Venture capital “catching up on ESG issues”
by Graham Buck
Venture capital has traditionally been a laggard in considering environmental, social and governance (ESG) aspects when making investments, claims the World Economic Forum. However, it reports that the tide is now turning as venture capital firms begin to push for adoption of ESG and recommends that start-up founders stay ahead of the curve.
The Geneva, Switzerland-based WEF says that global venture capital (VC) funding over the first nine months of 2021 reached US$454 billion against US$332 billion for the same period in 2020. One notable increase was in early-stage funding, which grew at 104% year-over-year in 2021 to peak at US$ 49 billion.
“VC firms are therefore a critical force in shaping the future of people, planet, and society as they continue to invest in the leading companies and disruptive technologies of the future,” writes Shrinal Sheth, Knowledge Specialist, Investors Industries at the WEF.
However, Sheth notes that despite this influence the initial public offering (IPO) on the London stock market in March 2021 by Deliveroo was regarded as disastrous while an Amnesty International report highlighted the failure of VC firms over human rights due diligence and suggested that venture capital has been a laggard when it comes to incorporating ESG considerations in investment processes.
“An incessant pursuit of generating outsized returns by focusing on investing, building and, scaling startups that generate rapid growth at all costs, the lack of pressure on VC firms to focus on ESG, and a lack of diversity are likely reasons for the slow ESG uptake,” she writes.
Tide may be turning
Venture capital can nonetheless play a key role in shaping the future, suggests Sheth who cites several developments in 2021 that indicate the tide is now turning:
- The launch of VentureESG, an initiative to push the VC industry on ESG supported by 250+ VC funds and Limited Partners (LPs)
- The launch by Principles for Responsible Investment (PRI) of a VC collaboration to improve industry wide practices
- The launch of MPower Partners, Japan’s first ESG-focused VC fund led by Kathy Mitsui, former vice-chair of Goldman Sachs
- New heads of sustainability hires at Gobi Partners, 3one4capital and Prosus/Naspers that demonstrate the growing importance of ESG in VC
Embracing ESG within VC
What can early-stage start-up founders do to stay ahead of the curve, asks Sheth? She suggests that they start small and build their company’s ESG capacity as it grows via the following five-point plan:
1. Analyse: In the early-stage, as you focus on getting the product-market fit right, you will likely go through multiple iterations both for your product as well as the business model. While speed is key during this process, take product-market fit a step forward— analyse the second and third order impacts of your product and any changes in your strategy that may open a whole new world of ESG risks and opportunities.
At this stage, it is also important to analyse if the product or service your start-up is providing will have a net positive impact on the world. For instance, the value that many tech start-ups add comes at a great cost to workers’ rights.
2. Identify: While at the outset your company may not seem very risky from an ESG perspective, any unidentified ESG issue will likely scale as quickly as your start-up, so it is important to identify material ESG Issues that can affect your business not only today but also during the scale up phase.
Studying the ESG risks impacting the sector your start-up falls in is a good first step. When raising funds, identifying VC firms that can help grow your business while building your ESG capacity is another important step that can have a great payoff in the long term.
3. Prioritise: As the founder, your goal must be to lay a strong foundation for building robust ESG processes. Just as you ruthlessly prioritise all potential features and solutions during product development, you must prioritise high value, low complexity ESG issues in your sector as well.
No VC firm will penalise your company for not having figured out everything when it comes to ESG. However, your customers may penalise you as the start-up matures and the reputational risk increases. For example, over 50% of Generation Z and millennial consumers would boycott a company for not being eco conscious.
4. Measure: According to Pieter Kemps, Principal at Sequoia Capital, what you measure depends on the business stage you’re in. It could be retention rate when you are trying to find product-market fit or monthly active users, as you scale up.
Applying the same line of thinking to ESG data, it is important to determine the one to three metrics that matter for the business stage your start-up is in. For instance, tech start-ups could begin by focusing on data privacy and diversity metrics. It is important to note that the chosen metrics should also be something in which the next set of investors can find meaning as well.
5. Communicate: Bring your customers into your sustainability conversation and be transparent about ESG being a work in progress as you grow. Your transparency and relationship with your customers will be your first line of defence if there’s an unintended sustainability issue.
Don’t forget about your investors though! Add your ESG value creation story in your investor-focused documents. If you can share some specific data linked stories, even better.
A final takeaway
Sheth concludes with a reminder that retrofitting a company’s culture to solve for ESG issues is much harder compared to embedding it in the company’s DNA from the beginning. Further, given the VC industry’s increasing focus on ESG, start-up founders looking to raise funds must be able to anticipate ESG issues now and as the company scales up in the future!
The complete version of the WEF article can be accessed here
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