Month: February 2024

Potential ESG Impacts in Startups Created by Early-Stage Minority Investors

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ESG is no longer just a buzzword but is now widely known to everyone, primarily driven by the urgency to address global warming, social issues, and corporate governance failures. Despite initiatives developed by various parties, ESG challenges persist, creating opportunities for venture capitalists (VCs) to play a crucial role. With a unique investment approach, VCs are well-positioned to support early-stage or unproven innovations that address ESG concerns not only with capital but also with resources such as knowledge, tools, and networks. Therefore, this article will explore the impacts on ESG that VCs can contribute to our society.

Impacts on ESG Driven by angel investors and incubators

There are several roles for the early-stage minority investors to play in guiding startups towards ESG, however, their influence admittedly varies depending on the nature and timing of their involvement. For instance, angel investors, through seed funding and close relationships, can help nascent startups connect with resources and like-minded individuals for impact-driven growth. This early guidance on ESG integration potentially lays a strong foundation. However, their smaller investments and shorter investment horizons often constrain their ability to significantly influence long-term impact during the critical early stages where startups may prioritize survival over sustainability. Similarly, incubators normally provide valuable strategic support and have a powerful impact on a startup’s business model. However, their focus on the initial stages often means they disengage before startups reach larger funding rounds and achieve more substantial impact efforts. To truly foster sustainable practices and long-term impact, collaboration between early-stage incubators/ investors and later-stage investors such as growth-stage venture capitals, with larger capital and resources as well as longer engagement horizons, becomes crucial.

Impacts on ESG Driven by Venture Capital

This section will delve into the ESG impact driven by VCs across three dimensions based on the significant impact VCs can create and the urgency to address pressing issues: Environment, focusing on accelerating carbon emission reduction; Social, examining impacts on workplaces and opportunities for change; and Governance, assessing the influence on startup governance and sustainable success. Each angle will highlight how VCs can contribute to organizational changes within startups and address broader issues through innovative funding initiatives.

  • Environment: Accelerating Carbon Emission Reduction

As we all acknowledged from the Paris Agreement, to limit global warming to 1.5°C, emissions need to be reduced by 45% by 2030 and reach net zero by 2050 [1]. More than one-third of the emissions reduction in 2050 requires innovative technologies that are currently under development, according to the International Energy Agency’s (IEA’s) net-zero scenario [2]. A significant portion of these technologies is still in their early stages, not yet market-ready, too costly to manufacture, or unproven at scale. Thus, substantial amounts of innovation capital will be crucial for decades to come. This need aligns with the nature of VC investments, which primarily seek investment opportunities in early-stage companies with significant growth potential while typically holding smaller equity stakes. Additionally, the relatively small investment size from VCs creates greater opportunities for many startups to secure funding, increasing the likelihood of successfully developing and scaling underdeveloped innovations. This unique approach positions venture capitalists as key enablers for the development of groundbreaking technologies to be commercially proved before attracting larger public market fund flows in the long run. At the same time, VCs tend to shift their investment focus towards industrial sectors which require higher- Emissions Reduction Potential (ERP) technologies such as carbon capture, utilization and storage (CCUS) and green hydrogen, according to PwC’s State of Climate Tech 2023 report [3]. This shift anticipates significant reductions in carbon emissions in the near future, aligning with the 1.5°C path.

In addition to supporting climate tech startups, VCs can play a pivotal role by promoting awareness and encouraging their portfolio companies to actively monitor and openly disclose their environmental performance metrics because numerous technology startups, particularly those in the crypto space and AI sector with high energy consumption, contribute significantly to carbon emissions. This proactive approach holds these companies accountable for their progress, fostering transparency and facilitating impact-conscious investors in making well-informed investment decisions.

  • Social: Creating Job Opportunities and Better Workplaces

The venture capital industry remains trapped in a diversity deficit, primarily led by white, elite-educated men and heavily concentrated in leading universities. According to the Stanford Social Innovation Review, this homogeneity tends to influence VC funding decisions, as the statistic shows that a staggering 86% of VC dollars in the US flow to male-only founder startups [4]. This issue holds significant importance, especially considering the substantial role startups play in job creation, contributing to nearly 1.7 million job gains in 2019 [5]. As a key driver for job creation, venture capitalists possess a considerable opportunity to instigate change and address this imbalance. Fortunately, change is underway as VC funds like MaC Ventures and ImpactX are challenging the status quo, focusing on supporting founders who came from marginalized demographic or minority background, while initiatives like AllRaise champion female leadership and advocate for doubling the share of capital controlled by women in VC by 2030 [4].

