Good practice note Responsible venture capital Integrating environmental and social approaches in early-stage investing In association with Report leads CDC Group FMO Published January 2020 This report is printed on 100 per cent Forestry Stewardship Council-certified recycled paper. 3GOOD PRACTICE NOTE RESPONSIBLE VENTURE CAPITAL Acknowledgements This report was commissioned by CDC Group plc and FMO, and prepared by Environmental Resources Management ERM. ERM’s lead contributors were Marc Williams Principal Consultant and Konrad Huber Partner. We are grateful for the contributions of the interviewees listed in Appendix F. Disclaimer This report is not a compliance document, it should be taken only as a source of ination, guidance and analysis, to be applied and implemented by each institution in its discretion in accordance with its own policies, which may or may not require all or any of the described practices to apply to its own investments. The ination and opinions within this document are not intended to constitute legal or other professional advice, and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. CDC Group plc, FMO and ERM do not accept responsibility for any errors, omissions or misleading statements in this document, or for any loss, cost, damage or liability which may arise from reliance on materials contained in this document. Certain parts of this document may link to external internet sites. CDC Group plc, FMO and ERM are not responsible for the content of any external references. 4GOOD PRACTICE NOTE RESPONSIBLE VENTURE CAPITAL Contents Foreword 5 About this report 6 cutive summary 8 01 The business case 11 02 Environmental social and governance ESG risks and opportunities 14 2.1 The venture capital VC model 14 2.2 Core ESG issues for VC 14 2.2.1 Job quality 16 2.2.2 Gender 22 2.2.3 Disruption and regulatory change 23 2.2.4 Supply chains 23 2.2.5 Data privacy and ethical use 24 2.2.6 Data security 25 03 ESG integration at VC funds 27 3.1 Responsible investment policy 27 3.2 ESG requirements 27 3.3 ESG roles and responsibilities 27 3.4 Actions by stage of investment 28 3.5 ESG reporting and disclosure 28 Appendix A. ESG actions by stage of investment 29 Appendix B. High-level ESG due diligence questionnaire for VC 30 Appendix C. Template for investment committee IC papers 31 Appendix D. ESG legal considerations for equity agreements 32 Appendix E. International standards and good practice 33 Appendix F. Interviewees 34 5GOOD PRACTICE NOTE RESPONSIBLE VENTURE CAPITAL Foreword Venture capital VC is a new asset class in many emerging markets and has the potential to achieve development at scale. Successful VC-backed companies often provide significant jobs, skills and a route into al employment in countries with growing populations and high youth unemployment. The technology-based firms generally targeted by VC investors can also leapfrog market constraints to enable large-scale access to essential products and services, including for under-served groups. Given these opportunities, CDC and FMO have been actively supporting the growth of the VC industry in our markets. As pragmatic investors in challenging markets, we tailor our approach to the nuances of each asset class. Equally, as development finance institutions, we have a deep commitment to responsible investment. Therefore, this report is intended to provide practical advice about how to invest responsibly in early-stage businesses in emerging markets; managing environmental, social and governance ESG risks and identifying opportunities, while supporting the growth of innovative companies. There is currently little guidance for responsible investors in the VC industry. For example, the well-established ESG management systems for private equity often do not cater for the challenges of early-stage VC investing. Similarly, international ESG standards are not yet well-defined for many of the issues commonly faced by technology-based VC companies, including concerns about the gig economy, the risk of artificial intelligence perpetuating discrimination and the responsible use of data. Conversely, there are opportunities for VC-backed companies to support women’s economic empowerment, provide decent work and tackle climate change. This report does not provide answers to all of these evolving issues, but it provides a framework for VC investors to consider and manage the ESG risks and opportunities most applicable to them. We hope you find it useful. Liz Lloyd CBE Chief Impact Officer CDC Group plc Jorim Schraven Director, Impact and ESG FMO – Dutch Development Bank 6GOOD PRACTICE NOTE RESPONSIBLE VENTURE CAPITAL About this report What is responsible investment A definition of ‘responsible investment’ could cover various approaches. For example, sustainability, socially responsible investing, ESG integration, applying a human rights lens, impact investing and gender-smart investing, among others. This report refers to responsible investment in the broadest sense, drawing on each approach where appropriate. The objectives of responsible investment can include – Managing risks – Risk management provides downside protection to funds and portfolio companies. This could include, for example, protecting a start-up from a damaging social media backlash or future-proofing a disruptive business model against regulatory change. – Adding operational value – Proactive ESG management can improve the perance of companies in all sectors. For instance, good practice in human resources can help attract and retain the best talent. – Identifying strategic opportunities – Adopting a responsible lens can help investors to spot new trends and areas of potential growth. For instance, by designing products for underserved female markets, creating technology that empowers workers or addressing demand for renewable energy through off-grid solar. What is venture capital Defining the asset class There is no simple definition of VC investing. VC focuses on companies that can achieve rapid, capital-efficient growth to build businesses of significant scale and value over a relatively short period. VC investments span a broad array of sectors and include a mix of technology such as software, online marketplaces and fintech and tech-enabled businesses such as energy and health services that need physical infrastructure. Figure 1 VC ecosystem What distinguishes VC from other types of early-stage investing – including small and medium-sized enterprises – is the potential to achieve capital-efficient scale and greater uncertainty around ultimate success. To maximise diversification and the likelihood of picking a winner, VC funds typically have large portfolios of around 20–30 companies. In comparison, a fully committed private equity PE fund would normally have around 10 companies. Higher risk-return profile In part due to the higher failure rate of their investments, VC funds generally require much higher returns from successful portfolio companies than traditional PE investors. For example, a ‘Series A’ VC investor typically targets companies that could make a 10 x return on their money. As a result, venture investments tend to be very high risk and suffer much higher failure rates than PE. As a rule of thumb for well-pering early-stage VC funds in developed markets, a third of investments will be written off, a third might return cost and a third will return 5x or more, and pay for the fund. Figure 1 VC ecosystem highlights potential sources of funding for a company as it scales. The greater risk for VC comes from investing in companies that are pre-profit sometimes pre-revenue and usually rely on innovative and unproven business models. It is therefore very hard to predict a particular outcome. The winners tend to be companies that have a transative impact on a large industry, potentially providing large numbers of jobs and impactful services. An idea Seed investment Series A onwards Growth capital Incubator Accelerator VC fund PE fund Strategic investor Initial public offering Angel networks ESG increasingly important to fundraising 7GOOD PRACTICE NOTE RESPONSIBLE VENTURE CAPITAL Purpose of this report Objectives This report is designed to provide practical advice for VC fund managers, to help them 1. Understand the strategic context of good ESG management. 