Starting up: Responsible investment in venture capital

This report explores the nascent development of ESG incorporation in the venture capital industry. It highlights current approaches and examples of emerging good practice; alongside the substantial barriers that need to be addressed for responsible investment to be more widely adopted across the venture capital industry.

It expands the PRI’s private markets resources , which have primarily been focused on other areas of private equity, infrastructure and private debt, where responsible investment practice is more advanced.

The PRI interviewed a range of venture capital investment managers, asset owners, and other stakeholders in the research for this paper. We welcome feedback that can be used to take our venture capital work forward – contact [email protected] to contribute to the discussion.

The sectors and disruptive technologies frequently targeted by venture capitalists can be exposed to a range of social risks, including:

• Privacy violations (e.g. in specific uses of facial recognition technology , data collection and marketing by social media companies )
• Bias and discrimination (e.g. in the use of algorithms )
• Income inequality and wage polarisation (e.g. through artificial intelligence and the move to automation , and the use of business models that do not recognise workers as employees ^[12] )

Investors are not paying enough attention to these risks, nor are they integrating human rights considerations into their investments.

A­ recent report by Amnesty International, Risky Business: How Leading Venture Capital Firms Ignore Human Rights When Investing in Technology , found that the world’s ten largest venture capital firms are all failing on their human rights due diligence responsibilities.

A lack of human rights due diligence could have significant consequences – venture capital GPs may be investing in companies whose products or services have ongoing human rights risks. They may also fund new and frontier technologies or business models that could have significant negative outcomes for human rights in the future.

Many venture capital success stories – companies that are now household names, such as Facebook and Uber – also remain a cause for concern. This is likely to continue as populations become increasingly exposed to venture capital-backed companies.

There is not enough focus on good governance across the asset class, evidenced by several high-profile governance failures at venture-backed companies, including Uber , WeWork , Deliveroo , and Theranos . Poor governance also increases the chances that social and environmental risks will be poorly managed.

This lack of focus is often by design. Many venture capital GPs feel that being founder-friendly – investing with few governance expectations attached – creates an advantage for winning deals in an extremely competitive environment. Where such investments are made, entrepreneurs are free to run and grow their businesses with very little influence from venture capital GPs.

There is generally a lack of independent directors on boards, with research indicating that early-stage companies have just 0.8 independent board members, on average, across the various stages of their lifecycle.

At a more systemic level, technology governance failure is a significant medium-term risk, according to 50% of respondents cited in the WEF Global Risks Report 2021 , and one that the venture capital industry is particularly exposed to, given the prevalence of investments made in technology – particularly frontier technologies.

The OECD defines technology governance as exercising political, economic and administrative authority in the development, diffusion and operation of technology in societies, through the activities of governments, companies, civil society organisations and communities of practice.

According to the WEF, the risks associated with poor technology governance include issues of privacy, liability, cross-border regulatory discrepancies and the potential for misuse by bad actors. ^[16]  

Other governance issues are also prevalent in, but not exclusive to, the technology industry. For example, the dual share-class structure found in some venture-backed early-stage companies, which grants founders superior voting rights over other investors, creates a discrepancy between economic ownership and control.

Research published in the Virginia Law Review suggests that companies with such structures face more governance challenges than those without.

Research indicates that the technology sector is responsible for around 1.8% – 2.8% of global greenhouse gas emissions but it could be as high as 3.9%. ^[17]

Reflecting this, our discussions indicate that many venture capital GPs (especially in the US) do not perceive the companies and sectors they invest in to be high greenhouse gas emitters; consequently, they often do not believe environmental risks and opportunities are relevant to their investment strategies.

However, climate-related risk can be material. For example, cryptocurrencies and the blockchain technology that underpins them – an area that has attracted significant venture capital investment – consumes as much energy as some medium-sized European countries, albeit some of it comes from renewable sources. ^[18]  

Furthermore, technology companies are likely to face greater scrutiny ^[19]   as investors increasingly realise that the data, products and services they provide are not environmentally costless ^[20] and focus more on their scope 3 emissions.

Importantly, venture capital GPs must do more to consider the environmental outcomes their start-up companies might shape once they achieve scale, by assessing their business models and associated risks from the outset.

