How can VCs evaluate the ESG of their portfolio companies?
21st June 2022
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 in 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 point 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
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.