Making Binding Commitments to ESG & Impact through the Fund Setup

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In the previous articles, we explained step by step how we think about ESG & Impact from a VC fund perspective. We made a case for why it matters and discussed the initiatives we have taken to integrate ESG & Impact into our investment process, portfolio management, and internal operations. 

‍In this last post (#6), we explain how VCs can make real, enforceable commitments to ESG & Impact through the legal and regulatory design of the fund. We’ll also share the choices we’ve made at byFounders, including how we’ve embedded key principles into our LPA and approached the Sustainable Finance Disclosure Regulation.

This will be structured into three sections:

1. Embedding ESG & Impact into the fund setup: The fund setup translates the strategy, and underlying value promises into a binding legal and regulatory framework.
2. Integrating ESG & Impact-related provisions into the Limited Partnership Agreement (LPA): Investors can make legally binding commitments to ESG & Impact through specific clauses in the LPA—particularly by focusing on Responsible Investment Provisions and Compensation Structures—and through customized terms in side letters.
3. Aligning SFDR Disclosure Requirements with the Fund’s Strategy: The choice of the SFDR article should naturally reflect the choices and positioning of the fund and not be force-fitted. 

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(1) Embedding ESG & Impact into the fund setup

Up until now, we have spoken a lot about the strategic and operational choices we have made regarding ESG & Impact - rooted in our belief of superior performance outcomes. As a final step, we need to decide what weight ESG & Impact carry in our fund setup - the legal and regulatory framework we operate under.

This defines the actual legally binding commitments we are willing to make! It includes what we promise and have to disclose to key stakeholders - as a VC, these are primarily (1) our Limited Partners (LPs) and (2) regulatory bodies. Accordingly, the fund setup should address three key areas: 

1. Resource Allocation: How capital can be used with special regard to who we can invest in and under what conditions. 
2. Compensation Structures: How (and if) compensation of the fund managers is tied to specific success criteria beyond pure financial returns.
3. Disclosure Requirements: What type of information we have to disclose to whom and in what frequency.

The fund setup should reflect our positioning and operational choices and, therefore, our value promise to LPs, startups, and employees. It is the last step to operationalize the ESG & Impact mandate - ultimately consolidating the key elements we have outlined in the previous articles in the form of a legally binding agreement. It’s the ultimate test for any strategy with regards to how it is backed up by a) contractual commitments and b) resource allocations. However, it's not as straightforward as you might think. ESG & Impact within the regulatory environment is still very nascent and has not yet been adopted to early-stage investing. We’ll explore this further in the sections below.

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(2) Integrating ESG & Impact related provisions into the Limited Partnership Agreement 

How tightly ESG & Impact are integrated into the fund setup varies widely. It can range from general statements of intent to specific obligations. This is reflected in two key documents: 

• Limited Partnership Agreement (LPA): The legal contract that outlines the rights and obligations of both the General Partners (GP) and its LPs - i.e., the investors of the fund. The LPA covers everything from how profits are shared to how decisions are made, including how ESG & Impact are considered in the investment strategy.

• Side letters: These are separate agreements between the GPs and specific LPs. They allow for additional terms or clarifications that may only apply to that particular LP (e.g., special ESG reporting).

While the LPA provides the legal framework for the entire fund, side letters can be customized for an individual LP. Since side letters can vary widely and often focus on reporting requirements, we’ll focus on the LPA, as this is the main document for implementing ESG & Impact-related clauses. Plus, if something is captured in a side letter, it probably isn’t mission-critical to the fund and more of a concession made to a particular LP. 

When adding ESG & Impact clauses to the LPA, there are two main areas to consider: Responsible Investment Provisions and the Compensation Structure. Let’s break each of them down in more detail, including how we've chosen to structure it.

Responsible Investment Provisions

Responsible investment provisions in the LPA commit the fund to specific environmental, social, and governance practices in investment decisions and subsequent management. These provisions usually cover:

• Investment standards: These are the specific ESG policies, external standards (e.g., UN Global Compact), and/or principles (e.g., PRI) that the fund agrees to follow. For example, the fund might commit to investing only in companies that meet certain environmental standards, maintain fair labor practices, or uphold transparent governance practices.
• Investment restrictions: These restrictions outline what the fund will not invest in, often covering industries or activities that may conflict with its ESG goals. For example, the fund might avoid sectors like fossil fuels, tobacco, or other areas that don’t align with its social or environmental priorities. These restrictions can help define the fund’s values and ensure its investments reflect those priorities.
• Reporting requirements: This part spells out how often and in what detail the fund will share information on its ESG & Impact performance. It can range from incident reports and periodic summaries of ESG activities to detailed reports with measurable outcomes.

Provisions like these ensure that ESG considerations are not just part of the day-to-day operations but are also legally required in the fund's framework. 

