#18 A back-of-the-napkin ESG framework for venture capital funds
An easy but robust way to calculate the sustainability of your portfolio
Venture capital funds on average don’t really employ sustainability analysis of their portfolio companies. Here’s a simple framework we could adopt across the industry so as to improve that. It’s inspired by a proprietary methodology used by a sustainable investment management practice which I founded and led until its recent acquisition. It also draws on the endless frustration of trying to apply rigid ESG frameworks in the real world, in particular emerging markets and early stage companies.
Background
There are a few reasons why many investors don’t care much about sustainability:
They associate the practice with lower returns.
The ESG framework is clunky and unclear. ESG is slowly becoming a global standard but using it is not getting any easier. There are many different ESG standards and data discrepancies remain ridiculous. As a result, depending on inclination, ESG analysis can be taken earnestly or treated as a greenwashing exercise - much of it is based on policies rather than outcomes. Similar problems plague other would-be sustainability models from the UN Sustainable Development Goals to impact investing methodologies.
The regulatory obligations have historically been either non-existent or effectively amounted to a box-ticking process with lots of room for interpretation.
First principles
I propose these three principles as the starting point:
The job to do a startup’s sustainability evaluation is yours, i.e., the venture capital investor’s. It is not the job of a data provider, an external consultant, or the startup itself. Don’t hope to get this done by sending out a questionnaire.
Reality beats policy. Many organizations out there have a committee-crafted PDF somewhere that promises a commitment to public health and a “firm stance” against child abuse. Some of those same companies are in the tobacco business and specifically target children with their marketing. Outcomes are what you should be measuring.
Intentionality is irrelevant. I don’t care whether the team claims to plug out their kettles at night to save energy. I don’t care about their self-estimated carbon neutrality. I care about the impact on their business as a whole on the world as a whole, whether it is intended or not.
Before you begin: exclusion
The first step to a sustainable portfolio is an exclusion list - stuff never to invest in. Good ideas here are illegal activities, companies using forced labor, extractive industries, arms, etc. Some things just don’t belong in a sustainable world by definition and it shouldn’t be hard to figure out what they are.
Assessment: the three questions
As you assess a portfolio company, there are three key questions to answer. If this business becomes very successful..:
Will it result in a fairer world?
Will it help reverse climate change?
Will its management keep making good decisions?
Measurement
I’ll call the number we arrive at here the Societal Value Score, or SVS. It will be between 0 and 1. For its three components, the only allowed values are 0, 0.5 and 1, for simplicity.
Let’s calculate the SVS of Humanode, a Web3 startup.
A fairer world. Will more people get access to education, services, legal and political representation and/or better income? If Humanode becomes successful then people will have biometrics-based ownership of their own data and decentralized networks will find it easier to implement one-person one-vote mechanisms into their protocols. So, yes, that counts as an improvement. One full point. Contrast that with a Web3 startup in the MEV-extracting business which captures value at the cost of other users of the blockspace - that company would get a 0 here.
Reversing climate change. This often has little to do with the project itself but more with the industry in which it operates. In Humanode’s case - is crypto / DeFi climate-friendly? Well, proof of work is a disaster, but for proof of stake and other consensus mechanisms it’s tough to say. Biased sources are happy to estimate the carbon footprint of gold and TradFi as far higher than that of crypto. Some very interesting DeFi projects are definitely incredibly promising in terms of helping the climate. But overall it might be too early to judge. Let’s call the industry climate agnostic for the moment, and give Humanode 0.5 points on this item.
Good decisions. This is all about diversity. My investment experience has made me convinced in a strong correlation between diversity, especially female representation, in a company (or an NGO, a social movement, etc.) and its financial success. This might be one of the few unequivocally material ESG factors. Supporting evidence for this claim is becoming ample (McKinsey, BCG). Part of the secret might be that companies that champion diversity stand far more likely to retain millennial and Gen Z talent. This assessment area is in fact so important that, to judge it, you need to take the time to understand the lived experience of the women and the minorities in the company, via unstructured interviews. If there are none, or if they are relegated to purely administrative roles, understand why this is so. Draw your own conclusions and accept no proxies - diversity policies, token female board members, etc. Relying on the narrow visions of young, privileged white and Asian men might be good ROI in the short run (example: Facebook) but can become grossly inadequate as societies change (example: Facebook). Here, Humanode tentatively gets a full point for having a women in a key research position, with the caveat that in a real situation we’d need to do a lot more legwork to understand the nuances, as explained above.
So, Humanode’s Societal Value Score is (1+0.5+1)/3 = 0.83. Repeat this exercise across your portfolio. The average number you end up with is the SVS to report in your communication materials.
Limits of the method
You will want to complement the methodology outlined above in two cases:
For companies that make physical products, not just software. Here, supply chains and up/downstream carbon emissions do come into play, and making use of a trimmed down version of the ESG framework to answer question #2 makes sense.
For companies that do investment, the core company’s SVS or ESG footprints are practically irrelevant - it’s the impact of their portfolio that matters. The finance sector’s funded emissions are by some measures 700 times greater than its own. For an investment company in your portfolio you need to do a whole new exercise of SVS estimation, similar to the one you’re doing for your own fund. If that’s unrealistic then be transparent about the fact in your reporting.
Summary
The methodology I outline is much more reality-driven and incomparably faster (and cheaper) to implement than any ESG assessment on the market, whatever your friendly consultant may be claiming. By using it, we can turn venture capital from a laggard into a driver of true sustainability.