Andrew Sherman, a senior partner at Seyfarth Shaw in Washington, D.C., is a corporate and transactional lawyer. He serves as a legal and strategic advisor to leaders of Fortune 500 companies and founders of rapid growth, emerging businesses. Sherman’s practice is concentrated on mergers and acquisitions, domestic and international franchising, and corporate counseling. When he’s not practicing law and dealmaking, you can find him writing books or teaching. Over his 35 years of experience, he has authored 26 books on business growth and M&A strategy. He currently teaches business at the University of Maryland and law at Georgetown Law School.
Drivers of ESG in Today’s World
The recent micro and macroeconomic pressures are a testament to the fact that M&A transactions don’t occur in a vacuum. Between the pandemic, war in Ukraine, and weather-related issues, “the more complicated the world becomes, the more relevant ESG variables emerge,” Sherman notes. “We’re at an inflection point in our history of capital markets, and our history of mankind, where environmental, social and governance is a proxy for much, much larger issues in our society.” These larger issues have sparked a societal paradigm shift where we’ve adopted a heightened awareness about the environment, each other, social justice and good governance.
“We’re at an inflection point in our history of capital markets, and our history of mankind, where environmental, social and governance is a proxy for much, much larger issues in our society.”
— Andrew Sherman
As our level of awareness rises, Sherman explains that whether it’s a private equity fund or family business office, every source of capital that drives M&A and other growth transactions is beginning to integrate ESG standards into their own capital formation tools. Buyers are adding new layers of ESG not only to due diligence, but to their investment criteria, reps and warranties, covenants, and post-closing disputes and disagreements. Sherman advises thinking of ESG as being relevant at the beginning of the transaction in terms of corporate strategy and financing commitments, running throughout the transaction in terms of due diligence, appearing within the body of the purchase agreement itself, in the form of reps, warranties, indemnities and covenants, and in post-M&A integration. He warns to bear in mind that if you’re a small company hoping to eventually sell, and are not in alignment with the buyer’s ESG standards, “they won’t just walk away from your deal, they’ll run away.”
ESG’s Impact on Valuations and Business Risk
When it comes to whether or not companies that adopt good ESG strategies will receive higher valuations, Sherman presents three schools of thought. The first, if you believe ESG variables are drivers of enterprise value, then companies with good ESG strategies will get higher valuations. He points to the example of culture, heightened due diligence surrounding the efficacy of a company’s culture and its levels of innovation, productivity and profitability will lead to higher valuations based on the efficiency of that company’s culture. The second is neutrality, ESG could emerge as something that is merely required as table stakes — you may not receive a higher valuation, but the absence of ESG compliance will result in a lack of interested buyers. And thirdly, ESG could cost you money — the costs associated with variables such as environmental compliance and employee wellbeing will affect your earnings, making you less profitable, and in turn, will dilute enterprise valuation. Sherman believes, at a minimum, it is neutral, but in most cases, ESG is a value driver. He adds that even if ESG is neutral to negative, we have a responsibility to the environment and to each other to make those investments. Regarding the potential fear of over-regulation, Sherman acknowledges that it has to be balanced against an awareness of the environmental and social risks that could arise if action isn’t taken.
The environmental and social risks are just one piece of the puzzle, real business and reputational risks also arise if ESG compliance isn’t taken seriously. Sherman points out that the most significant difference between three years ago and today is, companies used to be able to prove environmental compliance by checking a box and moving on, now it’s more complicated. For buyers and investors to make decisions around the value of an enterprise, compliance must now be reflected through action. “ESG due diligence is doing a deeper dive into the people issues, the human capital issues, the culture issues,” and if these are in place, then “good things will happen to enterprise valuation.” Sherman adds that “numbers follow, they don’t lead.” If you want a strong valuation, investing in your company’s culture is vital. If you haven’t invested in the proper programs that aid in employee growth, then you run the risk of having an “irrelevant” company and workforce failing to evolve.
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Standardized ESG Criteria and Due Diligence
Currently, one of the major issues facing every institutional investor is the need for standardized ESG standards that can be applied on a more harmonized basis. Sherman believes that in terms of ESG due diligence, we need to abandon the checklist mindset. “We tend to default to documents, and “that’s the starting point, but it can’t be the ending point.” He sheds light on the fact that we’re now able to do due diligence in ways that we could never have done. We now have the ability to gain insight into a company’s culture via a multitude of digital media sites.
Preparing for Sale and Incorporating ESG Considerations
When it comes to preparing for sale, it’s critical to exhibit transparency and accountability. “The prep process has become more holistic, I would spend a lot of time as a business owner thinking about who my buyer might be, and where ESG will fit in that buyer’s priority,” Sherman shares. He advises against ever feeding into the common inclination to push problems under the rug as everything will be exposed in due diligence. “If you aren’t treating people as they deserve to be treated, if your culture is weak, if your level of innovation is weak, if your governance has been weak, if you’ve been environmentally irresponsible, it’s going to come out.” Buyers want to step into a company that is aligned with their values, culture, and particularly, that their commitment to the environment, each other, good governance and leadership is already in place. The deciding factor over whether your deal is going to be accretive or dilutive comes down to all these factors — it’s no longer simply about math.
“If you aren’t treating people as they deserve to be treated, if your culture is weak, if your level of innovation is weak, if your governance has been weak, if you’ve been environmentally irresponsible, it’s going to come out.”
— Andrew Sherman
If you are a business owner of a lower middle market company with limited resources, this shouldn’t hold you back from demonstrating your commitment to ESG. “Being nice to somebody doesn’t cost you anything,” Sherman acknowledges. There are small incremental steps you can take to demonstrate your compliance to the E of ESG without spending. Similarly, the S isn’t expensive either, treating people with respect and investing in programs can create a culture where people want to work. The same goes for good governance and understanding your commitment to being a good steward.
Final Thoughts
As for some final words, Sherman cautions against the belief that ESG is going away, or is merely a fad. “I think if anything, more defined ESG standards will evolve over the next few years.” How we treat each other, the environment and the way we govern will be eternally important.
“I think if anything, more defined ESG standards will evolve over the next few years.”
— Andrew Sherman
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