Why ESG is only slowly making inroads into Venture Capital — and what can be done to speed this up?
(this article states the personal opinion of the author only)
The awareness of investors, funds and companies towards ESG (environmental, social governance) matters has tremendously increased during the past years, even the COVID-19 pandemic has not reversed the trend towards more sustainability. The extent of implementation of ESG policies on either the fundraising side or the investment side varies towards investment focus, scope of shareholdings (majority/minority shareholdings) and fund size and finding only slowly its way into Venture Capital (“VC”).
A. The importance of VC Firms and lessons learned from the past
VC companies play a critical role when it comes to shaping the future of technology, industry and society. Apple, Amazon, Facebook and Google, as examples, started with venture capital. More importantly, the products and services they offer had (and still have) a great impact on an unprecedented number of industries (e.g. marketing, communication, retail etc.). Uber, DoorDash and Airbnb, kind of the “next generation Googles” were also funded with venture capital at the beginning and fundamentally transformed industries such as transportation, housing and restaurants.
At the same time, many of the mentioned and other VC companies have run into major challenges when it comes to their business model and the management of the key stakeholders. It is well remembered that social media platforms faced and increasing scrutiny to their business model when it comes to selling user data or managing democracy and human rights.
Consequently, investors, governments and the general public are taking a much closer look at how the foundational values and practices related to management of societal impacts were considered in the earliest stage of companies. Coming from these experience, it should be clear, that the consideration of ESG at an early stage might help to avoid such challenges.
B. ESG risks and opportunities for VCs
I. Peculiarities of the VC model
ESG matters are treated differently in VC compared to Private Equity or multinational companies, taking into account the peculiarities of the VC model, namely the following, what is also the reason why ESG is not as prominent in VCs as, for example, in Private Equity funds:
- Capacity
Both, the portfolio companies and the VC teams’ focus is testing, refining and driving the business models. This responsibility and priority already ties up many of the capacities in the mostly small teams. ESG matters normally, therefore, are a not first ranked priority and receive less attention.
- Business Model
VC backend companies’ business models are evolving business models. This means they can and often must shift direction to adapt to a changing demand or new developments. Such changes may bring new and/or unforeseen ESG risks and/or opportunities to which the company has quickly to adapt, which again would tie up capacities. Additionally, each adaption bears the risk of either violating the VC fund’s or the company’s ESG strategy (if any implemented).
- Governance
Studies have shown, that the corporate housekeeping, in particular, setting up internal policies and procedures, in early stage companies is not a board’s priority. VC companies normally have only small boards typically consisting of founders and investors compared to those of public companies where a directors are responsible for legal, regulatory, audit, risk, corporate social responsibility etc.
- Reputation
Sentiment analysis (e.g. CBInsights Mosaic or Pitchbook) track reputation of ventures through social media and news media by looking for the total volume of discussion relative to peer companies as well as the overall sentiment of what is said. Those analysis show, that companies being embroiled in ESG controversies often receive disproportionate negative media attention which can have a debilitating effect on a pre-profit company that is looking for investors and customers.
- Limited influence
Most of the VC funds normally invest only minority stakes in companies. Their influence, therefore, is rather limited and decreases with further financing rounds and a dilution of the VC’s stake in the company (if no further investments are made). The more the company grows and the valuation increases, however, ESG matters and managing ESG risks become more and more important. Especially in that stage of the growth cycle, VC fund’s influence on handling ESG matters and risks diminishes, unless there is a good relationship to the management and the importance of this topic can be addressed.
The above mentioned aspects show, that ESG matters should not be disregarded even in early stage / VC companies. The challenge lies in finding the balance between not tying up too much capacities and imposing a too strict framework as well as giving the company enough space for development and growth.
II. Extent of ESG Measures Depends on the Investment Cycle
The ESG matters a VC fund and the portfolio company need to focus on depend on the stage of the investment/growth cycle. In early stage investments, it is essential that key ESG issues relevant to the business (model) are well understood and identified. Based on this understanding, an ESG focused culture should be created already in the earlier days — the smaller the company the easier to implement (seen from a process related perspective). This process is accompanied by identifying priority actions to detect and manage ESG matters.
The more a company grows, the more the business model evolves (or vice versa). During such growth phase, the ESG risks and opportunities need to be re-assessed on a regular basis and any policies or strategies implemented shall be adapted if required. At such stage, formal management systems for managing ESG issues can be developed and implemented, starting with a basic system. It should be ensured that sufficient resources are allocated to the management of key ESG issues. This is also accompanied by a clear allocation of responsibilities, for both, the day-to-day management and on the board level. As a last step, an ESG monitoring and reporting of KPIs will be introduced to make any changes visible.
