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Bridging the ESG Valley of Death

Updated: Mar 11, 2021

Venture capital has been absent from the ESG revolution. Here's how that can change.

In technology development, there is a common problem known as the “Valley of Death.” The Valley of Death is the time between when a technology is financially sustained through grantmaking for basic and applied science research and the time when the technology is commercialized to the degree it achieves positive cash flow with long-term growth potential attractive to global capital markets. When critical technologies are not able to bridge this gap - such as some energy, infrastructure, and biotechnologies - they are not able to realize their positive impacts on the world.

Source: "Into the Valley of Death." UC Davis Graduate School of Management, 2010.

Yet there is another "Valley of Death" that is not talked about as often. This is the gap for how effectively new technologies are managed for ethics, integrity, and preventing unintended harms they may unleash on the world. When technologies are in research laboratories they are subject to extensive controls. This begins with ethics standards set by major grantmaking institutions such NIH. Institutional Review Boards (IRBs) in universities ensure rights of research subjects are protected. Scientific journals require rigorous peer review before the publication of findings. Once technologies reach sufficient maturity for an IPO or acquisition, they become subject to transparency from ESG (environment, social, governance) reporting and rating agencies.

There is a long gap in the critical years in between – beginning with angel investors, accelerators, and crowdfunding platforms and continuing into early and late-stage venture capital funding – where there is largely no ESG practice or transparency. (Note: ESG is different from impact investing. ESG refers to the integration into investment decision making, active management and reporting on material issues such as labor standards, product lifecycle, data privacy, and fraud prevention. ESG is applicable to all companies, not just those with a social or environmental value creation thesis.)

Venture Capital has been absent from the ESG revolution.

The Principles for Responsible Investment (PRI), the entity that oversees ESG commitments and practices of investors, currently has over 3,800 signatories accounting for over $100 Trillion in assets under management. PRI signatories cover every asset class including public equities, private equity, debt, commodities, and real estate. Venture Capital as an asset class has been notably absent. There is currently only one PRI signatory among the 50 largest VC funds and a few dozen more from a base of around 3,000 funds worldwide.

Venture capital's engagement with ESG issues is critical to ensuring the next generation of leading global companies have responsible business practices. The early years of a company's development are a crucial time when the values, culture, and business models are set. The result of a lack of attention and management of ESG issues has been a series of ethical lapses in early- and growth-stage companies in recent years ranging from false claims (Theranos) to living wage (Uber, Lyft, et al.) to governance failures (WeWork) and many lesser-known stories.

Why does this gap exist? And what could be done to better manage ESG issues earlier in the company development process?

I recently shared some thoughts at the Private Equity International Responsible Investment Forum 2021 panel on "ESG in Venture Capital." Here are some highlights from my remarks.

5 Steps to Accelerate ESG in Venture Capital

Step 1. Appoint ESG Leads– (start the conversation)

The first step to advance ESG is to appoint someone to lead the process. In the last year 500 Startups, Pitango and Cathay Innovation have all appointed ESG leads and have begun setting up ESG processes.

One way to encourage more funds to adopt ESG is through peer-to-peer learning networks. A few such networks are happening already. During 2019 Omidyar Network and IFC hosted the Race to the Top Venture Capital Committee, which held a series of meetings with VC funds on developing common standards for evaluating data use and privacy practices of ventures. In Europe, the #ESGinVC initiative is convening funds to share practices. For portfolio companies, BSR hosts webinars with company leaders at Unicorn/Late Stage ventures on setting up ESG practices.

The VC industry is already very active on one ESG issue - advancing diversity, equity & inclusion (DE&I) in VC fund leadership and funding for diverse entrepreneurs. There are several DE&I initiatives including All Raise, Venture Forward, Project Include, and Diversity VC.

Step 2. Make ESG Standards & Tools Venture-Friendly - (keep it simple)

Most ESG standards and tools were designed for mature corporations and public equities investment analysts. Tools were built for use by subject matter experts and with sufficient scope to capture the complexity of multinational company operations and supply chains across the globe. In contrast, the median VC fund has around 38 employees. Ventures also have small teams, usually with backgrounds in technical and sales (and perhaps legal and communications), in the early stages. This can make anticipating and managing complex social and environmental issues challenging.

There are a few tools custom-built for ventures around managing people, DE&I, responsible technology products, and boards. (I keep a running list of tools for ventures on my website here: ) Yet simplified technical guidance for ventures is still needed across many other issues including risk management, sourcing & supply chains, environmental impact assessment, lobbying, ethical marketing, carbon emissions, environment, health, safety (EHS), human rights, and data privacy and security.

Step. 3 Issue Industry-specific Guidance – (the devil is in the details)

The initial conversations happening on ESG in venture capital have focused on identifying common metrics to report across an entire portfolio such as DE&I and carbon emissions. This is an important first step. However, the key ESG drivers of risk and return are often specific to each industry and each portfolio company. This requires tailored guidance for each industry.

For mature companies, industry standards are set by groups such as SASB, GRI, TCFD. These standards can be a helpful starting point to identify material issues for ventures. However, ventures often operate in emerging spaces where they are creating new technologies and markets. Popular emerging spaces include artificial intelligence/machine learning, autonomous vehicles, cannabis, cryptocurrency, synthetic biology, life extension technologies, and space technologies. Emerging spaces often lack industry standards and best practice case studies – in addition to a lack of regulatory oversight - to guide decisions.

There are a few strategies that could be used to advance industry-level guidance:

  • Market Research Reports: Market research providers such as CBInsights and Pitchbook publish reports on emerging spaces. Including discussions on ESG issues in market research reports could ensure they are considered by analysts and investment committees.

  • Industry Working Groups: Industries in need of standard-setting and best practice development could benefit from setting up an industry working group. One example is Regennabis which is building a network around ESG practice in the cannabis and hemp industry covering issues such as regulation, sustainable agriculture, and diversity & inclusion.

  • Third-party Review: Industries that face challenges ensuring scientific integrity or product quality could benefit from a third-party review. One example is PsyberGuide which provides expert reviews on mental health and wellness apps.

Step 4. Create ESG Ratings for Ventures– (more transparency sooner)

ESG ratings play an important role in providing investors information about company past performance and likely future challenges. (JUST Capital and Sustainalytics are two examples of ratings for public companies.) ESG ratings for late-stage ventures could provide deal sourcing and due diligence teams access to independent expert reviews on critical risk exposure and management. Ratings could also provide feedback to company leaders on performance relative to peers to encourage continuous improvement. (For a demo on ESG ratings for ventures, see Annex 3 of Responsible Investing in Tech and Venture Capital).

Step 5. Engage LPs – (apply existing ESG commitments to VCs)

Limited Partners (LPs) can play an important role in encouraging ESG integration in venture capital funds by considering ESG issues when deciding how to allocate capital among funds. LPs can ask ESG due diligence questions in their VC fund manager selection process, include ESG terms in Limited Partnership Agreements, and request that reports include ESG information. Several of the most active LPs in venture capital are already PRI signatories including EIF, CalPERS, CalSTRS, Adam Street Partners, and HarbourVest, among many others.

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