How Venture Capital Can Join the ESG Revolution

(Photo by iStock/Julia Garan)

ESG has become increasingly mainstream for investors in recent years, as part of a broader wave to embrace purpose and stakeholder capitalism: More than $100 trillion in assets under management (AUM) globally are managed according to ESG principles. This push is at least partly driven by what some call the “business case” for ESG: Empirical studies from as early as 2010 onwards show companies with high ESG performance outperform their peers financially, while 2020 has been a record year for influx into funds performing strong on ESG-principles (justified by the parallel finding that those funds financially outperform their lower-ranking equivalents).

However, venture capital has largely been left by the wayside: In a quick scan of the of the websites of the top 50 largest venture capital funds, we only found five which mentioned ESG or a commitment to sustainability, while only a few dozen more firms have made public commitments to ESG (among the more than 2,900 VC firms worldwide). A recent Amnesty International study found that almost none of the world’s largest VC funds consider human rights in their investment process. Only one ESG topic, diversity, and inclusion, has seen widespread focus among VCs so far.

Why has venture capital been so slow on the uptake? And what will it take to make venture capital join the ESG revolution?

Baseball, Pirates, and Unicorns

To understand how we got here, we should briefly consider history. Though venture capital was born in Boston in the 1940s, it came to power in California, out of Silicon Valley, over the last 50 years. Startup founders and investors originally sought to use technology to solve the world’s biggest problems, from saving and processing data (solution: microchip) to communicating seamlessly (solution: the internet). However, in recent decades there has been a drastic shift of focus to creating companies with potential for rapid growth, often driven by network effects, no matter the social cost. And so, social media companies, from Facebook to YouTube, have been implicated in misinformation, social polarization, and mental health problems, while gig economy platforms have contributed to a global underclass of low-wage precarious workers.

At the root of this shift was the need to generate above-market rate returns from funds investing predominantly in companies that fail. The strategy is sometimes compared to baseball: Top performing funds look for “home run” companies with exit valuations greater than $1 billion, the mythical “unicorns” (though only 1 percent of all start-ups receiving venture capital funding will ever reach this status). In order to identify companies with unicorn potential—and ensure they realize that potential—a core set of practices and beliefs were developed, exemplified by Reid Hoffman’s 2019 book Blitzscaling. Hoffmann defines blitzscaling as fast-scaling tech companies with the goal of virality, high retention, high margins based on network effects, and a desire “to grow at furious pace that knocks the competition out of the water.” Hoffman’s ideas and principles (e.g. “embrace chaos”) build upon earlier frameworks such as Eric Ries’ “Lean Startup,” which promotes rapid testing, prototyping, and deployment of products before adequate testing and safety controls. Moral, ethical, or even legal boundaries could be temporarily disregarded in the service of disrupting an industry and achieving rapid time to market. Maxims like “fake it till you make it” and “move fast and break things” have become pervasive in start-up cultures.

The venture capital industry is also led by a highly uniform group of leaders, overwhelmingly white, elite-educated men (forty percent of venture capitalists in the US are graduates of just two schools, Harvard and Stanford). Only 10 percent of VC partners in the US are female, and not even 1 percent are Black (according to recent NVCA statistics, with similar numbers for the UK and Europe. Unsurprisingly, perhaps, venture capital tends to invest in a similarly skewed group of entrepreneurs: In the US, 86 percent of VC money went to male-only founder teams, while, in the UK, only around 2p out of every pound went to ethnic founders between 2009 and 2019. The overwhelming lack of diversity has produced what Emily Chang describes, in her book Brotopia as a self-reproducing chauvinist and racist culture of exclusion.

There has been hesitancy to challenge this culture. Limited Partners (LPs)—mostly from university endowments, foundations, family offices, and pension or state funds—have put little pressure on VCs to change, likely over concerns they may lose their allocation in top-performing funds. In a recent iNet talk, Bill Janeway explains the economics of the industry in one simple statistic: only the top decile (10 percent) of VCs outperform the market over time, which makes the top VC funds very powerful in relation to the asset owners. One LP with a significant portfolio of investments in venture capital funds clearly explained this position in an interview with us: “Performance comes first; we are entrusted with our clients’ capital, and to date that outperformance has been best positioned with a certain set of [VC] managers.”

Venture Capital’s ESG Pioneers

Over the last 18 months, things have begun to change. Consumers are increasingly concerned about ethical business practices, as the rapid success of benefit corporations like Patagonia show, and as attitude surveys repeatedly confirm. But we are not only seeing shifts in consumer markets (such as towards sustainable fashion or organic and vegan food); we are also seeing it in employee attitudes and founding behavior: more and more founders start companies that are “mission driven,” “impactful,” or “sustainable,” adhering to ESG principles. Upstream, this has already resulted in changes in investment decision and portfolio management: Big asset managers such as BlackRock, TPG, and Bain Capital have started impact funds and are incorporating ESG ratings and considerations into their investment practice. At the same time, Black Life Matters demonstrations have sparked a renewed scrutiny of finance's blatant problem with diversity, racism, and sexism. In venture capital specifically, the ongoing success of long-standing impact-driven funds like DBL Partners in San Francisco has led to more interest and followers in new, progressive funds such as Obvious Ventures in the US or Pale Blue Dot in Europe. In parallel, a new wave of climate-focused startups are attracting attention, what some commentators are already calling a new boom.

