information about how to navigate the due diligence process, check out this video.

    Drawing Up the Transaction Agreement

    Post-COVID, M&A advisors now advise dealmakers to include ESG clauses in the share purchase agreements and asset purchase agreements. Material adverse effect clauses and interim operating covenants have now become common provisions.

    Material Adverse Effect Clauses

    Material Adverse Effect (MAE) or Material Adverse Change (MAC) clauses enable buyers to opt out of the transaction. That is, if some negative information arises that takes away from the deal’s viability. In case of any non-compliance issues arising, buyers can negotiate for their remediation depending on how vital they are to the transaction.

    For instance, if an issue is significant but making changes can resolve it, the buyer can add conditions for closing. The deal will move forward only if the changes are completed. However, if the issue is not that significant, the buyer can request that it be remedied. But within the time frame between the deal’s signing and closing.

    The buyer can also choose to accept the seller’s commitment to rectify the issue soon after the deal closes. Or during the integration process. If the seller is unable to comply with these conditions per the pre-determined timeline, the buyer can claim damages. But again, for a preset amount only.

    If the issue cannot be resolved before the closing, the buyer can request the seller to reduce the price. This reduction is a form of compensation for the risk the buyer will assume. Alternatively, the buyer can request that a portion of the payment be placed in escrow or reserve.

    This portion can serve as security for any losses the buyer may incur because of any losses they may incur. These losses may arise because of non-compliance issues. Restructuring the agreement can also be a request.

    Interim Operating Covenants

    The interim operating covenants outline the clauses that pertain to the targeted company continuing its operations during the deal. That is, in the period between the signing of the deal and its closing. Accordingly, the buyer may require the seller to disclose any new ESG-related issues that may arise.

    The transaction agreement will include customary representations and warranties related to the various company operations. And the regulatory landscape where it produces products and services. Buyers must take care to examine the representations closely and look for ESG-related disclosures.

    These may include alleged misconduct or non-compliance with specific codes that the target has overlooked.

    Post-Closing Integration Processes

    Integration in an ESG-compliant business ecosystem requires that the surviving company adopt ESG policies that align with both companies. Combining the best policies from the targeted company and the acquirer’s company could work to promote growth and reputation building.

    To make that happen, the buyer should ensure that the right policies are instituted and communicate them effectively. Recipients of the communication include supplies, contractors, vendors, and employees.

    Having ESG risk management protocols to address any future risk that may come up is a smart move. Buyers should focus on developing these protocols according to the risks disclosed during the due diligence process.

    Why Integrating ESG Principles into Mergers and Acquisitions is Crucial

    Awareness of environmental, social, and governance factors has become the core areas of focus for companies worldwide. Investors and stakeholders are also conscious of how ESG compliance impacts the company.

    Assessing ESG compliance during due diligence helps dealmakers understand the potential risks they might face. That’s how they can ensure generating optimum value from the deal.

    Companies can ensure sustained growth and adapt to constantly evolving regulations as regulatory policy-makers take steps to address climate change. And other social and governance issues.

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    Neil Patel

    I hope you enjoy reading this blog post.

    If you want help with your fundraising or acquisition, just book a call

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