C. How to integrate ESG at VC funds
Beside integrating ESG only in portfolio companies, fund managers can integrated ESG matters/strategies throughout the whole fund life cycle — from fundraising, to investing, holding and the exit of a portfolio company, which is already seen at some VC funds. The good practice of Private Equity funds can be taken as a starting point for VC funds, but it requires certain adaption to the VC peculiarities as set out above.
I. Responsible Investment Policy (Fundraising)
VC funds can implement a responsible investment policy, which sets out the funds’ overall values and mission, commitment to integrate ESG factors to better manage risk and generate sustainable long-term returns. It further clearly states and explains the relevance of ESG issues to the fund’s investment strategy. Especially for VC funds, it is important that the policy is reviewed once or twice a year to be able to adapt to any changes in the VC fund environment in order to reflect new ESG matters and experience made through the management system. There are two further common documents, in which ESG topics can be addressed. First, in the fund thesis which lays out the overall objective of a fund and which provides an opportunity for dialogue with LP’s about broader goals beyond financial returns. Second, the LP-GP term sheet which normally sets forth the terms and conditions including financial returns, management fees, profit distribution. The term sheet can also contain provisions for ESG due diligence and reporting of major risks, which is common practice for Private Equity funds.
II. ESG Requirements (Sourcing/Due Diligence)
When implementing the management system, the ESG requirements the VC fund intends to apply to its portfolio companies (and potentially during the sourcing and due diligence process) must be clearly stated. The ESG requirements vary from VC fund to VC fund and mainly depend on its investment focus (geographically / industry). Sourcing and investing may be easier for VC funds, if it is agreed that ESG requirements shall be implemented within an appropriate timeline and specifying certain milestones. It is self-evident, that ESG requirements set forth by local laws and regulations where the company operates and ILO’s core conventions (forced labor, child labor, discrimination etc.) are complied with. Further, it can be advisable to define and implement an exclusion list containing sectors/industries which are per se out of scope/prohibited for any investment.
III. ESG Roles and Responsibilities (Active Management)
ESG roles and responsibilities shall be clearly defined within both, the company and the fund. Ideally (and to avoid to get lost in translation), ESG responsibility is assigned to one member of the investment team or a board member respectively. That approach will secure consistency and allows for concentration of knowledge, skills and experience. An intensive dialogue with the management of the portfolio companies is essential. Setting board level policies on corporate social responsibility and risk management might be a good tool to get all investors in the syndicate on the same page of goals.
IV. ESG Reporting and Disclosure
An annual ESG report shall be prepared no matter if LP’s have asked for such or not. Summarizing current ESG issues and evaluating ESG data brings added value to both, the investors and the fund itself. The metrics tracked in such report provide an insight on improvements over time and where is still room for improvement. Additionally, such data potentially may help with fundraising and with regard to an exit. In case a VC fund decides not to prepare an annual ESG report, it should at least track data about serious incidents and — if required — report to LPs. Such serious incidents include fatalities, severe injuries, harassment, material breaches of the law, strikes and major fires. If such an incident happen, investigations should identify the root of causes and accidents and identify corrective actions to be taken. The UNPRI has established an ESG reporting and disclosure framework which either can be used as guidance or can be implemented, with the necessary amendments, where appropriate, directly by the VC fund.
D. Outlook
When taking a look at the VC investment trends for the next decade, it becomes clear, that a further disruption of certain industries will take place. Some of the most important frontier technologies, where VCs are currently investing in are:
- Public Health & Biosecurity: Synthetic Biology/Longevity & Anti-Aging/Gene Editing
- Public Safety & Security: Microsatellites/IoT/Self-Driving Cars
- Cybersecurity: 5G/Quantum Computing/Blockchain & Cryptocurrency
- Elections & Democracy: AI-Synthetic Image & Speech/Mobile Voting
Those frontier technologies and the up-coming disruption of certain industries provide a new level of urgency for early stage investors to evaluate and manage impacts of new technologies on society.
E. Summary
ESG slowly but steadily takes inroads into VC, mainly driven by the overall growing importance of ESG. The good practice and performance of Private Equity funds show, that investments and ESG are not exclusive. It is important, that the handling of the ESG risks and opportunities is adapted to the peculiarities coming along with the VC’s investment approach. For early stage portfolio companies a phased roll-out seems to be advisable in order not to tie up too many capacities and to prepare both, the board and the employees step-by-step to consider ESG matters in the decision making process and in the business model. Therefore, in each stage of a fund’s life cycle, ESG can and will find its role. VC funds should consider, that when it comes to an exit, the portfolio companies will be screened from an ESG perspective as well. VC funds adapting an ESG policy in the early stage followed by a continuous roll-out and improvement might profit from this.
