ESG rating for startup investment: in conversation with Elaia and Henkel Tech Ventures

By Anais Masetti - 27 January 2022

Along with sustainability, ESG has become a hot topic for both venture capital (VC) and corporate venture capital (CVC) funds. While virtually everyone is talking about the importance of ESG measures, the adoption of ESG rating for investment decisions is still in its early days.

How should funds go about assessing a startup’s ESG practices? When in the investment journey should investors conduct an ESG rating? How can funds avoid falling into greenwashing? And most importantly, why does ESG even matter for startup investment?

To answer these key questions, we reached out to two seasoned professionals, who also happen to be among Early Metrics’ clients: Louisa Mesnard, CMO at the VC fund Elaia, and Paolo Bavaj, Head of Henkel’s CVC arm Henkel Tech Ventures.

Below we highlight some of the opinions and best practices shared by them during our webinar.

What is the difference between ESG and impact investing?

Before delving into the recommendations for ESG rating, let’s address a common source of confusion. While they may sound similar, there are some important differences between ESG investing and impact investing.

Impact investors aim to fund startups that actively work towards bringing positive change to the world. They focus more on the impact of the value proposition of the startup than on the ROI it would generate.

Meanwhile, ESG investing is less about what the startup does and more about how it operates as a business. It means that a traditional investor will include ESG practices in its key investment criteria, while still relying on traditional ROI considerations to make its decision. ESG stands for Environmental, Social and Governance and shares some criteria with impact investment assessment. Hence, a fund that takes ESG into account might invest in impact startups, but are not limited to those.

To give a concrete example, a startup developing invoicing software would not focus on making the world a better place, so it would not be suitable for impact investment. But it might still have strong ESG practices such as equal pay and a transparent governance structure, making it eligible for ESG investment. On the other hand, if a renewable energy startup has strong ESG measures in place, it might receive funding from both ESG and impact investors.

Why should startup investors take ESG practices into account?

There are many factors that could motivate a fund to integrate ESG ratings in its process. Among those motivations, we can cite:

  • Ethics and a conviction that funds must invest in virtuous companies
  • A desire to positively influence company practices
  • Brand reputation and marketing
  • ROI and risk factors
  • External pressures, be it from LPs, consumers or regulators…

Aligning internal beliefs with external pressures

When asked which driver was strongest for Elaia, Mesnard replied that it was a tricky question because they were motivated by a mix of them. ESG rating is not a legal requirement for VCs, so regulatory pressure is not currently a factor. However, there was some external influence from the fund’s limited partners (LPs). Still, she explained that Elaia was primarily motivated by the belief that sound ESG practices were important to fulfil the fund’s mission. Mesnard stated:

“We wanted to avoid greenwashing which is why we took our time to build our ESG action plan. We’re investing in the future and the future has to be sustainable. ESG rating is a part of this strategy.”

As Henkel Tech Ventures is a CVC fund, it only has one LP to answer to: Henkel. According to Bavaj, they were motivated to integrate ESG to align the fund’s strategy with the parent company’s values. Indeed, creating a better world is part of Henkel’s ethos and ambition, so ESG investing is one among many steps taken by the group towards this goal. Bavaj added:

“We need data to have a qualified and educated discussion about the impact of our investments, which is where ESG ratings come in. We also need ratings to communicate to the LP that we’re investing conscientiously and not just basing decisions on personal beliefs.”

Greenwashing alert: branding and ROI should not be key motivators

Both Mesnard and Bavaj agreed that ROI considerations should not be the main driver behind ESG rating. Indeed, investors should have some degree of conviction that ESG measures are important regardless of financial aspects, lest they fall into greenwashing. The same goes for brand reputation: if a fund integrates ESG rating mainly to be perceived positively, there will be a high risk of backlash from the public.

Of course, it’s a fund’s job to assess the financial performance of an investment and the level of risk. But ESG rating should be conducted independently from financial assessment. In fact, using a standardised, reliable ESG rating process for investment decisions can provide transparency. It can serve as evidence that the fund is taking ESG investment seriously and not just using the term as a marketing tool.

When should an investor conduct an ESG rating of a startup?

Going through an ESG rating can be a lengthy process. So, it’s important to respect the entrepreneurs’ time and ask them to participate in such a rating only if the probability of receiving an investment is high. The experts agreed that ESG rating should be part of the due diligence process and therefore be carried out before an investment decision. An ESG rating provides data and information (on the diversity of the team, their workplace practices, their supplier relations etc.) that traditional due diligence doesn’t usually encompass.

Both Elaia and Henkel Tech Ventures have taken a strong stance on ESG rating. For them, the ESG due diligence process is mandatory – similar to the financial, legal or technology due diligence. While most entrepreneurs go along with this process, Mesnard pointed out that some have a lower level of awareness of its importance than others. To her, it’s part of a fund’s role to educate those entrepreneurs on why ESG matters.

Indeed, Elaia goes beyond doing pre-investment ratings. Every year they ask the startups that they have invested in to provide 100 data points on ESG criteria. Mesnard explained:

“The ESG rating should come before the investment. However, the conversation with the startup around ESG should be ongoing and not just a one-shot.”

Henkel Tech Ventures is also exploring how to further incorporate ESG in its relationship with invested startups. In fact, they are considering doing a yearly ESG rating of all their portfolio investments. This would allow them to have the necessary data to guide their startups towards better practices.

How should VC and CVC funds go about rating a startup’s ESG performance?

There are a variety of approaches to conducting ESG ratings for startup investment. Some prefer to keep the process in-house, others fully outsource it and many choose a hybrid approach. “For Elaia, doing a mix of in-house and external assessment is important,” said Mesnard.

Henkel Tech Ventures have a similar philosophy. Bavaj explained:

“We have our sustainability experts but we like to challenge our own view with external ones to make sure we don’t miss certain aspects and also to make sure we don’t believe our own propaganda.”

He added that sometimes investors fall in love with a startup’s technology and forget about the side effects. External ESG ratings, such as those provided by Early Metrics, are more objective and can therefore prevent this scenario.

Aside from the question of in-house versus out-of-house, how exactly should investors assess ESG? A thorough questionnaire is an easy way to get data. Yet, the experts stressed that face-to-face interviews are essential to get the full picture. Mesnard pointed out that the interview also gives an opportunity to the entrepreneur to question themselves and get new ideas on the improvements they should make.

Bavaj added that an interview gives crucial information that cannot be captured by a form, such as body language and how comfortable an entrepreneur is with certain topics. But above all, for him it’s about valuing the entrepreneurs’ time and building a strong relationship with them. According to Bavaj, simply sending a questionnaire, without direct interaction, can make a CVC fund seem arrogant and risks alienating promising startups.

We’re at the dawn of ESG rating for startup investment

As Louisa Mesnard put it, we are “at the stage 1.0” of integrating ESG in startup investment. Elaia is blazing a new trail as one of the first and still one of the few VC funds to have made ESG rating systematic.

Similarly, Henkel Tech Ventures is showing the way to other CVCs who want to add an ESG dimension to their decision-making process. Paolo Bavaj commented: “It’s the beginning of the journey and we’ll see where it takes us. If we don’t quantify ESG it stays a bit esoteric, so we need data via ratings to make it more tangible and transparent.”

These are indeed exciting times for ESG investment. Early Metrics always endeavours to provide investors and innovators with the right analytical tools to overcome current challenges. This is why we have launched our own ESG rating adapted to startup assessment and which is already being used by some of Europe’s leading funds, including Elaia and Henkel Tech Ventures.

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