Venture capital firms are missing out on the chance to address ESG in start-ups before they grow to scale and pose more significant ESG risks to people and planet, according to the Principles for Responsible Investing (PRI).
The PRI’s report Starting Up – Responsible Investment In Venture Capital, found few venture capital (VC) firms have dedicated ESG experts in-house, and ESG oversight responsibility often lies with investor relations.
“Nonetheless, there are examples of successful ESG incorporation practices that make sense for the asset class. For example, the use of tailored exclusion policies, specific ESG clauses in deal documentation, and post-investment surveys that monitor the risk exposures of early-stage companies as they grow,” wrote the report authors.
In 2020 European start-up tracker dealroom.co launched a database to track 4,939 ‘impact and innovation’ start-ups and scale-ups. It found impact investing accounts for more than 15% of total European VC investment, three times more than a decade ago, and double the global average of 7%.
Problem areas
A particular challenge rife in start-ups, PRI stated, was a lack of diversity, equity and inclusion. This is the case in Silicone Valley alongside the issue of a poor track record of sexual harassment incidents, the group noted.
The PRI also said another area that needs to be addressed is the lack of attention VC firms pay to environmental considerations when compared with social and governance. The report said: “Venture capital activity, especially that in blockchain and cryptocurrency technologies, has a notable impact on climate and this must be addressed.”
It also gave examples of governance concerns such as the use of dual share-class structures. The authors stated: “There is not enough focus on good governance across the asset class, evidenced by several high-profile governance failures at venture-backed companies, including Uber, WeWork, Deliveroo, and Theranos.
“Poor governance also increases the chances of social and environmental risks being poorly managed.”
The PRI pointed to a 2021 report by Amnesty International, which found the world’s 10 largest VC firms are all failing on their human rights due diligence responsibilities.
Peter Dunbar, senior specialist, investment practices at the PRI, said VC is lagging behind the rest of the private markets when it comes to ESG.
“Much of the industry focuses on providing solutions to some of today’s biggest problems, and investors can help to shape sustainability outcomes. However, that does not give an investor a free pass on ESG. Appropriately tailoring ESG in a way that adds value to early-stage companies is critical.
“VC firms have an excellent opportunity to ensure that good culture and management of ESG issues are embedded into a company from the outset, ultimately driving improved outcomes for the business, later-stage investors, society and the planet.”
Dunbar commented ESG expertise gives VC firms a competitive advantage due to high demand for ESG focus in the market.
Growing risks
Tracy Barba, head of ESG and global stakeholder engagement at VC firm 500 Global, said a formal mechanism for incorporating ESG considerations is needed. Without this, venture capital firms will keep incurring ESG risks as they grow their portfolios.
“These risks have the potential to intensify as their investments scale,” she said.
“Beyond the risks associated with investing in companies that don’t abide by basic ESG principles, many VC firms are missing an opportunity to attract high‐quality founders.
“Companies are increasingly seeking out general partners who can partner with them to advance their ESG goals, from pre‐seed up through an initial public offering.”