• Responsible venture capital , a report by CDC Group and Dutch development bank FMO, provides a framework for venture capital investors to consider and manage the ESG risks and opportunities most applicable to them.
• Harvard Kennedy School published Responsible Investing in Tech and Venture Capital to highlight several challenges and potential solutions for managing societal impacts of venture capital firms and portfolio companies.
• Growing the Seeds of ESG: Venture Capital, Start-Ups and the Need for Sustainability , published by German venture capital manager KfW Capital and Boston Consulting Group, outlines an approach the venture capital industry can take to assess and benchmark their ESG integration efforts.

• Diversity VC and Level 20 support a diverse network of venture capital professionals and provide recruitment guidance to venture capital firms.
• The National Venture Capital Association (NVCA) supports Venture Forward , a non-profit organisation promoting a strong and inclusive community within the industry.
• Some high-profile venture capital firms have also set up investment vehicles to improve diversity in the industry, known as diverse founder funds.

• The PRI’s report, How and Why Investors Should Act on Human Rights , sets out the three-part responsibility that all investors, including venture capital investors, have to respect human rights in their investment activities, as defined in the UN Guiding Principles on Business and Human Rights (UNGPs) and reflected in the OECD’s Guidelines for Multinational Enterprises.
• Amnesty International’s Silicon Valley Initiative focuses on the human rights risks of surveillance technologies. This is particularly relevant as nearly US$10bn was invested by venture capital into privacy and security companies in 2019. ^[23]
• The UN’s Office of the High Commissioner on Human Rights provides guidance and resources for implementing the UNGPs in the technology space through its B-Tech Project .

• Leaders for Climate Action has created an innovative sustainability clause for venture capital term sheets and shareholder agreements that bind companies to climate action.
• The PRI has produced guidance on TCFD reporting for private equity investment managers that could also apply to late-stage venture capital investors.
• The UN-supported Crypto Climate Accord has been established to decarbonise the cryptocurrency and blockchain industry. Venture capital GPs could use or adapt the initiative’s resources, which include guidance on ESG reporting and good practices related to energy and carbon accounting and procurement, as part of their investment due diligence or to improve practices at their early-stage companies.

• VentureESG , founded by GPs from GMG Ventures and Houghton Street Ventures alongside a Cambridge University academic, is a community of investment managers working toward defining the ESG issues that are material and relevant to venture capital and integrating them by using questionnaires, engagement with founders, and setting KPIs.
• ESG_VC has developed a 48-question standardised ESG portfolio company questionnaire. The BVCA hopes to use the survey responses to produce benchmarks and analyses that can establish what leading practice looks like in each survey area for businesses of different sizes.
• ROSE is a framework tailored to individual portfolio companies, focusing on measuring their impact on sustainability outcomes.
• Venture capital GPs may find some of the guidance contained in PRI (2014) Integrating ESG in Private Equity: A Guide for General Partners applicable to their investment strategies and businesses.

The biggest drivers of interest in ESG incorporation are:

• Senior leaders of venture capital firms
• A belief that ESG incorporation improves a fund’s risk/return profile
• Employees of venture capital firms caring about it personally

Interest in responsible investment differs geographically, with momentum and practice stronger in Europe. ^[24] In the US, ESG incorporation is often seen as a box-ticking exercise and scepticism about its value is prevalent, as we will explore in the Challenges section.

Figure 2: Current drivers of ESG incorporation in venture capital (Ranked from 1 – 5, where 1 represents the least likely and 5 the most likely)

Unlike public equity and fixed income markets, shifts in venture capital are primarily driven by changes in the preferences of start-up founders, with interviewees suggesting that a growing interest in responsible investment by them could also be a significant future driver.

Top venture capital GPs compete for start-up founders rather than LPs – if founders begin to prefer venture capital GPs that can partner with them to improve their management of ESG risks, then having responsible investment credentials may become a competitive advantage for venture capital firms.

