Environmental, Social, and Governance (ESG) is a framework used to evaluate and assess an organisation’s business practices and performances based on varying sustainability and ethical issues. The term was first introduced in the 2004 United Nations (UN) report, “Who Cares Wins”, which was a joint initiative of financial institutions invited by then UN Secretary-General, Kofi Annan. Almost two decades later, ESG has become popular among both investors and consumers as we strive towards sustainable development locally and globally. In 2019, the International Finance Corporation (IFC) developed a corporate governance progression matrix to guide small and medium enterprises (SMEs) to integrate ESG into their operations based on their stage.
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SME Growth Stage 1: Start-up Business
SMEs in the start-up stage often focus on product development and testing markets. They operate with a single-minded focus and limited resources. You’d find operations to be pretty straightforward. Here are some items you need to settle while the business is in its infancy:
- Have core functions been identified? The founder might be responsible for everything from HR to sales and marketing. As your business grows, these functions would be handled by an additional headcount.
- If you’re a private limited company, are your articles of association or constitutions adopted? Do you have simple bylaws which would guide your business in decision-making and fulfilment?
- When you have additional staff in your SME, have you outlined authority limits? Larger companies and organisations would have multi-tiered limits of authority. For an SME, the threshold may be guided by revenue and complexity.
- For sole proprietors and partnerships, one important control is often overlooked: basic bookkeeping, cash flow management, and tax functions. Do not let things get too complicated before you start incorporating these functions into your business. It would ease your application for future financing or when seeking investors.
- Another overlooked control measure is the separation of the founder’s and the business’s cash sources and bank accounts. Setting up a business account may take time – and incur some costs. You may want to consider earmarking a personal account specifically and solely for business purposes. That way the pool isn’t mixed up – especially during critical periods (such as when bills, rent, and salaries are due).
- For partnerships or private limited companies, it is important to have in place a partnership agreement or shareholders agreement. This outlines the roles and responsibilities of the partners and shareholders – especially when everyone is bootstrapping. What happens when there is a tie? How would you break it? If one wants to dispose of their equity, how will the partnership or company go about it? This figurative piece of paper could help limit or mitigate liabilities as well as fallouts when deals go sour.
SME Growth Stage 2: Active Growth
During this stage, the SME is focused on sales and revenue. To cope with the growing demand, you are likely expanding your team and your employees are starting to see complex issues to be solved. For instance, human resource (HR) issues will begin to surface. Reporting lines, authorities, and responsibilities are vaguely defined. Many on your team will need to wear multiple hats. For external investors, one major risk factor is ambiguous systems and policies. Worse when authority is concentrated on the founder or CEO. This lack of checks and balances may not segregate the founder from the business. With encouraging sales, you might consider bringing onboard new investors – which, conversely, dilutes your control over the business.
To be better equipped in incorporating ESG issues at this stage, consider the following:
- Ensure that core staff positions have been filled – even if one has to wear multiple hats. Establish the organisational structure and key policies.
- Documentation is much more critical compared to before. Strategic plans and budgets need to be documented for easy reference.
- You may need to engage external advisors formally. These could be accounting professionals, auditors, and even lawyers. They would provide the business with strategic input – especially in mitigating and managing risks.
- Staffing priorities need to be in place. Growth may force a 360 expansion. With finite resources, not all can be filled so rapidly. Being aware of the opportunity costs ensures the lack of personnel does not hold the business back too much.
- With more than one decision maker or more than two levels in the organisation structure, it is important to formalise the signing authority. At what level can the manager sign off? When do you need two or more founders to co-sign the payment? Who are alternative signatories?
- Your business may require advanced planning and sound bookkeeping systems in place. The more customers to serve, the more varying transactions you may find yourself to be in. Besides getting more customers, you may need to develop a system to ensure payments are collected as well.
- In the active growth stage, the SME needs to ensure it has a business continuity and succession plan in place. What happens when senior management leaves? How are replacements sought?
- At this stage, the founder(s), shareholders, and directors should be kept informed through consistent financial and non-financial information. Your business would have a brand presence online. Thus, becoming susceptible to potential reputational risks. Your key spokespersons and shareholders should not be kept in the dark should anything happen.
- Your business will need to go beyond complying with basic regulatory disclosure requirements.
- In the previous stage, the shareholders and directors meeting can be held in your living room. In active growth, shareholder relations need to be formalised. For private limited companies, the annual general meeting (AGM) needs to be held properly. Shareholders need to be treated equitably with clear lines of communication established.
- The business will also need to demonstrate its awareness of stakeholders as potentially interested parties. You will need to ensure they are engaged properly to ensure positive relations.
- At this stage, businesses which began as enterprises or partnerships may receive advice from professionals to incorporate. As a private limited company, the corporate legal persona heralds a new era of governance.
SME Growth Stage 3: Organisational Development
Organisational development is when SMEs are working on professionalising their structure and processes. You might find new positions which never existed being created: talent acquisition, compliance, legal management, contracts management, product development and management, project management and the list continues. Specialised expertise is brought into the business along with proper systems and controls. If you’re the entrepreneur and founder behind the business, you – along with others like you – find that the business begins to take an identity of its own. You will need good management and administrative skills.
