Being a first mover as an ESG-oriented VC fund can become the source of competitive advantage. It will help attract high-quality portfolio firms that are eager to help address some of the most pressing challenges of today, including the climate emergency. To do this, VCs need to evolve their selecting and screening capabilities, rethink their valuation models and redesign term sheets to incorporate ESG issues.
The complex challenges the world faces today — climate change, the energy transition, and growing inequality just to name a few — have forced large, incumbent companies to take action, reinventing their business models in some cases or radically re-engineering their products, services, and operations in others. These actions are crucial to securing a sustainable future. But large companies can’t do this alone. Indeed, they shouldn’t. Young, fledgling ventures need to be part of these solutions, too.
Any hope of addressing society’s most pressing problems, however, critically depends on VC funding for such startups. As part of our research, we conducted 17 long interview sessions with 25 different individuals representing 15 investors, LPs and other market participants — including the European Investment Fund (EIF), FMO Ventures Dutch Development Fund, Balderton, Beringea, and Index Ventures — from 5 different countries. We learned that incorporating ESG objectives in the VC process, while becoming increasingly common, is still a new practice. It is also challenging: VCs need to evolve their selecting and screening capabilities, rethink their valuation models and redesign term sheets to incorporate ESG issues. Despite these challenges, VCs are more aware and more ready to incorporate ESG objectives than ever before.
Many of our interviewees indicated that integration poses three key challenges.
First, promoting ESG objectives among portfolio firms is contingent upon the development of specific, practical tools, as well as measurement and benchmarking frameworks. Venture capitalists need to be able to assess, monitor, and advise on ESG performance of their ventures both from the risk mitigation and the value creation standpoint.
Second, promoting ESG practices among startups requires that venture capitalists first enhance and solidify the legitimacy of their own claims. This, in turn, will critically depend on integrating ESG objectives into VCs’ own operating model via incentives, processes, and structures. These changes are necessary for building VCs’ capabilities to influence startups as well as their authenticity in the eyes of startup firms.
Finally, and presumably most significantly, VCs need to find ways to support startups to increase the authentic incorporation of ESG factors. Processes required to apply ESG factors to startups differ from those applied to large, public firms because the costs of measuring, monitoring, and reporting on ESG factors will be higher in younger ventures, given that they face more considerable constraints in terms of human capital, management capacity, and financial resources. Relatedly, startups often pivot in terms of their core business model which makes setting firm ESG objectives more difficult.
Issues and Capabilities Needed
Having identified these systematic barriers to ESG integration, we believe that the critical next step for VCs involves building in-house ESG integration capability and ESG-based evaluation capacity within their own business model. Based on our interviews to date, we identified three main categories of issues VCs should prioritize:
Selecting and screening investments
VCs are good at evaluating teams and markets using traditional criteria, such as market, team, product, level of innovation and deal terms. Yet going forward, they must build a corresponding evaluation capability for ESG factors, especially for the due diligence stage. Doing so would enable them to assess the degree to which startups have genuinely integrated ESG factors both in terms of risk mitigation and importantly, in terms of capturing a potential growth opportunity.
The following questions should guide decision making of venture capitalists: to what extent does the venture’s business model contribute towards the resolution of a material ESG challenge in its industry? To what extent is the startup solution unique, innovative, and able to scale up quickly and profitably while achieving a positive societal impact by addressing the ESG issue? How sustainable is the opportunity given current ESG trends and how easy is it for the solution to be imitated by others? Not only does ESG integration significantly enhance a VC’s due diligence process but also, it enables the company to make more robust investment decisions. This type of ESG criteria should not only be considered at the due diligence stage but also that they should evolve through the different growth phases of the startup.
The VC valuation should accurately reflect the social and environmental impact that startups with strong ESG factors will generate in the medium and long term. Investors need to develop new tools suitable for measuring investments whose core objective is to synergistically generate financial performance and positive societal impact in an integrated way.
Investors should ask: How best can we assess the future value of an ESG-oriented startup? Benchmarking and comparable multiples will be needed. Similarly, information sharing regarding returns on ESG-oriented startups will become essential. Currently, there is a rapid construction of multiple databases and sources of financial information regarding startup funding and valuation. The overarching goal of these rapidly expanding tools is to increase investors’ sophistication in making choices within the ESG space in the near term.
Term sheet, monitoring, and metrics
We discovered that a growing number of VCs include diversity metrics as part of the information requirements to new portfolio companies. But a lot more needs to be accounted for. The term sheet traditionally sets up the rules of the game. The key question now is how to incorporate ESG requirements that a) are effective, b) drive value, and c) are not an unnecessary burden for portfolio firms. We identified a number of European VCs that have pioneered the incorporation of references to ESG factors as a critical signal of their commitment to ESG issues. To fully integrate ESG into the term sheet, VCs should be unafraid to engage with startups directly on ESG issues (i.e., specifically develop an ESG engagement plan); they should use voluntary materiality frameworks from public markets as a starting point for exploring material ESG issues in the startup’s industry; and they should be willing to experiment and learn through trial and error about the type of ESG rules that can be effective.
Identifying priority ESG factors is key. However, our interviews indicate that one-size-fits-all approach cannot be applied. For example, a biotech startup has different needs from a fintech startup, and a company developing electric cars’ batteries has different needs from one that focuses on plant-based alternatives, such as Oatly or Impossible Foods. Provided that VC is an industry specialized by sectors, VCs from the same sector may be able to work together, in the same way that they syndicate deals, to identify most relevant ESG factors.
The Purpose of the VC Industry
Institutional investors, i.e., the limited partners in VCs, are actively searching for more ESG-oriented investments in the private capital market. Being a first mover as an ESG-oriented VC fund can become the source of competitive advantage. It will help attract high-quality portfolio firms that are eager to help address some of the most pressing challenges of today, including the climate emergency. Not only the VC model but in fact, the very purpose of the VC industry may take on a new and ambitious goal: to identify and fund those ground-breaking new business models that will complement our efforts in the global quest towards a more sustainable and more inclusive future for all.