Return on Inclusion | March 6, 2023

Want to wring impact from ESG? Look to governance

Jasper van Brakel

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Guest Author

Jasper van Brakel

If ESG is a foot in the door to an economy built around sustainability, inclusion and equity, then governance is the power that’s going to kick that door wide open and make way for real progress on corporate environmental and social performance.

Governance doesn’t get nearly as much scrutiny as the other two ESG factors. It’s treated as a dull exercise in compliance and fiduciary duty to shareholders or discussed only in terms of increasing board diversity. Bringing more women and people of color onto boards is necessary, but it is not sufficient to drive the change impact investors and advocates want. Stakeholder capitalism that seeks input from stakeholders but is ultimately concerned with only one outcome—creating value for shareholders—isn’t really stakeholder capitalism. 

We need to change who makes decisions more broadly, along with the interests they’re accountable to and the incentive structures they work within. If we want stakeholder capitalism, we need stakeholder governance. 

It’s time for governance and ownership to get a divorce

The core concept here is to disentangle governance from ownership of the company. That sounds like—and is—a heavy lift. But we’re not starting at ground level: We can already see a shift toward greater stakeholder power in the rise of benefit corporations and campaigns for expanded board representation.

Benefit corporations, a nascent idea just 10 years ago, now number in the thousands and include a growing number of public companies, among them Allbirds, Coursera, Lemonade Insurance and Warby Parker. And activist ESG investors, fed up with the slow pace of change, have started filing shareholder proposals mandating that their portfolio companies become benefit corporations. The legal form is available in most states; provisions vary, but generally require that benefit corporations specify social and environmental goals, report publicly on progress and consider those goals alongside profitability and shareholder value when making decisions. 

Activist shareholders have made real progress in the past few years in pushing for more diverse boards, and adoption of the German system of codetermination, while it’s not on the front burner, has gained some high-profile advocates (including Sen. Elizabeth Warren). That system requires one-third to one-half of supervisory board members to be worker representatives, and having worked within it, I’ve seen that bringing employees into strategic decision-making can significantly improve a company’s social impact. Adding customers, supply chain partners and community representatives to boards would be another positive step—plenty of research shows diverse groups are more innovative and make better decisions.

Ultimately, though, to produce different outcomes, we have to embrace alternative governance structures.

The option gaining steam is conversion to a noncharitable perpetual purpose trust, which owns a majority of voting shares and appoints a board of directors. This is a flexible form and not every iteration solves for shareholder governance. Patagonia, for example, went all-in on assuring the company’s mission would continue, but the Chouinard family maintained control over the voting rights.

I’m advocating for a PPT more like the one that governs Organically Grown, a structure that not only preserves the mission and prevents an unwelcome sale of the business or undue extraction of profits, but also redefines fiduciary duty to include multiple stakeholders, reinvests profits and shares them with stakeholders, and enables investors to purchase stock and receive dividends from the corporation even while voting control is held in a trust. 

What about competition and access to capital?

I’ve been talking about this model in various forums over the past several years and I have found that people often assume it’s viable only for private companies, niche players or social enterprises. Not so: Pretty much any company could do this, including high-growth startups and publicly traded corporations.

Eyebrows rise when I say that. One common question is, “Can companies survive in competitive markets with this structure?” Absolutely. It often gives them an advantage because customers believe they are making a positive impact by buying from the brand. Organically Grown is thriving in a market dominated by hungry giants (one impetus for its conversion was to scale without “selling out”). I’m sure Patagonia’s sales will be stronger than ever with its profits going to fight climate change.

The answer to the follow-up question—“But can they attract capital?”—is more complex. It will be hard for companies with stakeholder governance models to attract capital from sources that are singularly interested in maximizing their own return. However, these companies are well positioned to deliver attractive returns at lower risk—a compelling proposition for long-term, patient investors, especially those focused on impact. 

The PPT model is compatible with traditional debt financing, and structures along the spectrum between pure debt and equity provide appealing alternatives. Revenue-based financing, for example, is an underused financing strategy that can be both investor and founder friendly. Convertible notes that generate a dividend and pay off at a predetermined point are another option. 

In terms of risk, in a mission-first business structure the focus is on the company’s long-term survival, not quarterly profit targets. And with all major stakeholder groups fully engaged, there are a lot of people who have something to lose if things go wrong. 

Skeptics note that the prevailing corporate incentive structure has the virtue of clarity and gives investors the assurance that their interests are primary. It’s true that stakeholder models have the potential to devolve into people competing for the interests of the group they represent at the cost of the others, or to produce solutions that are suboptimal for everyone. There is work to be done in refining the models with those concerns in mind. And certainly these companies need strong board leadership and a healthy process—but that’s true of all companies, and it’s not as if shareholder primacy guarantees investor security. Just ask Tesla’s stockholders. 

Can stakeholder companies solve big problems?

The concerns that strike me as most serious are these: If we as a society want to address the climate emergency, how can this strategy help? How can we use it to tackle big issues? Are we optimizing on the fringe or addressing central problems? 

There’s no question that businesses can and should contribute to solving systemic problems. But public-private partnerships are essential for real progress and stakeholder models, by nature collaborative, are better equipped to form and succeed at joint efforts. Many people working in conventionally structured companies realize what needs to happen, but the singular focus on producing short-term returns for shareholders keeps them from making the decisions they know are right. 

This is a governance problem and I get it: governance is not sexy. But carefully designed stakeholder structures that make mission goals a legal mandate could turn corporations into a huge catalyst to help solve social and climate-related problems. That’s because mission-first companies are fundamentally more than businesses—their goal is to build a vehicle for lasting positive impact. And unquestionably, we need more of that.

Jasper van Brakel, CEO of RSF Social Finance, has held leadership roles at companies in the U.S. and Europe. He writes regularly on innovative finance for a more resilient economy.