Capitalizing on Change: How ESG Prioritization is Transforming Venture Investments

ttitudes in society are shifting. The prioritization of ESG (environmental, social, and governance) factors in investment is going mainstream. According to the Nasdaq, 1/3 of Millennials (born 1981-1996) often or exclusively use investment products that take ESG factors into account. Momentum is gathering as an EY report indicated that 26% of 2022 investors decided not to invest with a manager due to inadequate ESG policies versus 21% in 2021.

And this trend is drawing the attention of the venture capital community. According to a 2018 Preqin survey of alternative asset managers, investors and fund managers foresee ESG practices and policies becoming increasingly important over the next five years; and 70% of venture investors and fund managers believe that ESG will matter more in the next five years. 

The fact that there is a growing correlation between attention to ESG and more valuable exit opportunities has also undoubtedly caught the attention of venture capitalists. A 2020 McKinsey study also found that in a hypothetical M&A scenario, investors would be willing to pay about 10% more for a company with an overall positive ESG record. 

The ESG market is huge as more than $100 trillion in assets under management globally are managed according to ESG principles and studies from as early as 2010 indicate that companies with high ESG performance outperform their peers. Also, in many respects, the growing interest in ESG is not surprising in the venture capital community as it goes hand in hand with rising VC interest in deep tech investments that are focused on addressing society’s toughest challenges such as climate change and global health. Deep tech and ESG support and reinforce each other as value propositions.

WHAT IS ESG?

ESG is a decision-making framework, a set of internal principles and processes within funds and portfolio companies regarding environmental, social, and governance criteria. As a framework, ESG assists VC funds in assessing how to invest responsibly and integrate sustainability into investment decisions by considering an investment’s financial risks as well as its broadly defined rewards along with its societal and environmental implications. 

It should be noted that these are not just moral considerations but profoundly commercial ones. As environmental resources such as clean, fresh water become scarce, their efficient and effective utilization is increasingly central to cost-effective business operations. 

For example, the cloud is profoundly natural resource-intensive. Data centers consume 3% of all electricity produced globally and by 2025, they will consume 20% of the worlds power supply. The typical data center uses 3-5 million gallons of water per day or the same amount of water as a city of 30,000-50,000 people. 

Consequently, venture capital investors who take environmental considerations into account are not only being moral but demonstrating good business sense.  It is therefore no surprise that venture capitalists are clearly increasingly prioritizing ESG:

This emphasis on ESG increases the more established and larger the venture capital firm is in terms of assets under management:

To go deeper, although there is no standard definition, ESG generally includes the following:

• Environmental Factors: Does the company respect and support the environment? Efforts in this domain include reducing carbon emissions and waste; solid waste and water recycling; technologies that mitigate the use of scarce resources (i.e., sodium-ion electric batteries over lithium-ion batteries); the advancement of green operations technologies in the cloud; encouraging alternatives to meat and the promotion of urban organic farming; and the general development of renewable energy and electric vehicles.
  

• Social Factors: How does the company interact with its stakeholders? This encompasses workplace safety, community investment; diversity and inclusion; gender and racial equity; pro-family rules and regulations etc. But the increasingly critical issue is the emerging debate over the use of the myriad types of data that tech firms accumulate on their users. As customers have become aware of the value of this data and its potential to be misused, privacy and security are increasingly of paramount importance to them. Europe and California have enacted stringent data privacy regimes that technology firms must pay attention to in order to provide their VC backers with the returns that they are seeking.
  

• Governance Factors: How is power structured in the enterprise? This includes board diversity; anti-corruption measures; just worker and executive compensation; ethical business practices; compliance; and a sound balance of power between workers, executives and shareholders.

CHALLENGES IN ESG INVESTING

As is the case in any new field of investing, venture capitalists must confront important challenges. A critical challenge is the lack of standardized metrics and tools. According to Prof. Johannes Lenhard of Cambridge University:

“At the moment, very few standards and fit-for-purpose tools are available for venture capital; while the PRI and SASB have come out with great tools for asset managers and buyout firms, they don’t quite cover where VC is: fast-changing companies, often in markets that are created from scratch. We are at the very beginning of the VC ESG journey and need to be diligent right now to create long-term and multi-stakeholder value.”

Relatedly, there is a concurrent lack of expertise regarding ESG within the venture capital community. This naturally leads to an imbalance as the larger funds typically have the resources to purchase the talent and expertise required to be ESG compliant while the smaller VCs struggle to obtain access to the talent. 