Respondents added that early-stage companies are increasingly likely to show more interest in ESG practices because they need to attract talented employees that want to align their values with those of the companies they work for. This is particularly important in the technology industry, where competition for talent is extremely fierce. ^[25]

Unlike other asset classes, LP engagement is not considered a major influence, nor was it cited as a strong future driver. Respondents also said that regulation – such as the Sustainable Finance Disclosure Regulation – is likely to push the venture capital industry to adopt responsible investment practices. More information on SFDR can be found in the PRI’s briefing note .

Almost three-quarters (72%) of respondents said that they have a responsible investment or ESG policy at their firm. Of those that did not, most said they were considering one. This is surprisingly high. As many policies are not publicly available, their quality –­­­­­­­­­­­­­­­­­­ ­­­­­­­in terms of rigour, oversight, and implementation – cannot be assessed.

Figure 3. Do you have an ESG or responsible investment policy?

Most respondents said they incorporate ESG factors in their investment processes during the due diligence, decision making, and monitoring stages. Far fewer consider them when preparing for an exit.

Figure 4. Do you integrate ESG factors into the following stages of your investment process?

Respondent approaches to ESG incorporation

Respondents were able to provide more detailed information on their approaches, some of which we highlight below as examples of current practice, categorised as:

• systematic approaches that incorporate ESG factors across the investment process
• targeted approaches that focus on specific material issues; and
• outcomes-oriented approaches that are linked to frameworks such as the SDGs.

Survey respondents indicated that they consider social and governance factors to be more important than environmental ones, corroborating some of our other investor discussions and highlighting the need to establish a dialogue with the industry around the environmental impact of technology.

Figure 5. Which factors do you consider important to assess for your portfolio companies? (Ranked from 1 – 5, where 1 represents the least important and 5 the most important)

Respondents could provide more detailed, additional responses explaining how they assess ESG factors. A selection of these are detailed below.

We asked respondents which ESG factors they received information on from their portfolio companies, which factors they reported to their LPs and which ones they tracked internally.

Portfolio company reporting to GPs

Overall, DEI and board practice and composition were the most reported factors. More broadly, social and governance factors received more than double the number of environmental responses.

Figure 6. Most commonly reported ESG factors

GPs reporting to LPs

Venture capital managers also tend to provide their LPs with more investment information on social and governance factors than environmental factors.

Figure 7. Most commonly reported ESG factors

Internal monitoring

GPs reported monitoring their own DEI and board practices more than any other factors. Respondents indicated that this allowed them to set a good example for their early-stage companies. This approach is becoming more widespread in the broader private equity industry, where GPs find it helpful to point to their own activities when asking portfolio companies to undertake work such as measuring their carbon footprints.

The survey asked respondents about their degree of ESG knowledge. Most were relatively confident of their ESG credentials in several areas.

However, in many cases, those with ESG responsibilities are not senior investment decision makers. Neither are they in full-time ESG roles. Resources at venture capital firms are much more constricted than at buyout firms, and having dedicated ESG headcount is often not prioritised.

Figure 8. How would you describe your ESG knowledge? (Ranked from 1 – 5, where 1 represents the least developed and 5 the most developed)

Respondents also indicated a strong interest in learning more about ESG incorporation, target setting and using the SDGs and other frameworks to inform their investments. The PRI will seek to address this in future work – see Next steps for more detail.

Figure 9. Interest in further learning

Some venture capital GPs interviewed have formal responsible investment policies that establish the scope and nature of their ESG incorporation approaches – such as UK-based manager Atomico .

However, they are often less robust and comprehensive than other asset classes and are not always publicly available. Some GPs have policies covering specific ESG topics such as DEI or anti-harassment without having an overarching responsible investment policy.

Many non-PRI signatories interviewed said they incorporated ESG factors into their investment processes in a less formalised way and did not have a policy to guide their work.

Some GPs and LPs use exclusion lists to conduct screening ^[26] but this is not always the case. Venture capital firms caution that generic exclusion lists used in other asset classes, such as the International Finance Corporation Exclusion List , are often unsuitable.

Such lists focus on risks unlikely to attract venture capital – such as weapons production – and miss out some controversial areas that the sector might be exposed to. GPs cited being asked to adhere to these as evidence that LPs do not always understand the asset class well.