- The business’ Core Governance processes need to be documented by this stage. That includes clearly defined roles and responsibilities – especially for key personnel. The Board of Directors (for private limited companies) and the management begins to show a clear division of responsibilities and authority. A Governance Champion would be identified with the responsibility of leading the business towards structured corporate governance.
- Decision-making and strategic oversight become more complex. The Board, for instance, now would include main shareholders. The company as a whole would have conversations about strategy, financing, and staffing. A succession planning framework for key personnel is put into effect.
- Shareholder, board, and management meetings become regular and are held with a structured agenda. Attendees will be given supporting documents with the meeting notice. The company secretary will be more involved in taking adequate minutes.
- Financial management of the company becomes even more complex. The SME may find itself appointing a chief financial officer with oversight of the finance division. Internal audit functions would be established complementing the audit on controls by external auditors.
- Business units in the growth stage would have clearer authority, reporting lines, and guidelines. They would often have unit-level objectives, strategic planning, budget, key performance indicators (KPIs), and clear accountabilities complementing the company’s own documented versions of the same.
- SMEs in this stage would prepare and audit their financial statements complying with national accounting standards – no longer merely to fulfill regulatory obligations for private limited companies.
- External advisors play an even more active role – borderline to keeping the SME accountable to agreed standards. Some SMEs may begin to present their basic performance reports to these external advisors periodically. In some cases, new advisors would be brought on board. For example, halal or shariah compliance advisors.
- Besides the latest updates, your business’ website would be offering governance-related information for stakeholders.
- More shareholders would also mean the AGMs would discuss key decisions, dividends, and plans. No longer would the AGMs be mere rubberstamps. Adequate shareholder participation will be a priority for the company.
- At this stage, some private limited company SMEs would be considering whether going public would serve their expansionary aspirations.
SME Growth Stage 4: Business Expansion
Once an SME enters the business expansion stage, you will notice that they begin to resemble large companies in business structures, management, and governance. Decision-making becomes an institutional activity. The organisation will also find itself subjected to ‘corporate governance’. A professional management team would handle matters which was once decided by the Founder(s). Most of the activities from the previous stage would be formalised or familiar to employees.
- The business would be adopting a corporate governance action plan. The role of the Company Secretary would move from external to internal. Alternatively, the Chief Operating Officer (COO) would assume the secretarial responsibilities and extend the information to the external Company Secretary.
- Corporate governance policies like a Code of Ethics or Code of Conduct, a whistleblowing code with environmental and social considerations, a succession plan, and HR or grievance mechanisms are adopted. Responsible business practices, too, become part and parcel of how the company operates.
- In the board, the Chairman of the Board of Directors and the Managing Director or Chief Executive Officer (CEO) would be separated. The Board would play an active role with a mix of non-executive directors. In the instance of publicly listed companies, independent directors would be appointed. With these directors come a variety of skills and experience.
- The Board will also delegate its functions to committees (common committees are risk committees, investment committees, and remuneration committees). The board will receive an induction and regular training on relevant industry environmental and social issues. Its procedures will be formalised to ensure effective meetings and input from the directors. The Board will also be responsible to approve the succession planning policy as well as the company strategy. In addition to that, the company’s risk appetite is subject to the Board’s approval.
- An array of internal controls systems, policies, and procedures would be in place with independent external auditors who report to the Board. Recordkeeping of sales and accounts becomes timely, secure, and scrutinised.
- By this stage, the company would have identified its environmental and social risks (and have a mechanism for its revision). Following that, it would develop a framework to address those risks. A board-level committee would be appointed to monitor the overall control environment. The Board also routinely monitors the company’s risk management and compliance with policies and procedures.
- Financial disclosure and transparency in this stage, too, would transform. Financial statements need to be prepared according to the International Financial Reporting Standards (IFRS) and audited with International Standards on Auditing (ISA). A recognised auditing firm would need to audit the company’s financial statements. In its annual report, the company would include ESG information. While the Board prepares the Annual Report, the AGM would approve it.
- Key non-financial information would also be disclosed to the public. Such information includes risks/opportunities and ESG practices. The company will need to disclose related party transactions to both the Board and shareholders. It would also disclose its risk appetite.
- All shareholders would also be updated regularly on company policy, strategy, and results. A mechanism for resolving shareholder-related disputes would be put in place. Apart from that, the company would have a formal dividend policy as well as an articulated policy on the treatment of minority shareholders.
In conclusion, the integration of Environmental, Social, and Governance (ESG) into small and medium enterprises (SMEs) is crucial for sustainable development. The International Finance Corporation (IFC) has developed a corporate governance progression matrix to guide SMEs to integrate ESG into their operations based on their growth stage. For start-up businesses, core functions, simple bylaws, authority limits, bookkeeping, cash flow management, and tax functions, partnership or shareholders agreement, and separation of the founder’s and the business’s cash sources are important control measures. On the other hand, for active growth SMEs, staffing priorities, formalising the signing authority, business continuity, and succession plan, consistent financial and non-financial information, shareholder relations, and stakeholder engagement are critical. Overall, integrating ESG self-assessment into SME growth stages ensures they operate ethically and sustainably.