ESG for seed-stage founders – What is SFDR and why does it matter for fundraising?

SFDR is much more than just an acronym, it’s one of the essential frameworks that startups need to understand in order to successfully fundraise in today’s market. In this blog, our ESG analyst Mona outlines what it means from a startup’s point of view and why you should care about it.

Today, startups are expected to not only deliver profits but also demonstrate their commitment to sustainable practices. In Europe, the Sustainable Finance Disclosure Regulation (SFDR) has emerged as a pivotal framework to ensure transparency in sustainable investment.

If you’re still skeptical, let me assure you that these aren’t just fancy words: based on a Morningstar report, there is a growing trend among investors to promote sustainable practices and products while also protecting their investments from climate-related risks. As a result, the classification to “light-green” Article 8 funds in Europe has nearly doubled since Q2 2021, driven by the introduction of new funds and the reclassification of products from Article 6 to Article 8 as well as market appreciation. As of Q2 2023, Article 8 funds made up 52.9% of all assets available for sale in the EU, while 3.5% of funds were categorized as “dark green” Article 9.

So in short, yes, you should definitely care about SDFR if you’re looking to fundraise. It’s important to proactively understand the regulatory demands and reporting requirements of the fund from which you are seeking funding. This is crucial as these requirements often align with the data investors seek regarding their portfolio firms.

In this blog post, I’ll help you get up to speed with the fundamentals of SFDR and its implications for startups' fundability.

SFDR – increasing financial market transparency

The primary objective of SFDR is to increase transparency of financial market participants' sustainability practices and to prevent greenwashing. The regulation mandates that all financial market participants, including Venture Capital (VC) and Private Equity (PE) firms, disclose how sustainability is considered in their investments. These disclosures include public information on investors’ websites regarding their sustainability approach, pre-contractual disclosures regarding their fund-level approach, and the inclusion of sustainability-related details in their annual reporting. These disclosures are requested by regulation set by the European Commission and administered for instance in Finland by the Finnish Financial Supervisory Authority as well as requested by funds Limited Partners (LPs). The extent of reporting and data required varies based on the entity's fund classification as well as, for instance, number of employees. The funds are categorized as follows:

Article 6 Funds

Article 6 funds have no specific sustainability objectives, resulting in the lowest level of ESG disclosure requirements. These funds can choose whether sustainability risks are relevant to their investment decisions. If they are relevant, the fund needs to disclose how it addresses them, and if they are not, it has to provide reasons why.

Article 8 Funds

Article 8 funds aim, among other things, to promote environmental and social characteristics and follow good governance practices. These funds are required to demonstrate how their portfolio companies contribute to the set characteristics and evaluate risks accordingly. Some funds may also decide on a share of investment made with sustainable investment objective, requiring a demonstration of how portfolio companies contribute to this objective.

Funds operating in the Nordics and Europe such as Antler, 360 Capital, and Norwegian VC Sandwater have funds classified in this category. Sandwater investor Adele Unneberg explains how their impact evaluation is ingrained in their overall due diligence (DD) process when analyzing new investments:

“As a first step, we ensure that founders and other stakeholders (e.g. co-investors) are committed to the impact thesis underlying the investment, which should be consistent with our target impact areas within climate and health. As part of this process, we work with the companies to define which impact KPIs will be used to track impact generation over time."

On top of their commitment to generate positive impact, Sandwater also wants to see awareness of any potential negative environmental or social risks related to the company’s operations.

“To this end, we ask companies to fill out our Impact and ESG questionnaire. If potential risks are uncovered as part of this process, we will seek commitment from management to monitor these post-investment, and take remedial actions where necessary,” Unneberg says and adds that as active owners they regularly follow up.

“We regularly follow up with all our portfolio companies through our “Gameplan” process of engagement and target-setting, which includes commercial, operational, technical as well as impact milestones and lend support as needed.”

Sandwater also asks for updates on impact KPIs and relevant sustainability risk metrics on a quarterly basis from portfolio companies.

“Our sustainability reporting practices are tied in with our overall portfolio follow-up process.”

Article 9 Funds

Article 9 fund investments aim to make a positive impact on society or the environment through sustainable investments. These funds need to show how their investments contribute to their impact objective and how this impact is monitored and measured. As of today, Article 9 funds will either i) demonstrate a contribution to an environmental or social objective or ii) contribute towards an economic activity identified within the EU Taxonomy. Article 9 funds may have specific impact criteria, or some may focus on particular impact topics. From a point of view of a startup that is fundraising, demonstrating a long-term sustainability strategy and measurable impact is crucial for attracting Article 9 funding.

