The Role of ESG Considerations in Venture Capital Investments

In recent years, there has been a growing market emphasis on environmental, social and governance ("ESG") considerations in identifying suitable investment opportunities. For venture capital investments, many start-ups are in their early stages of growth and may not dedicate sufficient resources to addressing ESG concerns. In this article, we explore the increasing importance of ESG considerations in venture capital investments, the methodologies used to incorporate ESG factors in venture capital investments and conclude by examining the impact of ESG considerations on the execution of a transaction.

The increasing importance of ESG considerations

Although there is currently a lack of formal and standardised means of incorporating ESG criteria across the venture capital industry, there is a growing interest in this area among venture funds. In a competitive and uncertain landscape, some venture funds are placing greater emphasis on ESG criteria to differentiate themselves as long-term reliable partners for responsible investing focused on sustainability and thematic impact-based businesses and ideas. The venture funds may also have to satisfy the green requirements of their limited partners. With ESG regulations getting increasingly standardised globally, companies will want to stay ahead by keeping abreast and avoid adopting any practices which may incur prohibitive costs or even damage business plans and growth prospects in the future when soft best practices become hard law. We expect ESG to become part of the new normal in the corporate culture of big and small companies, and its importance is expected to continue rising for the foreseeable future.

 

Environmental factors

Perceptions may abound that many start-ups do not have significant carbon imprints because they are in their early stages of development, and consequently, the environmental risks that they pose are limited and not worth mitigating. However, this could be a misconception as most start-ups (including those which focus on cryptocurrencies and blockchain technology) are technology-based and usually energy-intensive. There are also start-ups which have business plans and prospects centred around environmental and green themes, such as those exploring plant-based meat alternatives, data centres energy cooling, recycling, batteries and urban organic farming. At Bird & Bird ATMD, we have acted across a range of these companies at various stages of their development.

 

Social factors

While many start-ups offer goods and services which aim to improve the lives of the community, some of these offerings may have unintended social consequences. For example, privacy and personal data collection issues could arise where start-ups provide facial recognition technology or data collection services. There could be issues of bias and discrimination towards the minorities, or a loss of privacy or abuse and misuse. The increasing automation of processes could result in lower-skilled workers becoming redundant, and this exacerbates income inequality.

 

Governance factors

Many venture funds are still investing in portfolio companies with few governance requirements to make their investments appear more founder-friendly, although the landscape may be evolving. The presence of independent directors on the boards of many early-stage start-ups is not always a given, and this may result in less oversight of the management team. Some exit stage start-ups may continue to have dual share-class structures, which grant their founders super-priority voting rights over other investors, creating a discrepancy between economic ownership and control of the company. Likely, companies with poor governance records will also struggle to manage their environmental and social risks and also lose any potential bragging rights that come along with a tip top ESG policy.

 

Methodologies to incorporate ESG factors in investments

Broadly speaking, venture funds can adopt three approaches to incorporate ESG factors in their investments. Increasingly, ESG factors are "value drivers", and these introduce new business while bringing about risks. Hence, it makes sense to adopt a broad and systemic approach which incorporates ESG factors across the investment process by systematically including such factors in the investment analysis and selection processes, allowing venture funds to tailor their requirements based on the start-up's stage of growth. An alternative would be the targeted approach, which focuses on specific material issues and will be useful in identifying certain ESG factors that are specific to the sector in which the start-up operates. A final option would be the outcome-oriented approach, which is linked to frameworks such as the United Nations Sustainable Development Goals and is useful in assessing the start-up's compliance with ESG policies throughout the investment's lifecycle.

ESG factors that are commonly used by venture funds to determine the portfolio company's compliance with the relevant ESG policies include the following:

  • Environmental Factors: Environmental impact of the business, greenhouse gas emissions, usage of resources such as water
  • Social Factors: Social impact of the business, diversity metrics in the leadership team and among the employees, working environment and culture, human rights
  • Governance Factors: Practices and composition of the board of directors, the proportion of independent directors, data privacy issues, regulatory risks, anti-bribery and corruption policies

Impact of ESG considerations on the execution of a transaction

Many venture funds have investment policies that guide them on the types of transactions that they may undertake. For instance, some venture funds avoid investments in certain sectors such as gambling, addictive gaming and facial recognition technology due to the negative social impact caused by these goods and services.