The risks associated with using traditional exclusion lists in venture capital can be illustrated with the recent case of NSO Group, a surveillance technology company whose software purportedly helps governments prevent and investigate terrorism.

NSO’s main product, Pegasus, has been implicated in the activities of certain governments, with claims it has been used to spy on journalists and human rights activists. ^[27] NSO was backed by venture capital and later-stage private equity investment. Investors that might wish to avoid similar investments need an exclusion list that is fit for purpose.

Some venture capital GPs have developed tailored exclusion policies that better reflect their investment universe:

• Amadeus Capital Partners avoids investments in various sectors and/or business models, including those linked to gambling, predatory credit and debt traps, addictive forms of gaming, and facial recognition technology.
• Truffle Capital , a life sciences and tech investor, does not invest in companies whose scientific processes “lead to ways of modifying human beings”.

“In biotechnologies, scientific advances can lead to ways of modifying human beings that Truffle Capital deliberately refrains from investing in […particularly] non-ethical procreation, the modification of brain functions to modify performance rather than to treat a pathology, potentially addictive molecules or viral vectors that can be used for terrorism.”

Although some interviewees described venture capital as due diligence-light, many firms noted that they engaged formally and informally with start-up founders before investing to mitigate potential future ESG risks.

Some investors use pre-investment ESG questionnaires to identify and understand the ESG risks and opportunities a potential investee is exposed to. These range significantly in content, complexity, and the resources required to complete them.

Some focus on material ESG factors by using Sustainability Accounting Standards Board (SASB) standards. However, one venture capital investment manager signatory includes 94 ESG KPIs in its survey.

Such large data requirements are rare and, for start-ups unfamiliar with responsible investment, probably quite unpalatable, given their lack of dedicated resources (see Survey observations and Challenges ).

Other investors use more informal methods, with one noting that they try to assess a founder’s values and ethics by observing their behaviour towards others – for example, at a restaurant.

Doing so can help identify any concerning traits (such as misogynistic behaviours) that might feed into the culture of a start-up and subsequent business.

Given the poor track record of sexual harassment and other DEI issues in the venture capital and technology industries (see DEI and the venture capital industry ), venture capital GPs and LPs need to develop more rigorous due diligence processes to identify and assess this risk.

For example, many private equity firms engage third parties to conduct detailed background investigations on key personnel at prospective portfolio companies.

While not widespread, some venture capital GPs include ESG language – for example, sustainability clauses – in deal documentation such as term sheets and shareholder agreements as standard.

Others aim to include them on a best-efforts basis, dependent on factors including a deal’s competitive dynamics and founders’ views.

ESG language is also sometimes found in separate documentation, outside of term sheets and shareholder agreements. While not legally binding, this helps establish a common understanding of GP and early-stage company values.

Examples of template language for deal documentation can be found in Obvious Venture’s World Positive Term Sheet or the climate-focused VC Sustainability Clause from Leaders for Climate Action , which has been adopted by a range of German venture capital GPs.

Some of the venture capital GPs interviewed said they include an ESG section in their investment committee documentation. For example, UK manager Balderton Capital has a section dedicated to its Sustainable Future Goals , a framework consisting of ten ESG goals aligned with the SDGs.

Partners on the investment committee consider this information when voting on whether to pursue an investment or not. In one case, Balderton decided not to invest in a successful business because of concerns around the start-up founder’s values and the potential negative social outcomes the company might contribute to had it scaled dramatically.

Even where more systematic and formalised integration is lacking, there are examples of good practice at the investment committee stage on a more ad-hoc basis.

For example, one interviewed GP explained how it sourced an early-stage company whose primary business was vaping. It highlighted and discussed at length the ESG risks and opportunities of such a business but determined the risks were too great and could not be mitigated. Therefore, it passed on the investment opportunity.

Venture capital GPs that incorporate ESG factors often conduct annual surveys of their investees to monitor their ESG risks:

• Atomico completes a one-page Values Scorecard six months after it makes an investment and then on an annual basis until exit, allowing it to monitor its portfolio-wide risks. The scorecard is used to uncover red flags in diversity, environmental impact, the early-stage company’s future impact at scale, and governance matters. Atomico says it is not prescriptive and empowers its investment team and start-up founders to discuss positive and negative issues in these areas.
• Swedish investor Kinnevik uses its survey to track and publicly publish ESG KPIs .