2. Identify material ESG risks and opportunities for each investment. 3. Implement practical actions at the fund level to incorporate ESG issues into their investment processes. 4. Summarise practical actions that their investee companies can implement. Audience The target audience for this report is broadly mainstream VC fund managers and their advisors who invest in tech and tech-enabled businesses from seed stage onwards. Incubators and accelerators are not explicitly covered, although the guidance is broadly applicable. The report focuses on emerging markets, but should be applicable for VC fund managers globally. For investors that use a VC model in traditional sectors – including some impact investors – other guidance and standards may be more applicable, including well-established frameworks for the PE industry. Geography The report is focused on fund managers investing in emerging markets, where the ESG regulations and enforcement mechanisms are unlikely to provide the same protections that would be found in developed regions. Thematic ESG risks and opportunities also differ between emerging and developed markets. However, many of the principles and approaches related to the VC model itself are applicable to the global industry. Scope This report does not cover corporate governance, business integrity and compliance issues, such as anti-bribery and corruption, anti-money laundering and counter-terrorism financing. These topics are of critical importance for investors and companies, and are addressed in detail elsewhere see CDC’s ESG Toolkit for Fund Managers – Business integrity. 8GOOD PRACTICE NOTE RESPONSIBLE VENTURE CAPITAL cutive summary This report seeks to address the lack of publicly available advice on responsible investment targeting the VC industry. Existing guidance typically focuses on other asset classes, such as PE or listed equity. While there are similar principles for good ESG management between asset classes, VC has specific nuances, risks and opportunities. The business case VC investments range from very early-stage companies when founders only have an innovative idea, right up to established companies listed on stock exchanges. This report focuses on the earlier end of the spectrum, when VC-backed companies are generally nascent. At this stage, ESG risks and opportunities are generally perceived to be lower than PE investments in more ‘mature’ companies which typically have larger workforces, client bases and/ or physical footprints. However, while early-stage VC requires a different ESG lens, it can be critical to success. The ESG business case can be underpinned by various drivers – depending on the type of business – such as – Financial perance – A growing body of academic and investment research suggests that ESG issues have a material impact on the financial perance of companies. For example, a meta-study of over 2,000 studies by Deutsche Asset Management identified a strong positive correlation between ESG strategies and financial perance, with the strongest positive correlations identified for businesses operating in developing markets. Research on the impact of ESG in VC is more limited. However, a similar trend is possible for the reasons listed below, among others. – Fundraising – Limited partners LPs, including development finance institutions DFIs, impact and other responsible investors, increasingly expect VC funds to demonstrate a meaningful approach to responsible investment. – Exits – The ESG perance of a company can be an important factor in raising follow-on capital or exiting to larger PE funds, strategic investors, multinational corporations or launching an initial public offering. Indeed, ESG disclosure requirements are increasing on stock exchanges globally. – Consumer expectations – The purchasing decisions of customers, particularly millennials, are increasingly influenced by ESG values. – Labour productivity – Attracting and retaining skilled workers is often crucial to success for tech companies in emerging markets. – Reputational risk – A good reputation is critical to the success of many tech businesses. Companies are particularly vulnerable to negative reputational impacts during the early stages of growth, given the significant influence these can have on fundraising efforts and customer growth. – Market access – Tech companies are particularly likely to seek or have established global markets. Therefore, applying appropriate ESG standards will facilitate the greatest market access. – Regulatory environment – VC-backed companies often use disruptive technology or business models that are not effectively regulated by existing legal frameworks. Careful ESG management can help future-proof firms against interventions from regulators that negatively affect their business. ESG risks and opportunities The VC model is associated with particular ESG challenges. For example, investee companies often have limited resources, a lack of ESG expertise, rapidly evolving business models, high growth rates, aggressive hiring, limited governance and compliance processes, and increased vulnerability to negative reputational impacts. ESG risks are highly diverse and company specific. However, the following ESG topics are among the most relevant for VC-backed companies – Job quality – Labour and working conditions for employees and contractors are likely to be among the most pressing ESG issues for VC-backed companies. Early-stage companies should adopt a basic human resources HR management system. These will vary by sector, but will often include – Working hours, minimum pay and overtime. – Harassment. – Occupational health and safety. – Approach to gig economy workers. i – Attracting and retaining talent. – Gender – There is growing evidence that greater diversity at the company and fund manager level leads to various commercial benefits. – Supply chains – There is increasing pressure for businesses to consider ESG issues – such as labour and working conditions – beyond their own operations, and through their supply chains. Sectors relevant to VC with heightened supply-chain risks include agriculture, manufacturing and cleantech. – Data privacy and ethical use – This is a core business issue for many companies that receive VC funding. Companies need robust systems for collecting, using and sharing customer data. – Data security – Data security is also critical, especially for companies operating in the tech sector. A major