When conducting due diligence on a potential portfolio company, the investor may utilise pre-investment ESG questionnaires to identify and understand the relevant risks. It is also important for the investor to engage and interview the founders. Like any form of governance, the “tone from the top” is an important intangible value which drives the corporate culture for the treatment of ESG issues. Through due diligence, the start-up's governance and associated risk management systems can be established. Depending on the stage of the start-up's development, it may already be subject to certain mandatory ESG disclosure and standards requirements. An important question to ask is whether these start-ups are subject to any national ESG-related laws or any international standards such as the IFC Performance Standards, the Global Reporting Initiatives and the Sustainability Accounting Standards Board's standards. The investor will then need to ascertain how the current reporting and disclosure obligations of the start-up will be aligned with its ESG imperatives and goals. There may be an information burden overload that the start-up may then be obliged to effect or fulfil, and hence the alignment of such reporting has to be calibrated efficiently.

The scope of ESG due diligence may also extend to upstream and downstream due diligence on the customers and suppliers of the start-up and their respective degrees of ESG compliance. Where suppliers rely on forced labour for the production of goods or are heavy polluters, any such adverse association may affect the reputation and branding of the start-up and its goodwill with customers. The diligence process will involve suitable interviews with suppliers and customers to ascertain any such ESG-related risks that are posed.

Any ESG issues that are identified during due diligence could be immediately rectified where possible or be addressed through deal documentation (including conditions precedent, pre-completion undertakings or post-completion undertakings).

When valuing the start-up, venture funds should be aware that the valuation models used could result in an inaccurate valuation if wrong underlying assumptions are made about ESG risks or if these models assume incorrectly that the start-up is ESG compliant. For example, the valuation models may not take into account regulatory penalties imposed by the authorities on the start-up and any adversarial claims by third parties caused by breaches of ESG regulation. Moreover, a start-up that lacks ESG compliance would suffer from a poor reputation, and this may affect its sales and consequently its revenue.

To mitigate against increasing ESG risks, it is becoming commonplace for the inclusion of certain representations and warranties in the transaction documentation. Prevalent warranties would centre around include compliance with all applicable laws, including environmental, social forces laws, anti-harassment, anti-money laundering, anti-bribery and anti-corruption laws. It is not uncommon for warranties to be included that is the start-up not owned by, and has not undertaken transactions with, any individual who is the subject of economic or financial sanctions imposed by the United Nations or any other major trading blocs or countries.

Once the transaction has been completed, many venture funds would expect their portfolio companies to work towards certain ESG goals. It is increasingly common for portfolio companies to provide an undertaking that they will use their best efforts to comply with the ESG policies of the investor, which will be incorporated in the transaction documentation. The investors may also conduct annual surveys of their portfolio companies to monitor their ESG risks.

A distinction will be made between investors focusing on ESG and investors in the impact investing sector. While the aim of the former group is primarily to mitigate ESG risks in the investment, the latter group aims to generate a positive social impact, and the success of the investment will be assessed on both financial criteria and its impact on the community. This difference in objectives may be evident in post-completion obligations imposed on the company: investors focused on ESG will most likely include post-completion covenants relating to the rectification of ESG issues identified during due diligence (for example, the settlement of administrative penalties), while impact investors could include post-completion affirmative covenants relating to the achievement of certain fixed targets upon an environment impact assessment and key impact based deliverables in its annual budget and business plan.

Greenwashing

In line with the increased focus on ESG concerns, there has also been an increase in greenwashing, which is the deliberate attempt by companies to conceal environmentally unsound products. Greenwashing practices are problematic since they fail to generate legitimate impact and make it more difficult for venture funds to distinguish start-ups that are environmentally friendly from those that are not. This issue is worsened by the fact that start-ups attract less scrutiny than larger companies due to the size of their business. While venture funds generally do not seek long-term returns, they should remain vigilant to avoid investing in companies that undertake greenwashing practices, as this could significantly increase their legal and reputational risks. Increasingly, legislation has introduced financial sanctions, and penalties for greenwashing and any infringement would have an impact on the value of investments.

Conclusion

We anticipate the deepening of the ESG considerations in venture investments. However, investors should ensure that their ESG expectations are clearly defined and tailored to the start-up’s growth stage and its objectives to avoid overburdening early-stage companies. On the other hand, start-ups should recognise that the development of appropriate ESG practices and policies from the outset will benefit the company in the long run. Calibration is therefore necessary.


This article is produced by our Singapore office, Bird & Bird ATMD LLP. It does not constitute as legal advice and is intended to provide general information only. Information in this article is accurate as of 8 July 2022. Please contact the authors if you have any specific queries.

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