In addition to this, venture capitalists have the potential to drive substantial change not only in addressing social issues within workplaces but also in tackling broader societal problems, such as education inequity and financial inclusion, through funding provided to startups that develop solutions for such social problems. In the Beacon VC’s latest article, How Socioeconomic Status Affects Thai Education Inequity and How Stakeholders in the Community Can Address It, various edtech companies, including Ookbee, SchoolBright, and Open Durian, are highlighted for their contributions to addressing education inequity primarily stemming from socioeconomic disparities [6].

  • Governance: Driving Positive Cultures and Sustainable Success

Similar to nurturing children, the earlier the nurturing process commences, the more effortless it becomes to shape their foundational beliefs and habits. Venture capitalists play a pivotal role in establishing strong governance cultures, values, and behaviors within startups during their early days, preventing undesired actions or mindsets from becoming ingrained and resistant to change as the companies scale. Theranos, a medical technology startup, initially reached a valuation of $9 billion, but subsequently plummeted to $800 million. The decline happened because the founders intentionally presented fake medical testing and exaggerated the company’s profits to attract funding from investors. This case also brought about serious issues in corporate governance due to insufficient oversight and a board filled with close allies instead of independent voices. Similarly, GoMechanic, a car servicing and repairing platform initially valued at close to $700 million, experienced a significant valuation-drop due to reported over-inflated numbers and fictitious garages. Ultimately, it was sold for just $30 million [7]. The undeniable correlation between corporate governance and valuation emphasizes the crucial roles of investors and boards in driving sustainable value creation in a startup’s early days.

Furthermore, good governance is vital for startups to access essential capital sources from both private and public markets. Since governance has long been the main focus for private equity firms when considering investing in the company due to its significant impact on risk management and strategic decision-making. Additionally, the stock market listing process has evolved, with Nasdaq imposing new board diversity requirements, further emphasizing the growing importance of governance in the startup landscape.

In addition to fostering good governance within an organization, VCs also drive the emergence of new tools for regulators, including auditing firms, government agencies, and internal compliance teams, to validate and ensure the accuracy and compliance of disclosed information. This contributes to the overall enhancement of good governance within the ecosystem. Startups such as Mindbridge AI, 6clicks, Trunomi, and ClauseMatch assist enterprises in better managing risks and staying compliant with evolving regulations.

How VCs Play a Role in Shaping Companies’ ESG Pathway

VCs are playing a crucial role in shaping companies’ ESG pathways by integrating ESG considerations throughout the entire investment lifecycle from initial screening and due diligence to deal documentation, ownership period, and eventual exit. This integration highlights a commitment to responsible investing, where financial success aligns with positive contributions to the broader global communities and environment.

  • Implement ESG in Initial Screening

One of the most common practices that VCs opt for ESG evaluation during the screening process is having exclusion lists or specific deal-breaker criteria. The examples of exclusion lists are any companies on EU, UK, USA, or UN sanctions lists or those violating UN conventions and declarations on human rights or engaging in illegal activities according to Elevator Ventures’ screening criteria [8]. Some VCs like Astanor evaluates ESG risks in potential portfolio companies before investment.. For instance, environmental criteria involve avoiding highly polluting industries. Social criteria include avoiding dangerous substance handling that could jeopardize employee safety and surrounding communities. Governance criteria focus on avoiding operations in high-risk countries for money laundering, terrorism financing, or corruption, while ensuring good corporate governance [9].

Deal-breakers may arise from ethical concerns, such as indications of greenwashing or misleading environmental impact claims. For example, VCs may hesitate to invest if a climate tech startup lacks a clear and measurable impact on addressing climate challenges. Tangible results and a well-defined mission become crucial factors in the investment decision-making process.[10].

  • Implement ESG in Due Diligence

During the due diligence process, assessments can occur informally through methods like observing founders’ behavior, or more formally through ESG workshops and questionnaires.