Ideally, the results of such surveys should form part of GPs’ investment monitoring, in quarterly portfolio review meetings, for example, rather than being addressed separately.

Venture capital GPs can help early-stage companies establish and implement codes of conduct and other policies, such as those focused on anti-harassment or DEI, when they are ready to employ staff. ^[28] However, this is not yet widespread.

Indeed, some consider it anti-entrepreneurial or unnecessary to have such policies in place at an early stage. Conversely, some interviewees pointed to the relative ease and low cost of implementing such policies at an early stage, versus the potentially huge future costs associated with harassment or other issues that a company could face if it does not have the appropriate governance measures in place to deal with such incidents.

Establishing whistleblower processes is also an important tool to encourage a culture where wrongdoings can be rapidly addressed. This can include setting up communication channels that can be used should incidents of harassment, or other types of violations, occur. ^[29]

For example, Vintage Investment Partners , an Israeli venture capital fund of funds, includes the email and phone number of a retired judge on its website that anyone, from either the venture capital funds in which they invest to the employees of underlying companies, can contact. It states:

“As party to the initiative on addressing and eradicating ‘Sexual Harassment and Predatory Conduct in Israeli Venture Capital Funds’, Vintage Investment Partners has adopted a ‘zero-tolerance’ approach to any predatory practices by an investor against an entrepreneur seeking capital. If you have been faced [with] or suspect sexual harassment and predatory conduct by any Vintage Investment Partners personnel, you are encouraged to report such conduct immediately to retired Labor Court Judge, Dina Efrati, who has been appointed by the Israeli venture capital funds party to the initiative, to serve as ombudsman for anyone who has a sexual harassment claim against any of the funds.”

Venture capital GPs can engage their early-stage companies to educate them on the ESG risks and opportunities they may be exposed to. For example, Atomico has developed Conscious Scaling , a framework for dialogue between start-up founders and investors or boards, focused on identifying and mitigating long-term risks associated with a business model or technology’s impact on society, the environment, and all stakeholders.

GPs can also convene individuals from their early-stage companies at events – dubbed by some interviewees as ESG days – to learn from each other and discuss their ESG approaches. However, unlike in the buyout industry, this practice is not widespread among venture investors.

It is unusual for venture capital GPs to communicate information about ESG factors to potential buyers of their portfolio companies.

However, responsible investment practice continues to advance across financial markets. As potential buyers, such as private equity firms or stock exchanges, increase their ESG expectations, the onus will be on later-stage venture capital GPs to ensure that their portfolio companies meet these. For example, Nasdaq has introduced new board diversity requirements for companies listing on its exchange. ^[30]

Early-stage companies with limited resources and rapidly evolving business models tend to be focused on growth and product design, often to the detriment of other areas.

According to interviewees, convincing them that ESG issues are material is challenging. Investors also expressed concern that ESG requirements would overburden start-ups that may not even have employees or be generating any revenue.

To address this challenge, GPs (and their LPs) need to be pragmatic and tailor their ESG expectations accordingly, recognising that certain tasks will be more feasible or realistic once companies grow, attract further funding rounds beyond series A, take on employees, and start professionalising.

Based on our conversations, venture capital GPs also often feel their investments are low in ESG risk. They view their early-stage companies as providing solutions to problems.

Therefore, many GPs are not convinced that ESG incorporation adds value and see it as a box-ticking exercise that exists to satisfy LP and other stakeholder demands.

Nonetheless, venture capital GPs should recognise that investing in early-stage companies provides an opportunity to influence and instil good ESG practices from the outset.

As such, GPs can still work with investees at the earliest stages to lay a strong foundation for future growth, for example, by mentoring start-up founders to create a positive company culture and strong DEI practices.

Investors should also consider the actual and potential negative future outcomes of business models on external stakeholders (beyond employees), such as consumers, communities and suppliers.

