Impact and ESG in venture capital- getting the basics right and pushing forward

Co-authored by Johannes Lenhard, VentureESG or Katie Fulford-Smith, Big Society Capital.

The venture capital community (VC) increasingly recognises that Impact is something quite different from Environmental, Social, Governance (ESG) principles. However, what’s often less clear is exactly what is meant by each in practice.

In this blog, co-authored by Big Society Capital and VentureESG, we aim to set out what we mean by each, taking Impact and ESG in turn and summarise why and how both are important in VC. We hope that this will help others, particularly limited partner investors (LPs) and VCs, be clear on what ESG and impact means for them and articulate their own position. This piece is intended as a starting point for further engagement with both of our community-led initiatives, ImpactVC and VentureESG, to push the conversation and action in the sector forward.

Impact

Impact investing is the provision of capital to address the world’s most pressing challenges (as set out by The United Nations Sustainable Development Goals (SDG’s)) and includes investment in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare, and education’[1].

What is Impact in Venture?

In the venture context, Impact is about a startup’s mission or intent on achieving a specific social or environmental outcome, predominantly through their core products or services. At Big Society Capital, we define an impact startup as:

“A startup whose purpose is to contribute to solutions that create positive change — and over time enables and can evidence strong impact performance through proportionate impact practice”

Examples of a social or environmental outcome include ‘increasing access to fair and affordable credit for lower income households’ or ‘reducing fossil fuel reliance through innovative renewable energy technologies’. Impact outcomes are often referred to in a company’s mission or vision statements. Their impact is intentional and measurable and for VC backed startups, scales in lockstep with the business itself. Our blog ‘what is an impact start-up’ dives into startup level impact in much more detail.

Why do we think it’s important?

Trillions of dollars are required every year to solve the problems defined under the SDGs, and VC has an important role to play in helping us get there. VC provides much needed capital and non-financial support to innovative businesses that have the potential to change the world we live in for the better. By backing these solutions today, VC is sowing the seeds for a more environmentally sustainable and equitable world of tomorrow. We’re already seeing VCs switching on to the opportunity that Impact has to offer. They recognise that Impact can be a source of value to startups, from boosting performance to reducing risk. Some of the biggest and most valuable businesses of the future will be Impact startups.

ESG

Unlike Impact, ESG does not refer to a particular type of business rather, it refers to an approach to running a business and/or managing assets, where, investors, business owners and founders explicitly integrate the following factors in their everyday practices and decision making [2]:

Environmental: Factors that relate to the natural world. Examples include carbon footprint, pollution, waste, deforestation.

Social: Factors that affect the lives of humans where categories include management of human resources, local communities and clients. Examples: working environment, human rights (including modern slavery and child labour), data and privacy.

Governance: Factors that involve issues inherent to the governance of the business and the interest of wider stakeholder groups (e.g. workers, customers). Examples: bribery and corruption, compensation, board diversity and structure.

What is ESG in Venture?

Just as with public equities, ESG can (and we believe should) be applied to VCs and their portfolio companies alike. It describes a set of criteria for assessing responsible investment and business practices regardless of whether a VC or startup is explicitly trying to tackle a social or environmental problem. ESG focusses on how a VC or start-up conducts its business for example, a VC ensuring it has equality and diversity of people within decision making roles or an online gaming company ensuring it has robust data privacy and security.

This is a relatively nascent and evolving field in venture which, largely driven by regulatory pressure of SFDR, European LPs are expecting VCs to get quickly up the curb on. One of the challenges that community-led initiatives such as Venture ESG are trying to tackle is how to make ESG assessment frameworks relevant and proportionate to early-stage investing and startups.

Why do we think it’s important?

A recent article published by the World Economic Forum, sets out why ‘venture capital must implement robust ESG due diligence to help them create long-term, multi-stakeholder value and give VC funds a commercial advantage’. There is a growing expectation that the way the business community delivers value stretches far beyond maximising financial returns to shareholders. We’re seeing this play out visibly through the rapid growth in importance of ESG in the public markets and buyout investing; ESG ratings (and wider reports on the topic) are already standard practice for public companies (even if not yet fully apt at avoiding ESG washing due to their aggregate confusion).

Pertinent for VCs and startups with an eye on exits, later-stage investors are pushing down the value chain, with public market asset managers choosing not to invest in companies who don’t meet their ESG standards. The Deliveroo IPO case, for instance, saw various big asset managers refuse to buy into the company based on ‘ESG concerns’ highlighting the importance of robust ESG.

Similarly, for VCs lining up their next fundraise, news of highly influential LPs such as KfW Capital in Germany announcing a strict ESG agenda for fund investments, provides a leading indicator of what to expect from the wider LP community.

Conclusion

Impact and ESG are solving for different things but both are increasingly important aspects of VC that cannot be ignored.

VCs and startups seeking to build disruptive technologies and businesses of all types should embed ESG practices that are proportionate and useful to them at different stages of their scaling journey to building businesses with long-term multi-stakeholder value. At the same time, we expect VCs to continue to pivot towards Impact, as an increasing number of startups are building disruptive technologies intent on tackling some of the most pressing social and environmental challenges of our time. For Impact businesses, robust ESG becomes an important factor in re-enforcing the value that being an Impact business model can achieve and ensuring a company maximises its impact potential.

We’ve only scratched the surface on these huge topics so if you’d like to dive deeper please get in touch with Johannes Lenhard, VentureESG or Katie Fulford-Smith, Big Society Capital.

[1] https://thegiin.org/impact-investing/need-to-know/#what-is-impact-investing

[2] Fitch Learning, Chapter 1 Introduction to ESG, CFA Certificate in ESG investing

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