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The unique challenges of applying ESG in Venture Capital

In recent years, we have witnessed a rapid growth in market expectation for the integration of environmental, social and governance (“ESG”) factors into investment allocation.

Financial institutions have been called to action to recognise their responsibility in limiting the effects of climate change, promoting values of Diversity and Inclusion, and ensuring strong governance to underpin these efforts. Investors are expected to integrate ESG factors throughout the investment process and ensure active monitoring and reporting of ESG performance across their portfolios.

As the pressure from regulators, shareholders and consumers persist, so does the drive for standardised frameworks and methodologies representing industry best practice.

As a London Stock Exchange-listed VC with a portfolio of directly held Series A and B tech companies and a significant Fund of Funds programme, Molten Ventures is uniquely positioned as a GP and LP to observe the shifting regulatory and stakeholder expectations in this space.

The alphabet soup of TCFD, UNPRI, SFDR, NZIF, SASB and GRI represent just a handful of the plethora of standards and frameworks setting out metrics and guidelines for financial institutions to utilise in framing, demonstrating and improving ESG performance, both at a corporate and portfolio level.

However, many find that the sheer volume of these frameworks makes them difficult to navigate and at times contradictory in practice. They also largely fail to recognise the critical distinctions between various asset classes falling within the overarching categorisation as ‘financial institutions’.

This issue is particularly acute for the Venture Capital (VC) segment of the tech investing ecosystem which, in the context of these myriad frameworks, is typically bracketed together with private equity (PE) despite the former’s comparative newness to the ESG reporting space and the latter’s often more extensive resources and experience of ESG practices.

With this distinction lacking, the nuances of VC, both in terms of its structure and portfolio composition, are often unaccounted for.

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"VCs continue to face increased demands around their ESG performance monitoring and reporting, there is currently insufficient levels of resource by way of qualified ESG professionals with VC experience to deliver to LP/shareholder expectations, which can be starkly contrasted against PE firms who often have sizable dedicated teams in this area."

VC vs PE: portfolio composition

For VC investments, small and medium-sized start-ups are typically in the early stage of their growth with limited time, money and resource to prescriptively dedicate to their ESG agenda. Whilst they are very often doing excellent things across each of the three separate pillars of E, S and G, they invariably lack the expertise and experience required for targeted or deliberate integration of ESG into their business models, which may themselves be in the early stages of development and subject to significant pivots along the way. Indeed, for these early-stage higher-risk / higher-reward businesses operating in an environment where a high percentage are statistically likely to fail, efforts considered ‘non-business-critical’ such as dedicated ESG reporting will often remain at the sidelines.

With respect to ESG-specific agenda items, such as carbon emissions or board level diversity, VC-backed start-ups are often faced with targets and reporting expectations that are poorly and/or disproportionately constructed, with seemingly little consideration for materiality thresholds relative to their growth stage, corporate footprint or impact (both in the short and medium term). Whilst not always the case, these tech-oriented companies are often comprised of a fairly small number of individuals operating partially or entirely remotely with limited supply chains, finite talent pools and relatively minimal environmental impact.

Moreover, by its very nature, the VC focus on backing new and innovative technologies means that many portfolio companies are by design pioneering energy and resource efficiencies through technological advancements in emerging markets such as Climate Tech that are themselves creating opportunity to effect the systemic changes needed to address the multi-faceted and urgent challenges of the 21st century.

VC vs PE: investor influence

Not only do the composition of investee companies differ between VC and other asset classes, but the influence afforded to VCs as investment managers to push their own ESG agenda, or preferred best practice framework, is also constrained. As minority investors holding anywhere between 1-20% of equity on average, VC firms have finite influence over portfolio company decisions when compared to later stage-investors in the PE or buyout space who will often hold a controlling stake in portfolio companies. Indeed, it is an inherent feature of the early-stage venture investment model to see the size of equity holding and level of board influence diminish over time as later-stage investors are introduced who are better placed to help portfolio companies navigate the challenges associated with more mature growth.

It is also worth mentioning that whilst VCs continue to face increased demands around their ESG performance monitoring and reporting, there is currently insufficient levels of resource by way of qualified ESG professionals with VC experience to deliver to LP/shareholder expectations, which can be starkly contrasted against PE firms who often have sizable dedicated teams in this area.

At Molten Ventures, our approach to portfolio ESG engagement focuses predominantly on education and awareness building to enhance the ESG literacy of our portfolio companies through tools, resources and best practice guidance. While we philosophically do not believe it is our function to be overly proscriptive or demanding of ESG standards or the way in which this is delivered, we do see real value in providing our portfolio with the tools and support to develop their own company specific ESG agenda and better embed the principles of ESG into their day-to-day operations.

Working towards a solution

The methodologies and standards for navigating ESG in VC remain nascent and will evolve over the coming years.

We have been encouraged by the UN PRI’s move towards recognition of VC as distinct from other asset classes in its VC-focused Responsible investment DDQ for venture capital limited partners, but in order for meaningful change to be achieved at a VC or portfolio level, we will continue to advocate for all recognised industry bodies to better cater to the unique challenges and opportunities that VC firms face in integrating ESG into their investing practices, by building nuance and sensible thresholds grounded in materiality into the development of thoughtful and meaningful thresholds and standards.

Until such standards exist, Molten’s ESG strategy continues to focus on working with peers and pioneering community-led initiatives such as Venture ESG and ESG_VC to navigate the current ESG reporting landscape and to ensure that ESG can thrive within venture capital and facilitate a strong foundation to grow and support businesses and entrepreneurs who are building solutions for the future.

Authored by Ben Robson
General Counsel, member of the Molten Ventures plc ESG Committee of the Board, and member of the BVCA Excellence in ESG 2023 Awards judging advisory panel

And Grace Savage
ESG Lead, Molten Ventures

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