In informal assessments, as revealed in a survey by PRI, some investors gauge founders’ values and ethics by observing their behavior in social settings, such as restaurants [11]. This practice helps identify potential concerns, such as misogynistic behaviors, which may impact the startup culture and subsequent business. For more formal methods, in investment rounds led by Atomico, a conscious scaling workshop is conducted with each new portfolio company as part of the final due diligence process [12]. This workshop involves collaborative sessions between founders and investors/the board, with a focus on identifying and mitigating long-term risks associated with the business model or the technology’s impact on society, the environment, and other stakeholders. Elevator Ventures employs a verification approach for potential portfolio companies using ESG questionnaires, ensuring alignment with regulatory frameworks like Sustainability Accounting Standards Board (SASB) standards.

  • Implement ESG in Deal Documentation

Deal documentation reflects the commitment of startups to ESG principles. Agreements may include clauses that bind startups to certain ESG standards and practices including specific milestones related to the reduction of carbon emissions or the implementation of sustainable practices within the company. For instance, during investment negotiations with potential investees, Astanor uses their commercially reasonable efforts to embed ESG requirements in contractual documents signed by the Fund Manager to secure full alignment with Astanor’s ESG and impact ambition. Atomico requires its new portfolio companies, where it leads an investment round, to design and implement a Diversity & Inclusion Policy within three months and a Diversity & Inclusion strategy within six months of investment. Similar to Beacon VC, their portfolio companies under the impact investment mandate are required to reach an agreement with the VC on the ESG metrics outlined in the investment agreements. These metrics will be regularly tracked, and the portfolio companies will provide reports to Beacon VC in accordance with the agreed-upon terms.

  • Implement ESG during Ownership

 How a VC engages with portfolio company management during ownership depends on its investment strategy and governance model. For example, VCs may aim to oversee invested startups and actively participate in voting on ESG matters by securing a board seat, often requiring their leadership in the investment round or holding a larger share than other participating investors in the same round. Despite VCs holding a minority share, being early investors in a company provides a unique advantage by fostering a closer relationship between VCs and the founder and team. This closeness aids in cultivating an ESG mindset among them. Accordingly, how VCs can drive ESG implementation in invested companies is defined through two activities: Engagement and Voting rights.

  1. Engagement

Collaborating on ESG Program Development: VCs can work with portfolio companies to establish an ESG program, involving tasks such as drafting a policy, assigning responsibility for ESG operations, and setting up processes to manage ESG activities. To begin the ESG journey, ESG_VC has developed a standardized 48-question ESG questionnaire for early-stage companies, applicable from Seed to Growth stages and across both B2B and B2C sectors [13]. It provides a tangible ESG score and identifies key areas for startups to improve ESG performance. The Astanor Team has conducted an Impact Deep Dive within six months after investment [14]. This deep dive aims to establish the baseline for both ESG and impact, facilitating the development of a constructive ESG roadmap and the identification of the most suitable impact KPIs for the company.

Promoting Knowledge Sharing on ESG: Given the absence of standardized ESG incorporation practices within the startup industry, startups are facing with a continuous need to stay informed about the ongoing developments and emerging knowledge in this dynamic field. Venture capitalists have a potential to leverage expertise and experience on ESG matters across the portfolio by encouraging sharing of knowledge and good practices among different companies. For instance, a general partner could organize periodic meetings or conferences with representatives from all of its portfolio companies or startups in the ecosystem to discuss ESG topics. As an example, Beacon VC has partnered in creating a community known as Climate Tech Club, providing a space for startups and individuals who passionate about ESG transition to share knowledge and stay updated on the latest ESG information. The community facilitates ongoing knowledge-sharing sessions and workshops throughout the year, all are open for participation at no cost. An upcoming event in February is the ESG Essential Workshop, designed to guide startups through the practical steps of initiating an ESG report.

  1. Voting Rights

Board of Director role: Venture Capitalists with Board seats in startups are well-positioned to influence ESG considerations. This influence can take the form of Board Resolutions and the delineation of veto powers, which can be explicitly addressed and mutually agreed upon during the initial investment documentation phase. Subsequently, if any issues of ESG concern emerge, the VCs on the Board have the authority to exercise their voting rights, either in favor of or against such matters. Additionally, in case where concerns are raised by shareholders, the Board is expected to take action by engaging with other shareholders. Failure to respond to shareholders’ concerns could be perceived as a governance failure on the part of the Board.

