Responsible Venture Capital: ESG Practice in Early-Stage Tech Investing
The Venture Capital (VC) industry has trailed other asset classes in the adoption of Environmental, Social and Governance (ESG) practices, despite a growing body of evidence pointing to the materiality of ESG factors in assessing risk and opportunity at the early stage.
As impact investing practitioners with a foot in both Venture Capital and Fixed Income, we at Artesian, are watching the ESG story unfold across the tech sector from a very unique vantage point: at the earliest stages of the startup lifecycle right through to exit, public markets and beyond.
The Materiality of ESG Factors in the Tech Sector
One only need look at the significant loss in valuation for WeWork due to governance problems, or the reputational damage suffered by delivery and ride- sharing apps such as Uber and Lyft over the rights of workers in the gig economy, to see that ESG issues can be material to risk/return considerations.
Theranos, a late-stage venture that was forced to file for bankruptcy due to underlying technological integrity issues, is an example of the significant impact on financial returns to investors, highlighting the need to develop new mechanisms to uncover and mitigate ESG risks earlier. Deliveroo's poor stock market debut last year was also given the cold shoulder by some of the U.K.'s largest fund managers due to ESG concerns. Dual-class share structures that undermine shareholder rights and the poor working conditions of drivers were cited as reasons for avoiding its initial public offering.
The coronavirus pandemic has also put more companies under scrutiny for decisions and practices that impact employees, customers, and society. As a result, ESG factors have solidified as a key layer of diligence in evaluating investments.
Consumers too are becoming increasingly discerning about company decisions and practices, especially millennials. This ‘ESG Effect’ on consumer preferences is real. A study by Morgan Stanley’s Institute for Sustainable Investing found that millennials are twice as likely as the overall population to buy products from sustainable businesses.(1) In a 2017 study by Optimy, 60% of customers said they were willing to pay more for products from companies with reputable brands and good values. This is a significant consideration for any startup, given the $30 trillion wealth shift from baby boomers to millennials expected over the next 30 years.
In addition, employees who are more satisfied are more engaged, which has a material impact on company performance and the broader culture of an organisation. In a 2019 Gallup study, workers in the top quartile for employee engagement outperformed those in the bottom quartile across a range of metrics, including customer ratings, productivity, and profitability. In the Optimy study, 71% of millennials said they would choose to work for a company that has demonstrated a strong commitment to its community.
The Need for Responsible Investing at the Early Stage
Although venture capital is considered among the highest risk forms of investment, the industry does not yet have a widely accepted, systematic approach to ESG or societal risk management embedded in the investment process.
In its “Responsible Investing in Tech and Venture Capital” paper, the Harvard Kennedy School’s Belfer Center for Science and International Affairs asserts that there is a new level of urgency for early-stage investors to evaluate and manage the impact of frontier (or new) technologies on society.2
Furthermore, early-stage investors must be aware of the possible public purpose challenges posed to society through supporting associated frontier technologies, such as brain-computer interfaces, AI, or gene editing – all with broad-ranging potential for disruption (see Sample Public Purpose Challenges and Associated Frontier Technologies below).
Source: Technology & Public Purpose Project, Harvard Kennedy School’s Belfer Center for Science and International Affairs (2020)
In 2018, hundreds of organisations signed “The Paris Call for Trust and Security in Cyberspace”. In 2019, the biggest social media companies signed the “Christchurch Call” to help “eliminate terrorist and violent extremist content online.” And in Nov 2020, dozens of companies signed the “Tech for Good” call, including Sundar Pichai from Alphabet (Google), Mark Zuckerberg from Facebook, Brad Smith from Microsoft, Evan Spiegel from Snap and Jack Dorsey, the CEO of Twitter and Square as well as Cisco, Doctolib, IBM, OpenClassrooms and Uber.
ESG Integration & Active Ownership in VC
At Artesian, we seek to adopt an active - not passive - approach to ESG and are committed as signatories of the UN Principles of Responsible Investment .
While we have high conviction that you can "achieve transformational impact without sacrifice compelling risk/return metrics", we realise the need for ongoing research, analysis and education when it comes to ESG in practice, particularly in private markets.
Despite the lack of ESG frameworks for VC investments and the additional complexity for early-stage companies, we see the guiding principles are the same in any asset class. Leveraging our experience in the public fixed income markets, we have implemented impact data collection and ESG engagement protocols with our investee companies and we look forward to reporting on our progress.
Stay tuned as we share our journey!
(Originally posted on LinkedIn).