European VC firms such as Planet A Ventures, Norrsken VC, Pale Blue Dot, Green Code Ventures and Serena have funds classified in this category.

According to Lena Thiede, founding partner at Planet A Ventures, they kickstart the talks around ESG with the founders right from the beginning.

Planet A Ventures’ approach draws from standards set by Leaders for Climate Action, Thiede adds. They ask portfolio companies to:

• Establish ESG best practices
• Report on the Principal Adverse Impact (PAI) indicators under the SFDR, as well as individual impact KPIs
• Adopt a climate policy as well as a Diversity & Inclusion Policy within 12 months
• And support them to develop these policies and metrics

Another VC with an Article 9 fund, Serena, has secured an €80 million seed/series A fund called Racine², dedicated to “Social and Climate Impact themes”.

“Through pre-investment ESG due diligence (including PAIs/DNSH), we craft tailored action plans integrated into the operating team's guidance roadmap for the company. Specific requirements for Article 9 fund companies are included in legal documents. We also integrate PAIs into our annual ESG reporting,” Sybille Ranchon, investor at Serena says.

“Our commitment extends to our entrepreneurs, empowering them with actionable written content and workshops to help them understand these challenges and address them effectively.”

Agnes Svensson from another Article 9 fund, Norrsken VC, highlights that DD is an important opportunity for the fund to assess the impact potential and sustainability practices of startups.

“We benchmark companies on a number of parameters, and use this data to align on ESG improvement areas, capabilities and actions they take or intend to take to run their operations sustainably and ensure that impact remains in focus,” she says.

After the investment, they work together with the companies to establish good governance practices and align on an action plan around material ESG topics. Svensson explains that Norrsken VC has taken a stance to be a founder friendly Article 9 fund, meaning they only ask for data that they believe is material and helpful for tracking and helping their impact startups advance on their journey.

“All of this is done with a 'founder friendly' lens, meaning that we are mindful to protect our founders' time, to focus on areas that will truly move the needle for both impact and commercial growth.”

How SFDR impacts companies seeking funding

Each fund approaches SFDR in its own way, which is why the assessments at the investment phase and reporting requirements can differ. In general, funds classified under articles 8 and 9 conduct more in-depth risk assessments related to ESG and impact. On the other hand, the funds that require more ESG-related reporting generally offer continuous support to their portfolio companies to help them develop a robust ESG strategy.

Here are some key terms that might come up when you're fundraising and are engaged in talks with investors:

EU Taxonomy

The EU Taxonomy serves as a classification system designed to provide clarity regarding which economic activities are environmentally sustainable. The taxonomy defines six environmental objectives under which activities can be qualified as sustainable. If a fund claims to make investments aligned with the EU Taxonomy, expressed as a minimum proportion of taxonomy-aligned investments, it is required to provide periodic reporting on the alignment of their investments. For the investments to be taxonomy aligned, they must also adhere to the ‘Do No Significant Harm’ principle, ensuring they don't significantly harm any of the EU Taxonomy objectives as well as adhere to good governance practices.

Do No Significant Harm (DNSH)

Investors claiming to make sustainable investments need to consider the DNSH principle in the context of their investment not causing any significant harm to any other social or environmental objectives. A way to ensure that the DNSH principle is met is to identify and assess the PAIs for the investee company.

Principal Adverse Impacts (PAIs)

To date, financial market participants with less than 500 employees still have the option to decide whether they want to consider the PAI of their investment decision or not. If the fund considers PAIs, it must systematically collect data on these indicators. PAIs consist of 14 mandatory indicators, with nine related to the environment and five covering social factors. Additionally, at least one environmental indicator and one social indicator must be considered from a list of 46 discretionary indicators. To make things slightly easier, we compiled the following table to show the mandatory adverse sustainability indicators that funds request from their portfolio companies:

So, to make a long story short, SFDR has introduced a new era of transparency and responsibility for startups and financial market participants. Understanding its objectives and aligning with its requirements can be instrumental in securing funding and promoting sustainable practices. Essentially, a win-win for both startups and the planet.

If you’d like to share your thoughts on ESG reach out to Mona at mona@maki.vc. To learn more about our ESG efforts read our ESG Survey Report 2022 and ESG learnings from our portfolio.