Solving VC’s ESG Puzzle
By: Gabe Kleinman
Tags: Esg Investing, Entrepreneurship, Esg, Venture Capital, Worldpositive

“How does a venture firm ‘do’ ESG with early-stage startups?”

This is a common question that comes our way — from venture firms, limited partners, academics, and the media — and the answer is, well, not so obvious despite a craving for simplicity.

Environmental, Social, and Governance (“ESG”) standards are having a moment with climate change (and climate risk), broad socioeconomic disparities, and questionable corporate behavior in the zeitgeist. Talented employees (in a tight labor market) and consumers (in a crowded landscape) care more deeply about matters related to ESG unlike any time in our lifetimes. While big business has been on the ESG train for slightly longer due to mechanisms like SASB (type “ESG” into Google for a healthy serving of strategy consultant ads on how to “do it” well), financial services — especially venture capital — is having to catch up.

The reason VC’s are gaining ESG altitude is simple: institutional investors and family offices are now leaning in.

As a result, many top tier firms have launched dedicated impact funds tied more closely to ESG metrics (see: TPG Rise, Bain Double Impact, 500 Startups, KKR, Blackstone, and more). Most early-stage, ESG-curious funds are trying to make sense of it all by focusing on post-investment processes driven by non-investment team members: What should be measured? Whose standards should be followed? How does this manifest at the earliest stages, and as companies grow? Where does this come into play for the management company? Is this a “core fund” thing or need there be a separate fund for ESG?

Many are understandably lost amidst a dizzying array of rubrics and calculations, none specifically tailored for venture capital, that the core metric — real-world impact — is buried. We’ve been at it for over seven years at Obvious Ventures (as a firm, with limited partners, and the portfolio), and it’s hard. What many of our colleagues in venture might consider is that elevating these considerations upstream — instead of delegating hundreds of measurements downstream — can ensure immeasurably greater impact, and as fiduciaries, greater returns.

Here are five ideas on how to get out of the ESG woods and focus on measuring what matters.

1/ “KISS” Investment Criteria

It is becoming increasingly clear that startups tackling big problems, especially environmental and social, are outperforming their peers for two reasons: new market opportunities and risk mitigation. Through a Keep-It-Simple-Stupid (KISS) approach in addition to the basics of venture investing (e.g. tech, team, timing, total addressable market), an investment team can elevate its ESG game by evaluating risks and rewards in sourcing practices, pitches, and committee meetings. Bringing in investment criteria that explicitly evaluate the founders (“How do the founders talk about their purpose and company-building philosophy?”), high-level impact measurement (e.g. customers served, products or services delivered), and potential unintended consequences (“What could possibly go wrong?”) are critical screens that can help identify higher-return, higher-impact opportunities while taking risk into consideration. [At Obvious, we deploy these criteria for each company we bring to committee.] While more comprehensive evaluative rubrics have been available for decades, a more simple approach is worth considering as well.

2/ Focus On Solving Big Problems, Then How To Do It

While there’s always risk in looking exclusively at the big vision, it’s where ESG can be center stage instead of being delegated exclusively to non-investment professionals, post-investment. Diving too deeply into ESG within the upfront screening or diligence processes can also create unnecessary friction while penalizing startups for (a) simply being an early-stage startup, or (b) if their chosen field (e.g., heavy duty electric transportation) is positively impactful on a global scale but score poorly on an impact assessment due to their day-to-day operation (e.g., industrial manufacturing). By setting strict screening criteria upfront that automatically disqualifies companies based on non-core functions, VC’s might also miss opportunities to take ambitious founders with transformative ideas and help them do it responsibly, thoughtfully, and in a way that creates greater long-term value.

3/ Seeding Best Practices & Optional Measurement

Building a company from scratch is hard, and piling on ESG reporting requirements for early-stage companies can be non-trivially distracting to the mission instead of directly serving it. Additionally, a company with less than ten employees can’t effectively answer most questions on any impact assessment, nor should they have to. If the investment team has done its work, impact can be a straightforward calculation measured through sales of its products and services: swapping out a diesel bus with an electric bus (lower emissions and lower costs), selling plant-based cheeses versus bovine-based curds (lower emissions), or reversing a chronic illness instead of a lifetime of treatment (healthier outcomes at reduced costs). The opportunity here is to optionally seed operational best practices in the earliest days (e.g. term sheets, OKRs, values-building, corporate structure) rather than forcing it on them when they are focused more on survival than anything. The onus is on us as investors to shine a light on those best practices in a company’s earliest days while encouraging structured reflections on their operation, both holistically and on an ongoing basis.

4/ Be Intellectually Honest & Seek the Truth

There is a yearning to make this all simple and standardized, but the truth is these are nuanced debates with webs of tradeoffs that all point back to the investment team. I’ve witnessed recent examples of firms with rigorous ESG standards backing companies in others’ exclusionary categories, like alcohol and firearms — justifying the investment on the grounds that the company scores well on ESG tests. And while breweries like North Coast Brewing and New Belgium Brewing may source ingredients locally and treat their workforces well, they’re still selling alcohol (I do love me some Old Rasputin Russian Imperial Stout, and am deeply impressed with both of their B Corp ratings). Let’s simply avoid putting operationally sound lipstick on a world neutral or world negative company, and instead be intellectually honest with whether the company in which we’re investing is having real world impact. It has to be more than a box check.

5/ Choose Your Benchmarks, Let The Market Decide.

Finding the right benchmarks and evaluative tools requires a little experimentation here. Doing so by evaluating your own management company as a start can go a long way — helping to build empathy, earning credibility, and helping build a depth of understanding regarding what makes sense for you. We do a combination at Obvious Ventures, using the B Impact Assessment (for ourselves as B Corp Certified, and optionally with our companies as a reflective tool) and creating self-defined impact reports like the World Positive Report. The team at MIT’s The Engine uses the United Nations Sustainable Development Goals as their benchmark while also creating their own reports like The Engine Report 2019 & 2021. 500 Startups has jumped in the game in a meaningful way across their screening, investing, monitoring, and reporting practices. The list of firms creatively-yet-rigorously charting their own path is growing.

It’s an imperfect system, likely always will be, and that’s ok. Greenwashing will continue, questionable investments will be justified with ESG acrobatics, and we’ll face more challenges as an industry.

The good news: there exists an abundance of lighthouse firms with impact baked into investment process (without necessarily using the world “impact”), including our friends at Lux Capital, Data Collective (DCVC), Collaborative Fund, Atomico, Fifty Years, Generation IM, MIT’s The Engine, Aera.vc, and DBL to name a few.

And the movement is growing. As venture investors increasingly see upstream ESG screens as an advantage in strategic asset allocation, that’s world positive for LPs and entrepreneurs alike.