On the matter of diversity, equity, and inclusion, we are also seeing first success stories with the rise of new funds specifically targeting underrepresented and overlooked founders, from majority-black MaC Ventures or ImpactX in the UK to female-focused initiatives (e.g. AllRaise in the US) and national non-profits such as Venture Forward. These initiatives are committed to collecting and analyzing data, educating VCs and LPs alike, and ultimately taking action by writing more checks to underrepresented GPs and founders and bringing them into positions of power and decision-making (e.g. AllRaise wants to double the percentage of money in the hands of female founders and VCs by 2030).

However, while quantitative studies demonstrating improved financial outcomes have been the adoption trigger in other asset classes, the kind of ESG data and ratings available for public companies does not exist for ventures. Some initial evidence has begun to surface. For example, a ground-breaking HBR study showed increased diversity in VC decision-making teams lead to increased profitability both at the portfolio and overall fund level in venture capital firms. Similarly, a 2020 study by McKinsey & Company found that in a hypothetical M&A scenario, investors were willing to pay about 10 percent more for a company with an overall positive ESG record. However, comprehensive quantitative evidence will not be available for a while. Adoption of ESG practices for venture capital will require a leap of faith for first movers to experiment and try new methods.

Some of those experiments are already ongoing. In the US, for example, 500 startups hired an ESG specialist onto its team, Tracy Barba. Barba, herself coming out of the impact world, is not only very outspoken about the need for the whole industry to shift gears towards ESG but is actively working internally to support 500 Startups’ portfolio companies on ESG issues. In Europe, where ESG (and responsible investing more generally) have stronger roots, a variety of VCs have started to actively and openly embrace a shift. As has recently been reported, several ESG initiatives bringing funds together are pushing the agenda industry-wide. The group VentureESG (which we are both involved in), for instance, brings together over 150 VCs in an international community to share best practices, knowledge, resources, and aid the development of frameworks and metrics. Pitango Venture Capital out of Israel Kinnevek out of Stockholm and Kindred Capital and Balderton, both big funds in London’s ecosystem, are arguably among the strongest change-makers. At Balderton, their proprietary ESG framework—what they call Sustainable Future Goals or SFGs—was launched publicly in December 2020 while Kindred has recently published a comprehensive ESG policy for others to copy.

Four Solution Sets

In order for these efforts to become more widespread, a number of challenges must be addressed. According to the 2020 Pitchbook Sustainable Investment Survey, the most significant barriers to be overcome are a lack of clarity on how to define and measure ESG performance, a lack of ESG data on private companies, and persistent perceptions that ESG investing strategies generate lower returns. Investors have also cited a strong dislike of moving first or alone: Many GPs are waiting for industry heavyweights to move in the direction of ESG.

To mainstream ESG investing in venture capital, there are several steps that need to be taken by VCs, limited partners, data providers, and regulators.

1. Venture Capital Funds

Venture capital funds can begin their ESG journey by adopting ESG practices in their own operations. First steps could include adopting a diversity and inclusion plan and setting targets to improve diversity among their partners and hiring pipeline. Tackling the environmental dimension can happen in parallel, by implementing a carbon accounting to begin with; the advocate organization Leaders for Climate Action provides a smooth (and accountable) way into this part of the ESG journey.

From there, funds can focus on including ESG considerations within their investment processes. This is typically done by defining clear responsibilities: A partner should ideally lead the initiative but every part of the fund—from legal, communications, HR, and a representative from each investment team—could be part of an ESG taskforce. The first concrete outcome of the ESG work should be an ESG policy that covers the fund approach to ESG, starting with an exclusion list of industries and business models that cause harm where the fund will not invest and the process the fund uses to monitor and ensure compliance with the policy. And an ESG policy could also cover diversity and inclusion, team and working environment (e.g. parental leave), and governance principles (e.g. board structures).

The next step is to implement ESG considerations throughout the investment lifecycle. Fund managers can conduct due diligence into potential companies to better understand ESG issues. For example, a team researching a late-stage investment in a food delivery app would not only look at market share and growth potential of new customers but also the social impacts to the financial well-being of restaurants and drivers. ESG can also be integrated into terms sheets with specific clauses, such as a requirement to develop a Diversity and Inclusion Plan and an ESG Action Plan within a specified timeframe, a practice currently implemented by funds like Atomico.

Once the investment is made, VCs can play an active management role on boards and as strategic sparring partner through ensuring that the company identifies ESG gaps and develops a clear path towards progress on their ESG journey. Some funds provide coaching for companies, such as with Atomico’s “Conscious Scaling” workshop. Finally, funds should provide transparency around ESG issues by publishing an ESG report on the progress and performance of their companies (and themselves). 500Startups have led this effort recently with the publication of their 2020 ESG report.

