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Venture capital must embed ESG to back the companies of the future

Venture capital funds must implement robust ESG due diligence.

Venture capital has a unique opportunity to accelerate the growth of the companies of the future. Image: fauxels from Pexels

Lofred Madzou
Project Lead, Artificial Intelligence and Machine Learning, World Economic Forum LLC
Matthew De Jesus
Startup Operating Partner, Talis Capital
Serena Taylor
ESG & Impact Officer, Talis Capital
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Stakeholder Capitalism

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  • Venture capital must implement robust ESG due diligence to help them create long-term, multi-stakeholder value.
  • Doing so will give VC funds a commercial advantage, because they will better identify and mitigate material issues relating to new investments.
  • In contrast, venture capital funds that adopt a reactive approach to ESG will be caught out by incoming regulation.

In February, the UN PRI released a discussion paper detailing the development of environmental, social and corporate governance in venture capital, putting the spotlight on the attitudes and outlooks towards ESG among VC firms globally. ​​

Although the conversations around sustainable finance have grown substantially in the past 12 months, the venture capital industry has been slow on the uptake when it comes to ESG, let alone integrating 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 growth opportunities.

Venture capital has a unique opportunity to accelerate the growth of the companies of the future, not only with capital but with the guidance they provide throughout scaling. Making ESG considerations matter earlier in the venture capital lifecycle helps to prepare them for challenges as they scale.

Have you read?

Robust 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 Amnesty International study found that almost none of the world’s largest VC funds consider human rights in their investment process. Only one ESG topic, diversity and inclusion, has seen widespread focus among VCs so far.

“Under the UN Guiding Principles on Business and Human Rights, all corporate actors – including investors – have a responsibility to respect human rights, which includes the need to conduct human rights due diligence before making investment decisions. VC funds that choose not to conduct human rights due diligence are violating this responsibility.”

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

Despite the fact that the top funds are lagging behind, there’s plenty of evidence to suggest that increasingly more funds are prioritising action towards ESG, and are collaborating to form best practises through industry initiatives like VentureESG and ESG VC.

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

Deliveroo’s experience launching into the public markets highlights why this diligence is so important. Post-IPO, amidst the controversies around the misclassification of riders as “self-employed”, institutional investors like Aviva, M&G and Aberdeen Standard publicly declared that they would not invest: fundamentally impacting the bottom line of the numerous venture capitalists and angels who had funded the company to that point. As incubators for companies of the future, venture capital has a responsibility to evaluate 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 PRI’s 2022 “Responsible Investment in Venture Capital’ report.

ESG enables a more holistic mapping of material issues

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

“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 in order to create long-term and multi-stakeholder value.”

Dr Johannes Lenhard, researcher and lecturer, University of Cambridge

Using an ESG framework that prioritises material issues by sector helps investors to understand what issues could have a sizeable impact on the business in the future.

Let’s take a gaming company as an example. Stakeholders might be classified here as parents’ safety groups; children’s charities; games rating authorities; suppliers; employees; or investors. Material issues might include child safety; responsible product design to avoid gaming addiction; data privacy and security; cloud consumption; and digital carbon. Once these potential issues have been identified, the company can then develop a material issue action plan, and a list of disruptive ESG scenarios and mitigating measures. VCs who incorporate ESG diligence often work with the company once invested to support on mitigating these issues.

One reason for the slow uptake of ESG due diligence among venture capitalists may be that they find it challenging – and time-consuming – to highlight material issues in any instance because they are investing in inherently novel technologies, products and platforms that may deviate from traditional frameworks.

Although existing frameworks can provide a good starting point, they aren’t entirely fit for purpose when it comes to every early-stage venture capital investment: as pointed out above by Lenhard, SASB, for example, doesn’t have a set of industry-specific standards for new technologies, such as gaming, blockchain and web3, novel biotech processes, or the role of AI. New, and further developed and adapted, tools are needed.

Regulation is coming

The VC industry must also take into consideration the broader technology regulatory environment, including in the field of artificial intelligence. When VCs investigate ESG issues, the interrogation of responsible AI forms a key part of the analysis. Indeed, various controversies have highlighted that without proper oversight, AI may replicate or even exacerbate human bias, lead to discriminatory outcomes, and may cause potential job displacement.

The growing public concern over potential AI misuse has created a multi-stakeholder demand for trusted AI systems and led to global intensified policy activity. Yet the most ambitious policy response so far has come from the EU, where the European Commission released its Artificial Intelligence Act – a comprehensive regulatory proposal that classifies AI applications under four distinct categories of risks:

  • Unacceptable risk: these use-cases will be banned (e.g. social scoring).
  • High-risk: they will be subject to quality management and conformity assessment procedures (e.g. CV sorting software, robot-assisted surgery, credit scoring, facial recognition systems).
  • Limited risk: they will be subject to minimal transparency obligations (e.g. chatbots).
  • Minimal risk: they won’t face any additional provision (e.g. spam filters).

VCs that have portfolio companies operating in high-risk domains (e.g. healthcare, banking and insurance, transport, employment) should adopt a proactive approach to ESG before this regulation is implemented. They must also think about how broader sustainable finance regulation will impact their funds, such as the advent of SFDR and the EU Sustainable Finance Taxonomy. Failure to consider this regulation will bear a significant cost in terms of regulatory risk, preventable harms, reputational damage, missed growth opportunities, and ultimately undermine their bottom line.

Join us

Today, we see a broader shift from shareholder capitalism that favours the interest of one group of stakeholders to stakeholder capitalism, which incentivises companies to serve the interests of all their stakeholders, including employees, consumers and citizens at large. As responsible investors, VCs should welcome this movement and rethink their due diligence and portfolio management process to push forward this new environment. That starts by embedding ESG reporting metrics into their processes.

If you're a VC and are uncertain about how to complete this transformation, feel free to reach out. At the Forum, we’ve built a global and multi-stakeholder community to help you with this process.

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Institutional update

World Economic Forum

May 21, 2024

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