The consideration of environmental, social and governance factors, or ESG, has stumbled in public-markets investing. Now, venture capital funds and startups are reclaiming the ESG narrative — and the practice — to drive better performance in private markets
In public markets, ESG has become ambiguous and misguided. ESG ratings create aggregate confusion; marketing reports and disclosures have been more important than focusing on using ESG to improve how companies are run. Regulation has not been helping to focus on materiality so far. ESG-washing became widespread – and whistleblowers started launching rightful attacks.
Private market investors aren’t making the same mistake. VentureESG has worked with over 500 venture capital funds and 100 limited partners to identify three principles as a recipe to ‘do ESG well.’ These include beginning with a clear definition of ESG, focusing on material action over reporting, and integrating ESG across the company rather than siloing it.
We propose starting with the principles to reclaim ESG for VC.
Clear definition
ESG is by definition company- and investment-specific.
ESG is however often seen as just an abstract acronym. Investors and companies must make it their own. The term stands in for a large set of non-financial risks and principles – from good governance and human rights considerations to data management and environmental principles. When financial accounting was created about a hundred years ago these were things the accountants ‘forgot’ about – or didn’t yet know about.
While ESG is non-financial, i.e. not accounted for in profit and loss statements, ‘material ESG’ still has a financial impact. A materiality assessment should be a first step to define what ESG means for you, either as an investor or as a (tech) company.
We can now fight about what we should call these principles and practices that go beyond pure financial considerations and include stakeholders, such as employees and the environment. ESG is as good as any other word – from responsible investing to sustainability – but what we really don’t need is to fight about the language. We have had the argument for years (ESG = process and impact = outcome). Balderton Capital calls it ‘Sustainable Future Goals.’ Atomico uses ‘Conscious Scaling.’ General Catalyst names it ‘Responsible Innovation.’ Let’s avoid doing the anti-ESG guys a favor and get obsessed with language. Just be clear and transparent in your own definition.
Material action over reporting
Both public market ESG and regulatory and LP requirements – including the European Sustainable Finance Disclosure Regulation, SFDR, and its PAIs (principle adverse impact indicators) – are limited to mostly metricized disclosures. Many of the key performance indicators are not fit for purpose for (early stage) tech startups (does anyone in your portfolio think about waste water?); they are also based on the kind of one-size-fits-all approach that isn’t materially filtered.
Disclosures and reporting is hence not where the mid-term focus should be for the world of early-stage tech and venture capital; that kind of data is rarely available and usually not in good shape. What is collected is also mostly not meaningful. Every company is at a slightly different cross-section of sector and maturity and hence needs a slightly different ESG focus and roadmap.
Investors can use a materiality assessment – possibly during due diligence – as a first step to define what gaps there are and how to fill them. Setting ESG goals and laying out an ESG roadmap with regular check-ins, including by board members, will help build a better scale-up company.
Full-body workout
Putting ESG exclusively into the hands of the compliance, finance or legal department is a misstep. ESG, when materially filtered, concerns everyone’s processes, both for an investor and a company. In fact, there is a very limited business case for ESG compliance. ESG needs to be part of everyone’s job at both the VC investor and startup level. For a VC, thinking about material ESG issues in due diligence makes for better due diligence. At companies, taking ESG into account helps to build a more resilient business.
There is clear evidence that hiring with diversity and inclusion in mind is financially beneficial, including for VCs. Similarly, think about the many examples where building companies on bad governance principles has led to disastrous effects, from FTX to WeWork. Everyone needs to pull their weight, from the investor and platform person in a VC to the executives in a startup. It’s the kind of full body workout that we all love so much.
Recently, at a conference, one person pointed out half-jokingly that VentureESG didn’t exactly have a choice about ‘reclaiming ESG’, given it is in our name. But we are sticking to ESG for our work in venture capital and will stand our ground for substantive reasons, not branding. We know that integrating ESG both in how VC funds invest and how startups are run makes long term financial sense – and is hence a win-win-win. We might still sometimes call it something else – more specific, focused on particular areas, or more general, like responsible investing.
But we will always be precise about what we mean. And ESG is ultimately the uniting set of principles and tools. Let’s not cede that ground – and we’re calling on all of you to fight with us. Let’s reclaim the narrative – let’s reclaim ESG.
Johannes Lenhard is co-director of VentureESG and researcher affiliate at the Minderoo Centre for Technology and Democracy at the University of Cambridge.
Hannah Leach is a partner at Houghton Street Ventures and co-founder at VentureESG.
