ESG is coming to venture capital. Here’s how startup founders can stay ahead of the curve

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Shrinal Sheth, Knowledge Specialist, Investors Industries, World Economic Forum Geneva

• Venture capital is crucial in shaping the future of our people, planet and society.
• However, venture capital has been a laggard in considering environmental, social and governance aspects when making investments.
• The tide is now turning as venture capital firms begin to push for adoption of ESG. Here’s how to stay ahead as a startup founder.

If you’re a startup founder who has raised venture capital (VC) funding or is looking to do so, you know that global VC funding hit USD 454 billion in the first three quarters of 2021, up from USD 332 billion in 2020 over the same period.

What’s interesting is that early-stage funding grew at 104% year-over-year in 2021 to peak at USD 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.

Despite this influence, Deliveroo’s disastrous IPO this year and a report by Amnesty International highlighting the failure of VC firms over human rights due diligence demonstrate that venture capital has been a laggard when it comes to incorporating Environmental, Social and Governance (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.

Venture capital can play a key role in shaping the future

However, several developments over the past 12 months show that the tide is turning:

• The launch of VentureESG, an initiative to push the VC industry on ESG supported by 250+ VC funds and Limited Partners (LPs),
• PRI’s launch 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,
• The new heads of sustainability hires at Gobi Partners, 3one4capital and Prosus/Naspers demonstrate the growing importance of ESG in VC.

Increasing expectations on ESG integration are now extending to startups and SME businesses. However, there is a gap in the supporting ecosystem of ESG benchmarks relevant to the size of these companies. At Prosus, we set sustainability performance standards at the group level and then work with the companies to identify areas relevant to their business model and operating context.—Prajna Khanna, Global Head of Sustainability & VP, Prosus Group and Naspers Limited

How venture capital can embrace ESG

So, what can you do as an early-stage startup founder to stay ahead of the curve?

The short answer is – start small and build your company’s ESG capacity as it grows.

1. Analyze: 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— analyze 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 analyze if the product or service your startup is providing will have a net positive impact on the world. For instance, the value that many tech startups 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 startup. Therefore, it is imperative 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 startup 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.

“Identifying sectoral ESG issues early on is crucial to strategize with them in mind. At Wright, a key reason we are building electric aircrafts with 100+ seats is because large aircrafts account for 95% of aviation’s GHG emissions. Our mission is to lower emissions by building a cleaner solution that customers are demanding.”—Jeff Engler, CEO, Wright Electric

3. Prioritize: As the founder, your goal must be to lay a strong foundation for building robust ESG processes. Just as you ruthlessly prioritize all potential features and solutions during product development, you must prioritize high value, low complexity ESG issues in your sector as well. (Here are some ideas for priority issues for consumer internet companies).

No VC firm will penalize your company for not having figured out everything when it comes to ESG. However, the market, i.e., your customers may penalize you as the startup matures and the reputational risk increases. For instance, over 50% of Gen Z and millennial consumers would boycott a company for not being ecoconscious.

“The quest for a startup to integrate ESG into its DNA is a marathon, not a sprint. At SkyHive our journey to becoming a leader in impact has taken four years; starting with adopting the standards of a B Corporation and now leading the global dialogue on Ethical AI.”—Sean Hinton, Founder & CEO, SkyHive Technologies Inc.

4. Measure: As Pieter Kemps, Principal at Sequoia Capital says in the video below, 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 startup is in. For instance, tech startups 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. https://www.youtube.com/embed/EkCLw4ckYlc?enablejsapi=1&wmode=transparent

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.

Remember: 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, startup founders looking to raise funds must be able to anticipate ESG issues now and as the company scales up in the future!