Research shows that in the UK 28% of tech workers have seen decisions made about technology that they felt could have negative consequences for people and society – 18% of those went on to leave their companies as a result. The British Standards Institution launched the first Corporate Governance Guide for Responsible Innovation in 2020. This allows organisations to demonstrate they are innovating responsibly.

Asking focused questions of founders can help establish the social and environmental risks a company could be exposed to once it reaches scale.

Thinking through the negative impacts a company may have as it scales can potentially help avoid these issues developing in the future, particularly as these can be difficult for other investors further along the investment chain to change if they are already ingrained. ^[32]

Unlike buyout investments where investors have control of the company, or growth investments, which often come with board seats and a range of other governance rights, venture capital GPs are minority shareholders whose influence can often be limited.

Investee relationships

GPs pursuing a founder-friendly approach to venture capital (see Market overview ) believe that engaging with their early-stage companies to better manage ESG risks or opportunities, for example, by setting KPIs or specific policies, could reduce their competitiveness when sourcing and winning investments.

Often founders want to be left alone to run their businesses, and where funding dynamics are in their favour, they may choose to accept the investment that comes with the least conditions, giving rise to a rather passive investment strategy that does not lend itself well to ESG incorporation.

Nonetheless, anecdotal evidence from our research suggests that some founders are becoming more interested in ESG issues and seek input on the topic from GPs.

Venture capital GPs that undertake responsible investment also highlight that their ESG expertise helps them stand out from competitors and win deals.

This message needs to be more widely communicated to advance understanding and normalise ESG incorporation as a value-added undertaking.

Board seats

Venture capital portfolios can be large, with some GPs monitoring investments in more than 30 early-stage companies at one time.

Where investment team members take board seats, they are spread thinly and may not be as engaged as some of their growth equity or buyout peers, who might sit on fewer boards.

Furthermore, interviewees noted that GPs only interact with later-stage investee companies at a board level, and too much deference is often paid to company management.

This lack of in-depth engagement can lead them to overlook ESG issues that do not fall within a board’s remit, such as overtime practices and minimum pay.

The venture capital model itself also presents serious barriers. Many stakeholders question the value of ESG incorporation across a portfolio where:

• up to 75% of start-up companies fail;
• a growth-at-all-costs mindset is dominant, and sees huge amounts of capital invested into companies that struggle to be profitable. ^[33]

As a result, venture capital firms are reluctant to invest in dedicated ESG headcount.

The pool of professionals with deep experience of ESG incorporation focusing on early-stage companies is also limited. This is also reflected across LPs, service providers, and other stakeholders.

Collaboration among these groups, and between venture capital peers, on ESG topics could help to improve this issue.

Additionally, as a small number of successful investments drive overall returns, some venture capital funds invest in a high number of companies to increase the chances of a successful investment, making ESG incorporation challenging, especially where internal resources are constrained.

Paradoxically, using a systematic ESG incorporation approach could ensure that more risks are identified, and that company engagement is prioritised on a risk-adjusted basis, thereby reducing the overall failure rate.

The venture capital industry does not have a strong culture of client – or public – disclosure, with firms regulating the flow of information very tightly.

This is not just ESG related – for example, one GP explained that they only report fund-level investment performance to LPs, rather than disclosing the performance of individual holdings.

Venture capital GPs that collect ESG data do not always report it to LPs, making it difficult to monitor and engage on those risks.

Encouraging more venture capital investors to become PRI signatories and report on their responsible investment practices could be a good way to tackle this reticence around disclosure.

The majority (86%) of our survey respondents want to better understand how to set relevant ESG metrics and targets in venture capital, but there are currently few resources available that are tailored to the asset class.

Although broader industry frameworks such as SASB and Global Reporting Initiative can be helpful, they are not always appropriate. For example, SASB standards may be better suited to larger companies.

Guidance on ESG incorporation practices is not often tailored to venture capital either.

Industry initiatives to develop venture capital-specific metrics and frameworks are emerging (see Emerging initiatives and guidance ). This is an encouraging sign of increasing ESG interest, but a proliferation of competing standards would not benefit anyone and must be avoided.

Investment and ESG professionals at venture capital firms and asset owners also need more opportunities to collaborate with peers and raise standards within the asset class. The PRI is well placed to convene investors for that purpose.