The bottom line is that ESG should inform the VCs’ approach to how they run their own fund, how they invest and how they support their portfolio companies. Because ESG is as much a cultural shift as it is one of changing processes and practices, it is important to have management buy-in. Eventually, ESG should not be understood as an “add-on” but a core value in a VC fund leading to better investments and companies.

2. Limited Partners

Limited Partners (LPs) play an important role in advancing responsible approaches to venture capital funds in two ways: LPs can include ESG considerations when deciding how to allocate capital among funds and they can help advance a responsible and ESG agenda when it comes to their own portfolio management (e.g. make GPs regularly report on ESG or subareas such as DEI).

When selecting VC fund managers, LPs should incorporate Due Diligence Questions focused on the fund’s ESG processes and principles across the investment process. This can lead to LPs including ESG terms in Limited Partnership Agreements. Finally, to hold managers accountable, LPs should ask them for transparent reporting. (For example, HarbourVest Partners sets targets for diverse fund managers and reports on diversity metrics as a starting point.) Making follow-on investments dependent on ESG-performance could be a logical and strong next step on the LP journey.

3. Market Research, Data Providers, Ratings Agencies

Market research providers such as Pitchbook, Dealroom, and CBInsights provide important information to VCs on trends and growth forecasts for new technologies. These providers can support more responsible investment practices by including ESG information in their trends reports: Crunchbase and Dealroom have started to publish DEI data recently, but ESG data is absent. For example, rather than only providing information on the market opportunities and growth projections for AI-enabled enterprise software solutions, providers could also include key elements necessary for solutions to be in alignment with Ethical AI guidelines and risks and mitigations to be taken when investing in the sector such as avoiding employee burnout and workplace health issues.

ESG data providers can also play a role through providing ESG ratings for late-stage ventures that have achieved a certain threshold of valuation. Although ESG ratings are sometimes “confused” and unreliable for public markets, ESG ratings could provide transparency on a few of the most material factors to compare company performance in each industry. For a digital health platform this could be data on how good the company’s privacy policy and adoption of ethical AI principles are relative to peers. For a restaurant delivery platform, ESG ratings could cover labor practices and carbon emissions of vehicles in the delivery fleet.

4. Regulators

New and increasingly comprehensive regulation around ESG is starting to force investors and startup companies to consider, implement, and report on ESG factors. Regulators in Europe have already taken steps; for example, under the Public Services (Social Value) Act 2021, public suppliers in the UK need to adhere to the social value framework, which is closely aligned with ESG principles. In the EU, investors have to report on a comprehensive Sustainable Finance Disclosure Regulation (SFDR ) framework introduced in March 2021 (requiring sustainability-focused VCs to report on a large number of ESG indicators, including greenhouse gas emissions, the gender pay gap, board diversity, whistleblower protection and human rights performance).

In the US, the SEC has also announced comprehensive ESG regulation to be launched as early as late 2021 which will also affect venture capitalists. While ESG regulation has so far been haphazard with regards to venture capital and private capital more generally, we are expecting governments to step up more going forward.

Are Radical Approaches Needed?

Given how new ESG and responsible investing are to the startup ecosystem, reluctance to fully embrace it is not surprising. But solutions are already being tested by progressive first-movers, particularly in Europe (but with some shining lights in the US). Industry-wide initiatives like VentureESG are pushing for a comprehensive change as a collective, and participation in such groups is rising fast. Measuring how quickly change is happening is made easy in this way: How many strict commitments are these groups enforcing and how much assets-under-management do they represent in six or 12 months? While current measurements of the industry size are deeply flawed (such as this market analysis from Different Funds), more reliable measures of AUM aligned with ESG in VC will come about quickly.

There is a danger that the industry will push ESG aside as a superficial exercise of compliance and reporting, which would do more harm than good. Greenwashing and whitewashing might lead to what a research group out of MIT, examining public market ESG activities, aptly called “aggregate confusion.” Establishing transparency and accountability quickly will be key to prevent that from happening to VC.

What GPs and LPs alike are looking for is an authority to move. Since regulators will be slow overall—and so might big state-aligned LPs—change will be pushed forward further from progressive-thinking funds, and from outside of the established ecosystem. Alternative funding platforms focused on revenue-based finance or debt (see Adventure Finance for an overview) present alternative risk-capital options. And zebra startups follow a more sustainable, often cooperative-based approach to building “real” companies rather than mythical unicorns. Pressure from zebra founders and alternatives to VC might from the outside contribute to change on the inside.

The bottom line is clear to us: The model of venture capital financing will have to shift to incorporate ESG considerations. Whether it is the fear of missing out to alternatives or the belief in the “business case for ESG” that is pushing the industry matters less. The question is how quickly the shift will happen and by whom it will be driven.

Read more stories by Johannes Lenhard & Susan Winterberg.