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Compensation Structure

Another factor to consider is how the fund's success is evaluated and rewarded, including whether incentives should be tied to more than just financial outcomes.

VCs typically earn money through two mechanisms:

• Management fee: A fixed percentage of the fund's committed capital (typically around 2%) is paid to the fund managers regardless of the fund's performance. This fee covers operational costs and compensates the managers for their work overseeing the fund.
• Carried interest: A performance-based fee representing a share of the fund’s profits (typically around 20%). This is designed to reward fund managers for generating returns for their investors.

Carried interest schemes can be designed to reward managers not just for financial gains but also for meeting specific Impact or ESG goals. For example, to promote positive social and environmental outcomes, VCs can link a portion, or even all, of the carried interest (i.e., profits) to the achievement of specific sustainability goals. This is also known as impact-tied carry (or dual carry), where fund managers receive a higher share of carry if their investments meet (or exceed) pre-specified goals.

It can be structured in two ways:

• Portfolio-wide goals: A single impact KPI and goal are set for the entire portfolio. For example, the fund's overall goal could be to reduce greenhouse gas emissions by 100,000 metric tons of CO₂e per year. If the portfolio as a whole meets that goal, fund managers receive the full share of carry; otherwise, they might receive less or none at all.
• Individual company goals: A unique impact KPI and goal are set for each portfolio company. For example, the impact metric for one portfolio company might be “number of lives saved,” with the goal of saving 10,000 lives annually. Another portfolio company might have the impact metric “tonnes of CO₂e reduced,” with the goal of reducing 500,000 tonnes within five years. In this setup, fund managers earn carry based on each company's performance relative to its unique goal.

If you're interested in how this works in practice, you should check out this article from Mustard Seed MAZE (MSM) or visit Impact Linked for more information.

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(3) Aligning SFDR disclosure requirements with the fund strategy

Another key part of the fund setup is meeting regulatory requirements. In the EU, this mainly relates to the Sustainable Finance Disclosure Regulation (SFDR). It requires financial market participants (FMPs) and financial advisers (FAs) to clearly report on how they consider sustainability risks in their investment decisions. To that end, the EU has designed three categories that have varying degrees of sustainability (or Impact) focus:

• Article 6 - not explicitly focusing on sustainable investment strategies
• Article 8 - promotes environmental or social characteristics
• Article 9 - aims to achieve an environmental or social objective

Although funds get to self-categorize themselves - the choice of article directly impacts the level of disclosure required. As a baseline, an Article 6 FMP/FMA must report on sustainability risks by:

1. disclosing how sustainability risks are integrated into investment decisions and
2. disclosing how the assessment of sustainability risks affects financial returns. 

Articles 8 and 9 must meet the requirements of Article 6 FMP/FAs, along with additional reporting obligations. These include, among other things, disclosing how sustainability characteristics are met, outlining sustainability indicators, describing the investment strategy and asset allocation, and providing information on where to find further details. For Article 9 investors, the criteria are stricter and must be more explicit about how the investment product aims to meet sustainability objectives.

Choosing the “SFDR Article” should result naturally from the fund's operational and legal choices. Reporting requirements escalate significantly when moving from Article 6 to Article 8 and even more so from Article 8 to Article 9. This translates into greater resource requirements for the fund and founders.

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(4) Recap

Many ESG & Impact strategies are put to the test when it comes to legal and regulatory implementation. If you practice what you preach, it will also be reflected in your fund’s structure and commitments. 

Some of the main takeaways include:

• The LPA is your main instrument: The LPA is the main legal document to translate your fund’s strategic and operational choices into binding commitments. This is codified in your funds a) investment guidelines, b) compensation structure, and c) reporting requirements.
• Carefully consider an impact-tied carry scheme: Expanding your fund’s definition of success and anchoring it into the compensation structure requires diligent analysis. While it may sound good on the surface, a poor operational implementation can sometimes achieve the opposite. This is one of the reasons why we stuck with a traditional compensation model.
• SFDR should mirror operational and legal choices as per the LPA: It’s important that the choice of SFDR Article is a natural outcome of the strategic and operational choices. If you’re aiming for the “green status” of a higher article, you’ll need to ensure that your processes, resources, and reporting structures are fully prepared to support it. While it is still possible to self-categorize as an Article 8 or 9 fund with weak ESG and/or Impact goals, we don’t think that will be enough in the near future. As expectations change, funds that don’t step up their game may find it harder to attract investors or maintain their credibility.

As the VC ecosystem continues to evolve, so will our strategies. ByFounders will continue to double down on the impact-aware agenda, although we recognize that broader collaboration is necessary to effect change on a larger scale. We are committed to keeping our thoughts and principles open-source (incl. our tools) because we want to encourage more collaboration and transparency in the industry.  By sharing our playbook, we hope to inspire others to join in so we can learn from each other and collectively drive this agenda forward.