By: Sanovar Singh Bajwa & Davis Li
For many years, a business’s sole purpose was to create shareholder value for investors and was evaluated purely based on its bottom line. However, increased globalization and interconnectivity through technological development have made businesses more involved in the lives of consumers, which has changed the role of business in society. Furthermore, many individuals and organizations have begun to rethink our current model of government and philanthropy being used to solve society’s biggest problems and have turned towards the private sector by asking companies to respond to broader societal challenges. The rise of corporate social responsibility (CSR) allowed stakeholders to evaluate businesses on social and environmental measures in addition to profitability. Investors have used these new metrics to develop investment philosophies that integrate ethical considerations into the investment process.
Impact investing is an investment strategy that most actively creates environmental or social change, with the goal of generating positive financial returns and societal returns. With over 1,720 organizations managing USD 715 billion worth of impact investment assets in 2020, the investment style has gained significant traction recently and has been adopted by many different types of investors, such as large financial institutions, pension funds, family offices, private wealth managers, foundations, individuals, commercial banks, and development finance institutions. Impact investors provide capital to address many of the world’s most pressing issues in several sectors, including sustainable agriculture, renewable energy, conservation, microfinance, and basic services like housing, healthcare, and education. Although impact investments can be made through a variety of asset classes, venture capital allows organizations to maximize societal returns by investing in innovative businesses that have the most potential to create change.
There are several frameworks and metrics used to calculate and measure financial returns, such as internal rate of return (IRR), but measuring social impact and societal return has been a major hurdle for impact investors. ESG reporting practices completed by three-quarters of the world’s large and mid-cap companies have provided investors with useful qualitative information, but don’t provide a clear framework or quantitative metrics required to measure returns. With that being said, there are a few metrics and frameworks that are being used in preliminary ESG valuations of venture capital companies.
The best environmental indicator by far that is quantifiable is the total possible greenhouse gas emissions reduced if the company scales into fruition. It is much more difficult to determine the possibly reduced emissions when a company is still in early stages, hence why the prediction is made if the company were to scale.
The best environmental indicator by far that is quantifiable is the total possible greenhouse gas emissions reduced if the company scales into fruition. It is much more difficult to determine the possibly reduced emissions when a company is still in early stages, hence why the prediction is made if the company were to scale.
For governance, oftentimes the percentage of independent directors on a startup board is a good indicator. An independent director brings a third-party impartial view on issues as well as their own industry experience, which adds immense value to early-stage companies. A rule of thumb outlined by Crunchbase is that a minimum of 25% representation is optimal for a mid stage venture-backed startup.
Ultimately, ESG and CSR principles are expected to become more heavily emphasized in the venture capital world. However, universal and common standards for these principles need to be established in order to truly start enforcing these concepts.