Shareholder Resolutions: In case VCs do not have a Board seat, they also have the option to propose resolutions compelling companies to address specific ESG concerns. While not always successful, these resolutions draw attention to critical issues and may motivate companies to take action to avoid adverse publicity. Given the growing demand for ESG information in corporate financing and from investors, including private equity firms, banks, and other capital providers, there is indirect pressure on startups to consider ESG as part of their business goal. This role helps investors, irrespective of the shares they hold, in holding companies accountable for their actions and demanding change when necessary.

  • Implement ESG during Exit

The survey from Deloitte revealed that US Private equity investors are nearly three times as likely as corporates to approach ESG due diligence consistently and formally, and nearly twice as likely to include ESG clauses in M&A contracts [15]. Furthermore, Nasdaq recently introduced new board diversity requirements for listed companies. This development indicates a notable advancement in ESG considerations across financial markets, particularly among potential buyers like private equity firms and stock exchanges. As a result, VCs can play a key role in ensuring portfolio companies meet these standards.

Barriers to ESG Implementation at Each Investment Process

Despite the clear intention of VCs to incorporate ESG considerations into their investment process, several challenges arise due to factors such as limited data and standardized metrics, subjective interpretations of ESG criteria, and the varying readiness of startups. The following points highlight the complexities VCs face in aligning investment strategies with ESG practices.

  • Challenges in Initial Screening and Due Diligence:
    1. Data Reliability and Standardized Metrics: The availability of reliable and standardized ESG data remains a hurdle for VCs. The challenge lies in verifying the accuracy of data sourced solely from the company, without third-party verification. The absence of universally accepted metrics further complicates the consistent assessment of potential investments’ ESG performance.
    2. Subjective interpretations: ESG data often includes qualitative information such as, stakeholder engagement practices, supply chain ethics and labor standards, leading to variations in interpretation among individuals. Differing perspectives on what constitutes strong ESG practices may create ambiguity in the evaluation process.

 Challenges in Deal Documentation and Ownership:

    1. Readiness of Startups: Not all startups are equally prepared to align with ESG principles. VCs may encounter resistance or limited ESG infrastructure in some companies, requiring additional efforts to bring them in line with the desired sustainability goals.
    2. Contractual complexities: Embedding ESG clauses in agreements can be complex, requiring careful consideration, legal expertise, and skilled negotiation. For instance, Finding the right balance between specific targets and flexible frameworks can be challenging. Too specific clauses may hinder adaptability, while overly broad ones lack accountability. Defining clear consequences for non-compliance with ESG clauses requires careful consideration of proportionality and unintended impacts.
    3. Limited influence in later stages: As startups progress through funding rounds, the power dynamics between VCs and founders often shift, and the stakes that VCs hold normally decrease in later rounds, reducing their control over ESG implementation. For example, a VC may no longer have enough voting power to actively influence board decisions or push for specific ESG measures.

By recognizing the challenges that VCs may face during the process of embedding ESG practices into their investment processes or within the startup culture, VCs need to take into account the stage of startups and balance proactive ESG management to avoid unrealistic expectations. It is crucial to recognize the need for startups to concurrently achieve financial viability and expand their business operations. Accordingly, there is a roadmap suggested by ESG_VC, stating when ESG implementation should be reasonably initiated at each stage of the company.

How Other Capital Providers Drive Sustainable Startup Growth

While venture capitalists play a crucial role in shaping a startup’s early culture and governance, fostering long-term success involves a symphony of financial players, each with their own unique instruments. Here are how other capital providers can contribute to creating sustainable and impactful startups:

  • Financial Institutions:
    1. Corporate Financing: Beyond traditional loans, financial institutions can offer innovative financing solutions like sustainability-linked loans, where interest rates are tied to the company’s achievement of ESG goals. This financial product incentivizes startups to integrate sustainability into their core business model. Additionally, financial institutions can provide special loans to consumers for ESG projects with reducing interest rates. For example, KBank launched the “Solar Save” campaign, presenting a 0% interest rate for the first four months on solar PV installation projects and maintaining a low interest rate of 3.75% for the initial four years [16].
    2. Tools and Education: Financial institutions can assist startups by leveraging their resources and corporate networks to educate them on ESG trends and regulations. They can also provide essential tools such as ESG or carbon management platforms, facilitating the initiation of ESG measurement within organizations. These proactive approaches empower startups to make well-informed decisions that align with greener practices. In terms of education, KBank organized the “Earth Jump 2023” seminar, bringing together leaders from both the public and private sectors to discuss and exchange perspectives on fostering “sustainability” as a catalyst for business growth [17].
  • Other Stakeholders in Public Markets:
    1. Sustainability Indices: Stock exchanges provide alternative fundraising avenues for startups with strong ESG commitments. Stock Exchanges may introduce specialized platforms or indices that track the performance of companies with strong ESG commitments, attracting investors seeking impact alongside financial returns.
    2. ESG requirements for listing in Stock Exchanges: Stock exchanges may implement stricter listing requirements that prioritize ESG principles and responsible governance practices, encouraging transparency and sustainability among publicly traded companies.
    3. Client-led Voting for ESG Matters: Asset management firms provide an alternative approach for investors who invest via the firms to have a say in vital company matters like mergers, acquisitions, director elections, and ESG matters. Traditionally, the responsibility of voting has been reserved for asset managers, in the realm of ESG concerns, asset managers’ investor-clients are demanding an increasing say on companies’ ESG matters. As a result, Blackrock, for instance, plans to broaden this right to all clients, and it is piloting the expansion of voting rights in the UK. Other asset management firms such as Vanguard and DWS Group, are also embracing this trend [18].

Closing Thought:

In the dynamic landscape of sustainable investing, early-stage minority investors, especially VCs, serve as pivotal architects, steering startups towards impactful ESG pathway. Their collaborative efforts contribute beyond capital injection, offering innovative financing solutions, education, tools, and alternative fundraising avenues, fostering a holistic approach that resonates with sustainable investing. However, for sustained impact, this orchestration requires collaboration with other investors and stakeholders, including those who come later and the management within the company. The long-term journey to sustainable startups necessitates a continuous symphony of efforts from diverse stakeholders, ensuring positive change extends far beyond the early stages.

 

Sources:

[1]  https://www.un.org/en/climatechange/paris-agreement

[2]  Executive summary – Net Zero Roadmap: A Global Pathway to Keep the 1.5 °C Goal in Reach – Analysis – IEA

[3]  https://www.pwc.com/gx/en/issues/esg/state-of-climate-tech-2023-investment.html#fewer-early-stage-deals-but-a-steady-inflow-of-first-time-investors

[4] https://ssir.org/articles/entry/how_venture_capital_can_join_the_esg_revolution

[5] https://www.bls.gov/spotlight/2022/business-employment-dynamics-by-age-and-size/home.htm

[6]  https://www.beaconvc.fund/research/how-socioeconomic-status-affects-thai-education-inequity-and-how-stakeholders-in-the-community-can-address-it

[7] https://www.financierworldwide.com/ingraining-good-governance-in-start-ups-buck-stops-with-the-investors

[8] https://www.elevator-ventures.com/unpri-esg-policy/

[9] https://astanor.com/wp-content/uploads/2022/12/SFDR-Disclosure-GHVI-S-LP.pdf

[10] https://www.eu-startups.com/2023/10/what-vcs-look-for-in-climate-tech-startups-opportunities-and-deal-breakers/

[11] https://www.unpri.org/private-equity/starting-up-responsible-investment-in-venture-capital/9162.article

[12] https://atomico.com/esgpolicy

[13] ESG_VC (esgvc.co.uk)

[14] SFDR-Disclosure-GHVI-S-LP.pdf (astanor.com)

[15] https://www2.deloitte.com/us/en/pages/about-deloitte/articles/press-releases/private-equity-leads-corporate-deal-teams-on-esg-in-mna.html

[16] https://www.kasikornbank.com/th/news/pages/solarsave.aspx

[17] https://earthjump-thailand.com/#about

[18] https://professional.ft.com/en-gb/blog/investors-demand-greater-esg-voting-rights/

 

 

Author: Supamas Bunmee (Jae)

Editors: Warittha Chalanonniwat (Paeng), Wanwares Boonkong (Pin), and Woraphot Kingkawkantong (Ping)