Venture capital must integrate ESG to support the companies of the future

  • Venture capitalists need to implement strong ESG due diligence to help them create long-term multi-stakeholder value.
  • This will give venture capital funds a business advantage, as they will better identify and mitigate material problems with new investments.
  • On the other hand, venture capital funds that take a reactive approach to ESG will be caught up in future regulation.

In February, the UN PRI published a discussion paper detailing the development of environmental, social and corporate governance in venture capital, highlighting attitudes and perspectives towards ESG among venture capitalists. in the world. ​​

Although conversations around sustainable finance have grown significantly over the past 12 months, the venture capital industry has been slow to embrace ESG, let alone integrate it into decision-making. As defined by the CFA, ESG investing represents the environmental, social and governance criteria that investors are increasingly using as part of their analysis to identify material risks and opportunities for growth.

Venture capital has a unique opportunity to accelerate the growth of companies of the future, not just with capital but with the advice they provide along the way to scale. Making ESG considerations material earlier in the venture capital lifecycle helps prepare them for the challenges as they evolve.

Strong ESG due diligence leads to long-term multi-stakeholder value creation

A Stanford Social Innovation Review article found that only a handful of the “top 50” funds to date have made public commitments to ESG, or sustainability, on their own channels. Similarly, a recent study by Amnesty International revealed that almost none of the largest venture capital funds in the world take human rights into account in their investment process. So far, only one ESG topic, diversity and inclusion, has captured the attention of VCs.

“Under the UN Guiding Principles on Business and Human Rights, all business actors – including investors – have a responsibility to respect human rights, which includes the need to exercise human rights due diligence before making investment decisions. Venture capital funds that choose not to conduct human rights due diligence violate this responsibility. »

—Michael Kleinman, Director, Silicon Valley Initiative, Amnesty International/AIUSA

Despite major funds lagging behind, there is ample evidence to suggest that more and more funds are prioritizing ESG action and collaborating to shape best practice through industry initiatives such as VentureESG and ESG VC.

Venture capitalists need to be vocal about which business models they would or would not invest in, and define a framework for how they plan to integrate human rights and ESG into due diligence. Historically, stakeholders such as employees, regulators, suppliers, civil society organizations, investors and “end users” were not formally considered in the traditional venture capital due diligence process. , which has been to the detriment of the venture capital community.

Deliveroo’s experience of launching into public markets shows why this diligence is so important. After the IPO, amid controversies around the misclassification of runners as “self-employed”, institutional investors like Aviva, M&G and Aberdeen Standard publicly stated that they would not invest: fundamentally impacting the results of the many venture capitalists and angels who had funded the company up to that point. As incubators for the companies of the future, venture capitalists have a responsibility to assess the prospect of potential harm to stakeholders and any unintended consequences of the company’s product or platform. And, of course, to protect their bottom line and reputation.

Image: Data from the 2022 PRI Report on Responsible Venture Capital Investing.

ESG allows for a more holistic mapping of hardware issues

ESG due diligence can improve decision-making in early-stage and growth-stage venture capital because it takes a long-term, holistic view of the business. Long-term thinking is important for venture capital, due to the longer-term time horizons of investments.

“At present, very few standards and suitable tools are available for venture capital; while the PRI and SASB have developed excellent tools for asset managers and buyout companies, they don’t quite cover where venture capital is: fast-moving companies, often on markets created from scratch. We are at the very beginning of the VC ESG journey and need to be diligent now in order to create long-term, multi-stakeholder value.

—Dr Johannes Lenhard, researcher and lecturer, University of Cambridge

Using an ESG framework that prioritizes material issues by sector helps investors understand which issues could materially impact the business going forward.

Take the example of a game company. Stakeholders could be categorized here as parent safety groups; children’s charities; game rating authorities; Suppliers; employees; or investors. Material issues may include child safety; responsible product design to avoid gambling addiction; privacy and data security; cloud consumption; and digital carbon. Once these potential issues have been identified, the company can then develop a material issue action plan, along with a list of disruptive ESG scenarios and mitigation measures. VCs who incorporate ESG due diligence often work with the company once invested to help mitigate these issues.

One of the reasons for the slow adoption of ESG due diligence by venture capitalists may be that they find it difficult – and time-consuming – to highlight material issues in all cases, as they invest in inherently new technologies, products and platforms that may deviate from traditional systems. frames.

While existing frameworks can provide a good starting point, they are not entirely fit for purpose when it comes to any early-stage venture capital investment: as Lenhard pointed out above , SASB, for example, does not have a set of industry-specific standards for new technologies, such as games, blockchain and web3, new biotechnology processes or the role of AI. New, developed and adapted tools are needed.

The venture capital industry must also consider the broader technological regulatory environment, including in the area of ​​artificial intelligence. When VCs investigate ESG matters, interviewing the responsible AI is a key part of the analysis. Indeed, various controversies have pointed out that without proper oversight, AI can reproduce or even exacerbate human biases, lead to discriminatory outcomes, and can result in potential job displacement.

In 2019, the Center for the Fourth Industrial Revolution at the World Economic Forum brought together an informal multi-stakeholder group of leaders, known as the Global AI Council (GAIC), with a keen interest in creating a positive future with AI systems. advanced AI.

One of the Council’s objectives is to provide strategic guidance to the global community on priorities for AI governance and cooperation, as well as the policy implications of advancing AI.

The project takes place over several months and brings together a diverse group of individuals including science fiction writers, economists, policy makers and AI experts.

The council aims to open up the possibilities for its positive economic future by utilizing the creativity and expertise of these participants, as well as opening up the process to a much wider range of contributors.

She is also in the process of initiating a second thread of the project, in parallel with the workshops: a film competition in partnership with the XPRIZE Foundation. Participants will create short films showcasing their ideas for a future economy in a concrete form that speaks to individual aspirations and fears.

Growing public concern about the potential misuse of AI has created cross-party demand for trustworthy AI systems and led to increased global political activity. Yet the most ambitious policy response to date has come from the EU, where the European Commission published its Artificial Intelligence Act – a comprehensive regulatory proposal that classifies AI applications into four distinct categories of risk:

  • Unacceptable risk: these use cases will be prohibited (e.g. social scoring).
  • High risk: they will be subject to quality management and compliance assessment procedures (e.g. CV sorting software, robot-assisted surgery, credit score, facial recognition systems).
  • Limited risk: they will be subject to minimum transparency obligations (e.g. chatbots).
  • Minimal risk: they will not be confronted with any additional provisions (for example, anti-spam filters).

Venture capitalists that have portfolio companies operating in high-risk areas (e.g. healthcare, banking and insurance, transport, employment) should take a proactive approach to ESG before the implementation of these regulations. They also need to consider the impact of broader sustainable finance regulation on their funds, such as the advent of SFDR and the EU Sustainable Finance Taxonomy. Failure to heed these regulations will incur a significant cost in terms of regulatory risk, avoidable harm, reputational damage, missed growth opportunities, and ultimately undermine their bottom line.

Today we are witnessing a broader shift from shareholder capitalism which promotes the interests of a group of stakeholders to stakeholder capitalism, which incentivizes companies to serve the interests of all their stakeholders, including employees, consumers and citizens at large. As responsible investors, VCs should welcome this move and rethink their due diligence and portfolio management process to move this new environment forward. It starts with integrating ESG into their processes.

If you are a VC and you don’t know how to carry out this transformation, do not hesitate to contact us. At the Forum, we have built a global, multi-stakeholder community to help you with this process.


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