December 13, 2023
How can VCs evaluate the ESG of their portfolio companies?

VC funds are growing exponentially regarding return on investments (ROI) and the magnitude to scale a venture. Critical metrics for evaluating a business include reviewing the business and revenue model via due diligence. However, VCs often leave out the evaluation of environmental damages or negative externalities. Therefore, the pertinence of ESG in due diligence has seen growth.

ESG investing represents the environmental, social, and governance criteria that investors are increasingly using as part of their analysis to identify material risks and growth opportunities. It is one of the principal methods used to analyse the offsetting carbon requirements of a business. However, the lack of robust measurement and benchmarking frameworks for early-stage startups or even VC fund managers poses a considerable risk to incorporating ESG practices. 

There are three challenges VC fund managers face while incorporating ESG practices in their valuations. First, VCs find it challenging to assess, monitor, and advise on the returns generated by their ventures in terms of ESG. It trickles down into inefficiencies from the risk mitigation and value creation points of view. These inefficiencies are absent from capital investment practices. 

Second, for a VC fund to promote and encourage their ventures to incorporate ESG practices, they must include the suggested practices in their incentives, operations, processes, and structures. It creates a value chain that needs to be emulated by ventures that receive capital from the VC funds and develops authenticity. Third, it is evident that the process and tools required to evaluate ESG practices in relatively new ventures differ significantly from those applied to large, public firms. It is primarily because the costs associated with quantifying, assessing and reporting on ESG factors will be substantially higher in early-stage ventures since these ventures face higher constraints in terms of human capital, management capacity, and financial resources. Therefore, when startups recreate or modify their business model for cost optimisation or counter diminishing returns to scale, ESG benchmarking is even more difficult.

Measuring ESG and VC Framework for ESG Valuations

These challenges make it necessary for VC funds to devise strategies to help them and their ventures incorporate ESG practices. Measuring ESG becomes a challenge for VCs since early-stage firms do not have ample cash available to burn and increase their EBITDA rate, which would worsen their company valuations. Moreover, data for private market companies are not readily available as it is for public market companies, making it difficult to devise a strategy for their ventures or make investment decisions for potential ventures in their portfolios. 

For long-term financial performance to be maximised, VC teams must incorporate ESG metrics in due diligence, financial analysis and company valuation. In this case, megatrend analysis becomes an extremely useful tool to analyse the metrics that suit the product/service the business is attempting to deliver. In addition, Megatrend analysis identifies significant and broader ESG trends associated with the venture. 

For instance, an early-stage EV startup would have significant climate risks associated with it in terms of battery production, which is used to develop the heart of an EV. However, these companies would often overlook the carbon costs associated with producing the battery, supply chain emission cost, and inventory emission cost. Furthermore, the VC fund invested in the business would require detailed data on emissions to devise a strategy. The strategy would either ask the company to adopt practices that offset their carbon emissions in the long run or aid them in purchasing renewable energy credits for instant carbon offsetting. 

In developing a framework, VC funds can establish a general body of rules and methods they would follow in integrating ESG due diligence and risk management. Furthermore, this framework can have a specific criterion that can be manoeuvred as per the kind of venture they are investing in, or particular firm needs as determined upon due diligence and financial analysis. This ESG framework can help VCs, and their ventures garner success and value creation.

Reporting and Indicator Strategy 

VC funds can incorporate benchmark reporting strategies such as the disclosure obligations under Task Force on Climate-related financial disclosures, and Business Responsibility and Sustainability Report (BRSR), among other things. These reporting standards and frameworks can make it easier for VC fund managers to tailor their ESG strategies and their venture's strategies to align with related climate, social or governance goals.

In addition to reporting frameworks, VC fund managers can also create indicators that their ventures would be required to follow post due diligence is completed. These indicators would range from environmental and social to governance protocols. For instance, a venture could focus on achieving certain climate goals by a specific time and make it their primary indicator for further valuations and business models. This makes economic forecasting for businesses more accessible. In terms of social, ventures can incorporate practices that promote diversity or contributions to CSR initiatives to meet their social goals.

Moreover , on the governance aspect, ventures can have the option to set policies of onboarding independent directors or to set a cap on the number of external entities who can take up a seat among the board of directors. Implementing and focusing on any of these indicators can help a venture concentrate on one goal and tailor it to perfection to incorporate ESG practices appropriately.

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