How To Apply ESG Investing To Venture Capital

By Bennett Cohen

Last year put a premium on companies that advance environmental and social objectives, and as markets observed companies responding to the unprecedented shocks, the consideration of ESG (environmental, social and governance) factors in assessing the long-term viability of companies broke into mainstream investing.

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Funds that apply ESG principles captured $51.1 billion of net new money from investors in 2020, according to Morningstar, more than doubling the prior year’s take. This growth is driven by consistent findings that ESG investing does not compromise financial returns, and quite often outperforms.

While historically an ESG lens has been applied to large, publicly traded companies, venture capitalists working with companies at an early stage have a special opportunity to help founders get ESG right from the get-go.

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

Despite becoming more mainstream, the term “ESG investing” often still causes confusion because it is used to refer to a wide range of investment strategies. In its simplest form, ESG investing acknowledges that these issues can have significant impacts on the risk/return characteristics of specific companies and portfolios.

Traditional ESG investing incorporates a social, environmental and governance lens to minimize risk and maximize financial value over the long term.

Other investment strategies that can carry the label of ESG investing include “values-based-investing,” where investors screen from their portfolios companies that don’t align with certain social or environmental values (e.g., no tobacco companies), 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 to every venture capital investor, while values-based or impact investing may only be relevant for VCs with specific investment strategies.

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

Measuring ESG

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

For example, it’s practical to compare the fuel efficiency of vehicles sold by Ford to those of GM to see which company is more vulnerable to social and environmental risks — such as increased fuel efficiency standards — or more prepared to profit from social and environmental opportunities such as consumer preference shifting to electric vehicles.

For a venture capitalist looking to integrate ESG investing, the path is not as straightforward for two key reasons: First, the data to inform ESG analysis and compare startups to comparable companies doesn’t exist in the way it does for publicly traded companies. Second, while large established companies can have a whole team dedicated to producing ESG-related information and engaging with ESG-oriented investors, startups may not be able to afford to dedicate bandwidth from even a single employee to ESG initiatives. These factors leave VCs with the challenge of devising their own fit-for-purpose ESG frameworks and principles.

A VC framework for ESG investing

We’ve found it’s helpful to break our ESG approach into three pieces: due diligence, engagement and reporting.

With the overarching goal of maximizing long-term financial performance, it is important to integrate ESG into due diligence, financial analysis and valuation. We begin by identifying the most relevant environmental and social megatrends at the global, regional and industry levels that may create significant risks or opportunities for a startup’s projected business. The growing pressure to reduce CO2 emissions is a global environmental megatrend, while the push to re-shore critical industries like semiconductor manufacturing is a regional (U.S.) social megatrend.

Megatrend analysis is a useful exercise in “zooming out” enough from the startup being evaluated to ensure that nothing significant is being overlooked. Investors need to then connect the relevant megatrends to the company’s specific risks and opportunities.

For instance, a specific opportunity could be for a company with a more energy-efficient technology to boost revenue by marketing their product as a solution for reducing CO2 emissions in the electronics industry, while a specific risk could be an inability for a company to sell to a U.S. government customer if it relies on an foreign semiconductor supplier.

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

Assuming the decision is to invest in the company, this diligence can lead directly to an ESG engagement plan, which focuses on helping the company mitigate the material risks and pursue the key opportunities identified during diligence. An engagement plan should be tailored for each company and become part of the ongoing support and value-add between a VC and their portfolio.

ESG should not be about box-ticking or time-wasting paperwork. A key takeaway here is that ESG enhances a VC’s diligence and helps them make smarter investment decisions, while ESG engagement adds value for portfolio companies. Pursued in this way, ESG helps VCs and startups achieve success and value creation.

Tracking and reporting

While the prospect of tracking ESG metrics might inspire groans from VCs and startups alike, having one “killer metric” across a portfolio for each category of E, S and G makes the process relatively painless and provides a set of clear comparative indicators (something historically lacking for early-stage companies). While a single metric cannot give a 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 all-encompassing environmental megatrend and is correlated with most environmental issues. We believe the future of all industries will be lower emissions. A VC investor may be more interested in the total possible greenhouse gas emissions reduced if a company is a home run versus what will most likely be a small current impact for an early-stage company, but both are useful to track.

For social performance, diversity is one possible key indicator, which can be tracked across key dimensions and all levels of a company. Diverse teams are better performing and less likely to have significant blind spots. When successful, diverse startups create wealth for a diverse group of people, bolstering equity. To track diversity, companies need to consult local counsel to see how they can best collect and share this data, because the rules vary by jurisdiction.

For governance, we’ve found the best indicator to be the percentage of independent directors on a startup board. Independent directors can bring an impartial perspective as well as industry experience that adds value for the company. Independent directors also add another dimension to the board’s diversity. The right percentage will evolve as a company grows. For a mid-stage venture-backed startup, having a minimum of 25 percent representation is optimal.

Finally, because every company is different and can enhance value by articulating the specific positive impact they are having for society, we support leadership to select their own key impact metrics and identify which of the UN Sustainable Development Goals they enable. Explicitly articulating how a company’s work ties to the UN SDGs allows them to communicate to a global audience of potential supporters in a universal language.

A final thought

Because tomorrow’s largest companies are today’s early-stage startups, it’s worth the additional effort to help put startups on the right ESG trajectory in their earliest days. Getting ESG right early means not having to pay dearly to fix it later. If Facebook and Google had pushed hard on diversity early on, they likely would not be struggling to hire and promote women and minorities today. 

Integrating ESG investing into venture capital is still an emerging field. Because the area is nascent, the VC community benefits from sharing best practices. However, we aren’t the only ones who benefit. Tomorrow’s largest corporations will inevitably have a significant impact on how we rise to global challenges like climate change and social equity, so helping them lay a strong ESG foundation as startups serves us all.

Cohen is a partner at Piva Capital, a VC firm investing 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. Before joining Piva, he established 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.

Illustration: Dom Guzman