What are the origins of ESG?

ESG stands for Environmental, Social, and Governance. Investors are increasingly using these factors when assessing risk and growth opportunities for their investment portfolio. 

Arguably, ESG became mainstream the moment Larry Fink, CEO of Blackrock, penned  his 2018 letter to CEOs on the importance of stakeholder capitalism in shaping finance, and its focus on employees and community.

2018 went onto become a watershed moment when 70% of institutional investors embraced ESG in some shape or form. 

Fast forwarding to 2022, according to the Belfer Center Report, most types of investment, or asset classes, now use ESG to monitor or manage ESG performance including bonds, equities, and commodities. 

The exception here is Venture Capital, which is best described as playing catch up.

The externalities of unbridled growth

Some irony exists in VCs lagging behind on ESG initiatives. Post 2000, it was in part thanks to venture capital that we saw the meteoric rise of internet companies like Google, Uber, Facebook, and Twitter. VCs financed these companies, whose rapid growth and governance overreach has had a resounding impact on society, technology, and government. 

Social media platforms who were once the darlings of society have since been scrutinized and held to account for selling data and pressed for how they uphold democratic rights and freedom of speech. Rideshare platforms have faced labor litigation suits on wage equity as they redefine labor markets. 

To add insult to injury, what has not helped the optics for VCs is that they are generally perceived as a uniform bunch of highly educated, white elite. According to the Stanford Social Innovation Review, 40% of VCs come from one of two business schools -  Stanford and Harvard. Furthermore, only 10% of VC partners in the US are female and just 1% are black. 

Needless to say, this leaves a huge chasm that needs to be bridged. The Brotopia label inspired by Emily Chang’s popular book serves only to highlight the cultural leap that needs to happen for investors and their portfolio companies to align with the new values of Diversity, Equity and Inclusion that have come to the fore since the pandemic. 

To give credit where it is due

To be fair, part of the reason that VCs  have been slow to adopt ESG is that they are typically the first to invest in frontier disruptive technologies, such as genomics, blockchain, and AI, where there is often little existing regulation or scrutiny from government officials. Although this is changing, seemingly by the week.  

As PwC’s 2021 Private Equity ESG report outlines, there are some good reasons why VCs trail other asset classes when it comes to environmental, social, and governance issues. Unlike private equity, many VC portfolio companies are early stage and lack the influence, size, and strategies to monitor and manage risks with programs such as CSR (corporate social responsibility). This is of course more profound in firms that focus on leading early rounds of investment.

What will it take to affect change?

So when will we see the venture capital industry fully commit to ESG? 

There are some companies stealing a march, mostly in Europe, such as Balderton and Kindred Capital. Other examples include Antler in Asia and 500 Startups in the US. 

Regulation is bubbling in the form of Sustainable Finance Disclosure Regulation (SFDR) in the EU but is not mandatory for VCs just yet. The Biden administration claims to be stepping up to the plate with its own legislation. But, like most regulations, they will take time to come into effect, especially with a starkly divided Congress. 

There is no doubt that we are living through a watershed moment in consumer sentiment triggered by the racial justice and gender equality movements of late. On the environmental side, we've witnessed a rise in natural disasters we have seen during the pandemic. Corporate sentiment has changed too. Procurement departments want to know about the sustainability record of a company before they hand over their contracts.  A new, younger generation of limited partners are also calling the shots at many VC firms.  

The implications for startup founders  

How do startup founders with products that align with ESG navigate these waters as they seek investment and build up ESG legitimacy? 

While many VCs are creating diversity metrics to differentiate, it remains to be seen how much substance lies behind this gesture. Be sure to look out for VCs that carry the VC Diversity Standard, an accreditation that provides funds with best practices on diversity and inclusion in venture capital. 

Many startups may want to consider which of the UN Sustainability Goals they most align with. Or even apply for the rigorous B Corp certification.

The ability to demonstrate that commercial returns go hand-in-hand with the opportunity to create a difference to society through sustainability has worked for trailblazer portfolio companies raising capital like Germany’s mobility startup Lilium or the vertical farming company Bowery Farming. It is just a matter of time until these norms will become more widely adopted among the broader venture capital community.