ESG for VC: A Guide for Responsible Investors
by C3 – Companies Creating Change

Environmental, Social, and Governance (ESG) has recently become a focal point for companies, investors, and even in political discourse. While ESG concerns are gaining attention globally, regulatory responses are just starting to take shape. Notable examples include the European Union's Sustainable Finance Disclosure Regulations (SFDR), the United Kingdom's Sustainable Disclosure Regulation (SDR), and initiatives like the Task Force on Climate-related Financial Disclosures (TCFD) and the Task Force on Nature-related Financial Disclosures (TNFD).

Simultaneously, the industry is eagerly anticipating the finalization of an ESG disclosure rule for funds and advisers by the U.S. Securities and Exchange Commission. Within the United States, states are struggling with the decision to adopt either anti-ESG or pro-ESG regulatory frameworks.

This article aims to demystify ESG for venture capitalists (VCs), shedding light on its value from a portfolio and firm-level risk management perspective. It provides straightforward steps to kickstart the journey of integrating ESG into the investment process.

ESG is an approach to managing a business and assets where investors, business owners, and founders consciously integrate specific factors into their daily operations and decision-making processes. It transcends mere policies and reporting, encompassing tangible practices throughout the entire VC value chain.

ESG represents a set of criteria for evaluating responsible investment and business practices, regardless of whether a VC firm or startup explicitly addresses social or environmental issues (as in Impact Investing). In the midst of discussions and debates, there is often confusion between ESG risk management, ESG Investing, and Impact Investing. To set the stage for this article, let's distinguish these distinct investment strategies. 

View the graphic below to learn about the spectrum of ESG investment strategies. Investors position themselves along this spectrum, guided by their investment thesis, ESG and impact beliefs, and the type of returns they seek.

Risk Management
ESG involves incorporating practices throughout the VC value chain, including integrating ESG considerations into investment decisions during due diligence, fund management, and portfolio oversight. This integration results in more robust risk management and mitigation practices, enabling investors to navigate an evolving landscape while safeguarding their financial interests.

Better Deal Flow
Beyond risk management, there's a broader shift in the entrepreneurship and asset management ecosystem towards adopting ESG. According to a survey by the World Economic Forum, 64% of startups consider investors' sustainability expertise when fundraising. Startups actively seek investor support with a focus on value creation, providing VCs with an opportunity to distinguish themselves by offering ESG assistance.

Better Fundraising
A quarter of Limited Partners (LPs) and General Partners (GPs) in Pitchbook's Sustainable Investment survey express hopes that sustainable investing will transition from a niche asset class to a mainstream focus in a few years. This positions VCs that incorporate ESG considerations at a competitive advantage, making them more appealing to attract additional funds.

While ESG may seem complex due to the absence of a universally accepted framework across various stages and sectors, early-stage VCs can leverage their position to initiate ESG implementation at a basic level, progressively building upon them as the firm evolves. Firms adopt various strategies, such as engaging external consultants or establishing an ESG task force within the organization to drive the ESG agenda.

To get started, investors need clarity on where they fall under the investment spectrum and how they plan to address ESG. This clarity facilitates the articulation of a comprehensive strategy, ensuring uniformity throughout the firm and the investment portfolio.

Following this first step, VCs can identify and assess ESG issues material to them, ranking them based on likelihood and impact on the financial, economic, reputational, and legal aspects of the firm .Venture ESG's Materiality Assessment for Venture Capital provides comprehensive guidance on this topic.

When considering ESG, there are two layers to focus on: the firm's internal ESG considerations and those related to the investment process and portfolio. To avoid feeling overwhelmed, VCs can start by identifying a few ESG risks that span the spectrum and prioritize them based on likelihood and impact.

At the firm level, key considerations remain similar regardless of the VC's invested sectors. However, the rigor of ESG parameters and implementation can vary among the different stages of VC development. Examples of where to start include:

E: Initiating emission reduction efforts by measuring and pledging to reduce emissions, beginning with at least scope 1 emissions.

S: Implementing a comprehensive diversity policy throughout the firm to ensure adequate representation of women among partners.

G: Implementing robust policies and procedures to manage and report conflicts of interest effectively.

At the investment level, ESG principles should be applied throughout various phases of the investment process, starting with due diligence to identify potential red flags. From there, investment decisions can be made based on those considerations. This may involve excluding investments with significant risks or highlighting them as critical aspects to monitor in the post-investment stage.

Taking a proactive approach, some VCs have introduced ESG-related clauses in their term sheets, outlining what aspects to be vigilant about and articulating expectations from portfolio companies.

At the post-investment stage, VCs can collaborate with startups in their portfolio to assess ESG risks material to them. Risks become more nuanced based on the startups industry. KfW Capital and BCG have identified material risks across various dimensions such as environment, social capital, human capital, business model and innovation, and leadership and governance.

It's crucial to acknowledge that the ESG landscape is still in its early stages for startups and VCs. While initiating reporting is a positive step for alignment and transparency regarding ESG risks, startups may face challenges due to the time and resources ESG reporting demands and their limited familiarity with the field.

VCs have the potential to be valuable partners in this regard. However, due to the absence of universally accepted ESG reporting frameworks specific to various sectors, the reporting guidelines must be practical for startups, enabling them to apply them effectively when engaging with all investors on their cap table.

Several tools and resources can facilitate your ESG journey:

• Starting Up: Responsible Investment in Venture Capital, UNPRI (Link, 2022) 
• Growing the Seeds of ESG: Venture Capital, Start-Ups and the Need for Sustainability, BCG and KfW Capital (Link, 2021) 
• Materiality Assessment for Venture Capital, VentureESG (Link, 2022) 
• The ESG_VC Measurement Framework User Guide for Investors & Entrepreneurs, ESG_VC (Link, 2021) 

The world of VC and startups is on the verge of a transformative era where ESG considerations go beyond checkboxes and compliance, representing a fundamental shift in how we approach investments and business practices. Although VCs and startups might think it's premature to focus on ESG, incorporating these principles sooner will ensure a smoother adaptation and growth.

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