Venture Capital and Public Purpose: Analyzing ESG Frameworks and Trends

The growth of purposeful venture capital

In his widely read 1970 New York Times piece, economist Milton Friedman wrote what was once considered an almost indisputable guiding principle for corporations and investors: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits." 

Over the last 20 years, investors and corporations alike have been moving away from Friedman’s purist version of shareholder capitalism and experimenting with stakeholder capitalism. They no longer only pursue profit for their shareholders, but also consider their responsibilities to society at large. The increasing effects of climate change, income inequality, and political conflict, in the US and abroad, have increased the value of mission-driven business plans that consider a broader set of stakeholders. Furthermore, the 24/7 news cycle and growing push for transparency and ethical standards allow consumers – and the general public –  to hold corporations (and their investors) to increasingly higher standards.  

Venture capitalists feel additional pressure as more socially-conscious limited partners have pushed them to prioritize mission-driven startups. Indeed, the impact investing market grew to $715Bn in 2020 (an increase of 43% from 2019) due in large part to the influx of impact-focused limited partners. On the startup side, as the venture capitalist space grows more crowded and competitive, many promising startups can choose the investors they want to partner with – increasingly, they select those partners dedicated to public purpose. At the same time, companies are staying private longer, providing a bigger window of opportunity for venture capitalists to influence the achievement of impact within their portfolio.  

The pursuit of public purpose is financially viable – if not desirable – for VCs. Public purpose is more than just a PR or marketing campaign; it is often tied to companies’ bottom lines and profitability. Startups that address the needs and challenges of their communities in their business models create “shared value,” which in turn generates material financial returns. Indeed, a group of professors and researchers at the University of Oxford Saïd Business School recently completed a study that demonstrated that companies with stronger environmental, social, and governance (ESG) records financially performed better than their peers in the early and tumultuous months of the Covid-19 crisis. 

How to capture purpose 

A major challenge for investors is how to capture and measure the shared value generated by their portfolio. ESG or impact investing frameworks identify criteria and metrics that merit consideration from both corporate management and impact-oriented investors. Some frameworks even include methodologies for how to rank or score performance against these criteria and metrics. There are hundreds of frameworks ranging from those establishing high-level goals to those targeting a narrow component of public purpose, like climate. On one end of the spectrum are the United Nations’ Sustainable Development Goals, which call on governments, corporations, and even individuals to end poverty and injustice, among other aims. The Task Force on Climate-Related Disclosures is on the other end of the spectrum, explicitly highlighting what metrics and operations warrant public review in the context of environmental protection. The myriad of existing ESG frameworks currently available can often be a source of confusion and divergence. Still, these resources deliver value in holding corporations and their investors accountable for their impact. After analyzing more than 20 different investing frameworks, predominantly focused on ESG, we have identified several trends that show promise in how to effectively assess companies’ impact.  

A non-exhaustive list of ESG frameworks' trends  

Interconnectivity  

It is important for investors to recognize that a company's impact resounds in its physical and virtual network, which extends to employees, contractors, customers, suppliers, investors, and impacted communities, among other potential stakeholders. The Long-Term Stock Exchange (LTSE) directs listed companies to map their critical stakeholder groups and consider the role they play in one another's success. Several other frameworks – including the Global Reporting Initiative (GRI), the Institutional Shareholder Services (ISS) E&S Quality Score, the Sustainability Accounting Standards Board (SASB), and Sustainalytics (Morningstar Company) – emphasize the need to specifically report on suppliers’ management of issues around human rights, land use, biodiversity, social impact, child and forced labor, labor rights, environment performance, and product safety. 

Long-term strategy 

The strongest frameworks consider long-term impact. LTSE requires companies to report their policies for long-term value creation including (1) consideration of a broader group of stakeholders and the critical role they play in one another’s success; (2) measurement of success in years and decades and prioritization of long-term decision-making; (3) alignment of executive compensation and board compensation with long-term performance; (4) engagement with long-term shareholders; and (5) boards of directors' engagement in and explicit oversight of long-term strategy. These reports help ensure high-quality growth capital and minimize stock-price volatility. Similarly, Integrated Reporting (IR) emphasizes the organization’s governance structure, the forward-looking risks and opportunities that might affect its ability to create value, and its resource allocation strategy for the long-term. 