However, there is also a fundamental tension between venture capitalists’ longstanding commitment to maximizing returns at all costs and the ESG commitment to subordinate maximum financial return to the greater good or at least a more holistic definition of the concept of maximum return. 

Again, this is why the soon-to-be-introduced SEC regulations regarding ESG are so important as they will allow venture capitalists to rationalize ESG decisions to institutional investors and other stakeholders. Standards, metrics, talent and legal frameworks are all required to catalyze ESG investing in the US venture capital community.

ESG INVESTORS

Even at this early stage, some important venture capitalists have emerged as ESG investors. DBL (Double Bottom Line) Partners is a pioneer in this space. Its first bottom line is to deliver top-tier venture capital returns while its second bottom line is to work with companies to enable ESG improvement in the regions where they operate. The company believes that:

…double bottom line practices that companies choose to adopt can be significantly beneficial to the fiscal bottom line both via direct benefits of cost savings and value creation, and via indirect benefits of creating goodwill with their market, customers and community, and enhancing employee morale and retention.

DBL Partners success in their approach is evident in that as of 2021, they had closed their fourth round, which was a $600 million impact venture capital fund that invested in clean energy, conservation and resource optimization, transportation and mobility, the future of work, and agriculture and food.

Based in Oakland, California, Better Ventures is an early and seed stage venture capital fund whose mission is to improve the world by catalyzing mission-driven entrepreneurship. The firm focusses on companies that are working towards the UN’s Sustainable Development Goals and it strongly believes that companies with a mission-driven purpose perform better in the market. Investments include Clinify Health, Avalo and Pluton Biosciences. 

Founded in 2000, Emerald Technology Ventures is a Swiss venture capitalist with €1 billion in assets under management that invests at both early and late stages. It is focused on the climate change and sustainability sectors. Among the 70 companies in its portfolio are Eologix, Meat Food Tech Oy and xFarm Technologies. 

Human Ventures is a New York City operation that is part venture capitalist, part studio and part enterprise agency. It has combined all three elements to build a business creation platform for entrepreneurs who are focused on industries that address basic human needs. They define this as businesses that solve real human problems with unit economics that scale and a deep sense of responsibility. Their portfolio includes Adelaide, Glow Labs, and Whoosh.

There are ESG-oriented venture capitalists who are much more explicitly focused on environmental technologies, particularly those involving clean/renewable energy. For example, Clean Energy Venture Group provides seed capital to energy startups. CEVG was founded in Cambridge, Massachusetts in 2005 and has over $500 million in AUM which is a testament to its success. The criteria for its investments are:

• Clean energy-focused investment
• Investment returns must meet particular levels
• Startups or the management team must have expert knowledge in the area
• The pre-money valuation must be less than $10 million
• All companies should be in the Eastern US

Notable investments include 60Hertz, ConnectDER, Nth Cycle, and Clear Trace. With over $1.1 billion in AUM, Energy Impact Partners is one of the largest venture capitalists in this space. It focuses on startups that optimize energy consumption and boost green energy production. The company invests across a broad spectrum of areas in the clean energy space including smart buildings, mobility, electrification, industry 4.0, and energy convergence. Amongst its investments are Ecobee, Trifecta, Sense, Mosaic, Arcadia Power, Powin, and AutoGrid.

This listing is indicative of the broad variety and growing scope of ESG venture capital investors in the United States:

The growing prioritization of ESG factors in investment is welcome and should act as an impetus for the innovation that VCs prize so highly. However, there is a profound irony within the VC industry. It needs to apply ESG principles not just to how it makes investments but also to how it is internally organized. 

As an industry, venture capital is remarkably uniform with the vast majority of venture capitalists being white males from a tiny universe of schools—astoundingly 40% of VCs in the US graduated from either Harvard or Stanford. In contrast, only 10% of VC partners are female, and only 1% are Black. 

This has profound implications for investment decisions as female entrepreneurs are 63% less likely than men to obtain venture capital financing; less than 2% of venture capital dollars are allocated to Black and Latino entrepreneurs; and 2022 data indicates that matters are worsening as Black entrepreneurs experienced a 45% decrease in financing in 2022. The full potential of ESG as a catalyst for innovation, improved business operations and better returns will not be completely demonstrated until the venture capital industry uses ESG principles to reform and revamp its modus operandi.