How to apply ESG investing to venture capital – Crunchbase News

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Through Bennett Cohen

The past year has focused on companies advancing environmental and social goals, and as markets watched companies responding to unprecedented shocks, the consideration of ESG (environmental, social and governance) in the assessment of the long-term viability of enterprises broke into traditional investment.

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Funds that apply ESG principles captured $ 51.1 billion in net new money from investors in 2020, according to to Morningstar, more than double the catch of the previous year. This growth is driven by consistent findings that ESG investments do not compromise financial returns and often outperform.

While historically an ESG lens has been applied to large publicly traded companies, venture capitalists who work with early stage companies have a special opportunity to help founders get ESG up front. .

All VCs seek to support companies that will have transformational and positive long-term impacts on society, and supporting portfolio companies with appropriate ESG tools and perspectives at an early stage will increase their chances of long-term success.

Although increasingly common, the term “ESG investing” is often confusing as it is used to refer to a wide range of investment strategies. In its simplest form, ESG investing recognizes that these issues can have significant impacts on the risk / return characteristics of specific companies and portfolios.

Traditional ESG investing integrates a social, environmental and governance lens to minimize risk and maximize long-term financial value.

Other investment strategies that may carry the label ‘ESG investing’ include ‘value-based investing’, where investors screen out of their portfolios companies that do not correspond to certain social or environmental values ​​(for example, none. tobacco company), or “impact investing,” where investments are made explicitly to promote positive social and environmental outcomes, such as increasing racial equity or decarbonizing the global economy.

Traditional ESG investing – which seeks to maximize financial value over the long term – is relevant for every VC investor, while value-based or impact-based investing may only be relevant for VCs. with specific investment strategies.

Below, I propose a framework for applying traditional ESG investing to venture capital.

Measure ESG

The term ESG was invented in 2004 and grew up in the world of large institutional asset managers and publicly traded companies where there is a large amount of data available to support the integration of ESG factors into investment analysis.

For example, it’s handy to compare the fuel efficiency of vehicles sold by Ford to those of GM to see which company is most vulnerable to social and environmental risks, such as increased fuel efficiency standards, or better prepared to profit. social and environmental opportunities, such as the shift in consumer preference to electric vehicles.

For a venture capitalist looking to integrate ESG investing, the path is not so straightforward for two main reasons. First, the data to inform ESG analysis and compare startups to comparable companies does not exist the way it does for publicly traded companies. Second, while large established companies may have an entire team dedicated to producing ESG-related information and working with ESG-focused investors, startups may not be able to afford to. dedicate the bandwidth of a single employee to ESG initiatives. These factors leave VCs with the challenge of designing their own tailored ESG frameworks and principles.

A venture capital framework for ESG investing

We have found it useful to divide our ESG approach into three elements: due diligence, engagement and reporting.

With the overriding objective of maximizing long-term financial performance, it is important to embed ESG into due diligence, financial analysis and valuation. We start by identifying the most relevant environmental and social megatrends at global, regional and industry levels that can create significant risks or opportunities for a startup’s planned activities. The growing pressure to reduce CO2 emissions is a global environmental megatrend, while the drive to relocate critical industries like semiconductor manufacturing is a regional social megatrend (US).

Megatrend analysis is a useful exercise in “zooming out” enough of the startup being evaluated to ensure that nothing important is overlooked. Investors then need to relate the relevant megatrends to the specific risks and opportunities of the business.

For example, a specific opportunity might be for a company with more energy efficient technology to increase its revenue by marketing its product as a solution to reduce CO2 emissions in the electronics industry, while a specific risk could be an inability for a company to sell to a US government customer if it relies on a foreign semiconductor supplier.

Linking risks and opportunities to financial scenarios shows the impact on long-term value and returns, and makes it clear which risks and opportunities are most important. In the bandwidth-constrained world of startups and venture capitalists, it’s critical to focus engagement on the biggest risks and opportunities.

Assuming the decision is to invest in the business, this due diligence can lead directly to an ESG engagement plan, which aims to help the business mitigate material risks and pursue key opportunities identified during due diligence. . An engagement plan should be tailored to each business and be part of the ongoing support and added value between a VC and their portfolio.

ESG shouldn’t be about ticking boxes or wasting time on paperwork. A key takeaway here is that ESG improves a VC’s due diligence and helps them make smarter investment decisions, while ESG engagement adds value for portfolio companies. Thus continued, ESG helps VCs and startups to succeed and create value.

Monitoring and reporting

While the prospect of tracking ESG metrics may inspire groans from VCs and startups, having a “killer metric” in a portfolio for each category of E, S, and G makes the process relatively painless and provides a set of guidelines. ‘clear comparative indicators (something historically lacking for start-ups). While a single metric cannot give the complete picture, this approach makes reporting easy and concise.

The indicator strategy

For environmental performance, the best single indicator will relate to greenhouse gas emissions. Climate change is the most global environmental megatrend and is correlated with most environmental issues. We believe that the future of all industries will be less polluting. A venture capitalist may be more interested in the total reduced greenhouse gas emissions if a business is a home run compared to what will most likely be a small current impact for a start-up, but both are useful to follow.

For social performance, diversity is a possible key indicator, which can be tracked across key dimensions and at all levels of a company. Diversified teams perform better and less likely to have significant blind spots. When successful, diverse startups create wealth for a diverse group of people, thereby enhancing equity. To track diversity, companies should consult with a local lawyer to see how they can best collect and share this data, as the rules vary by jurisdiction.

For governance, we have found that the best indicator is the percentage of independent directors on a startup board. Independent directors can bring an unbiased perspective as well as industry experience that adds value to the business. Independent directors also add another dimension to the diversity of the board. The right percentage will change as the business grows. For a start-up financed by mid-term venture capital, a representation of at least 25% is optimal.

Finally, because every business is different and can increase value by articulating the specific positive impact it has for society, we help leaders select their own key impact indicators and identify which of them. United Nations Sustainable Development Goals they allow. Explicitly explaining how a company’s work relates to the United Nations SDGs allows it to communicate with a global audience of potential supporters in universal language.

One last thought

Because the biggest companies of tomorrow are the startups of today, it’s worth the extra effort to help put startups on the right ESG trajectory from their earliest days. Passing the ESG early means you don’t have to pay a lot to fix it later. If Facebook and Google had put a lot of emphasis on diversity from the start, they probably wouldn’t be struggle to hire and promote women and minorities today.

The integration of ESG investment into venture capital is still an emerging area. Because the domain is nascent, the VC community benefits from the sharing of best practices. However, we are not the only ones to benefit from it. The biggest companies of tomorrow will inevitably have a significant impact on how we tackle global challenges such as climate change and social equity, thus helping them lay a solid ESG foundation as startups serve us all.


Cohen is partner of Capital of Piva, a venture capital firm that invests in the future of industry and energy. He has over 15 years of experience at the intersection of energy, mobility and sustainability, spanning venture capital, startups, large corporations and consulting. Prior to joining Piva, Bennett founded the venture capital arm of Royal Dutch Shell in San Francisco, where he led investments in clean energy and advanced mobility startups, and chaired Shell’s global mobility investment committee.

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