Integrated Reporting  

As Colin Mayer, a Professor and former Dean of the Oxford Saïd Business School, puts it, "purpose is not about charity or philanthropy, but hardnosed [sic] business. It is about delivering profits to shareholders through identifying ways of solving problems of others." ESG frameworks are continually redefining “profit” to reflect purpose and the associated values and costs of assets not encompassed in traditional corporate assets. They achieve this by producing integrated reporting structures that highlight the interconnectedness of financial performance and ESG performance. IR, for instance, introduces a concept known as "the capitals'' that incorporates a broad list of resources and relationships used and affected by an organization, including financial, manufactured, intellectual, human, social, and natural capital. The components that generate these types of capital should be reported in a way that highlights their interconnectedness and ensures that the maximization of financial capital takes place hand in hand with − and not at the expense of − the other types of capital in the longer term. SASB's Materiality Map also highlights how closely linked ESG performance is to financial performance. Companies reporting SASB standards typically disclose on average 26 variables across five key dimensions (environment, social capital, human capital, business model & innovation) that all have a financially material impact on the business.  

Industry- and sector-specific standards  

Increasingly, ESG frameworks are adopting more sector-specific criteria, metrics, and analyses. For example, SASB categorizes standards across 77 industries. Technology & Communications is separate from Food & Beverage, Health Care, Consumer Goods, and so forth. SASB further breaks out companies by sector within those industries; within Technology & Communications, SASB clusters companies by Hardware vs. Semiconductors vs. Internet Media & Services vs. Software & Services. By developing industry- and even sector-specific standards, frameworks can take into account the nuances of their respective companies. For example, SASB reports that Customer Privacy is likely to be a material issue for more than 50% of Internet Media & Services companies, but not for Semiconductor companies. These nuances are critical to effectively capture the shared value generated (or not generated) by companies. 

Emphasis on measurement   

Some investors and companies sign on to the UN Sustainable Development Goals, although these lack specific metrics and benchmarks. For example, one SDG is “the eradication of poverty,” which fails to outline any concrete value to measure the progress of that goal. Further, the concept of eradicating poverty is disputed by signatory organizations. These shortcomings highlight how investors and companies can no longer reasonably rely on vague and subjective terms.  

Newer ESG frameworks provide data-driven criteria and metrics so that executives can objectively measure effort, output, and impact. Instead of relying on an organizations’ commitment to “eradicate poverty,” investors can evaluate their performance through disclosures on how much workers are paid, how much they are provided in healthcare benefits, and so forth. SASB offers clear technical protocols for how companies can report these metrics to standardize definitions, scope, and accounting to allow comparisons across companies. MSCI ESG Ratings generates reports that rate/scale such metrics and enumerate levels of risk. These frameworks not only give companies the tools to incentivize positive action but also standardize and quantify companies’ performance so that investors can compare them.  

Consistent reporting over time 

It is essential to consider companies’ performance in the context of public purpose not just consistently, but also over time. Businesses evolve, as do the social, political, and environmental contexts in which they operate. As such, the definitions of, commitments to, and influence on public purpose also evolve. Frequent measurement and reporting can not only help companies recalibrate their public purpose strategies, but also help investors gain an actual/historical view of a company’s standing on ESG issues. MSCI scores companies not just on their most recent quarterly performance, but also on their 3-year historical record on managing risks and opportunities. Companies can map where they intend to move on certain issues, but ESG standard reporting and measuring practices hold them accountable to such plans.  

A growing movement   

Today, almost all frameworks are opt-in and self-reported, but their growing popularity is increasing reputational/social pressure for companies and investors to pay close attention to them. More and more investors, and even the general public, have been calling for companies to hold themselves to the standards that these frameworks provide. MSCI provides ESG ratings for more than 8,700 companies included in its regional and country indices. In 2020, 533 companies disclosed SASB metrics in their public company communications, up from 118 in 2019. With popularity comes proposed legislation. The UK Financial Conduct Authority has proposed a law that makes companies state whether their disclosures are consistent with TCFD standards, and the European Commission recommends these disclosures. Similarly, the New Zealand Ministry for Environment has recently announced plans to make similar climate-related disclosures mandatory for certain public companies and financial institutions 

Making sense of and taking action on the trends 

These trends are both inspiring and exciting, as they have the potential to better hold companies and their investors accountable by approximating purpose. The amount of insight they are able to produce has been fostering the development of platforms like Clarity AI, Proof of Impact, and Socialsuit, which are specifically invested in analyzing large impact data sets against ESG criteria to monitor and optimize organizations' impact on people and the planet. 

However, existing ESG frameworks and their spillovers still fall short of covering a crucial aspect of public purpose: a comprehensive model to predict and solve for the unintended consequences of technology. For example, environmentally-focused frameworks highlight the benefits of companies that switch their suppliers to ensure that materials are sourced sustainably (as they should). At the same time, these frameworks fail to take into account how these new climate technologies affect job creation or displacement, as well as other less obvious societal aspects. 

We, along with Liz Sisson, Fellow at the Technology and Public Purpose Project at Harvard’s Belfer Center for Science and International Affairs, are developing a diligence and monitoring tool that accounts for these unintended consequences. Join us for our research and analysis tool demo!