The last decade has marked a shift in global venture capital focus towards solving more complex issues that affect our daily lives, such as climate change. Venture capital investors, which traditionally targeted the funding gap for high-risk startups that other investors shy away from, are now transitioning away from solving problems which would be considered as luxuries, to drive innovation in businesses which incorporate environmental, social, and governance (ESG) policies.

However, as the case with all emerging trends, increased regulatory pressure has meant ESG as an investment screening tool has become burdensome, and has been largely looked at as a tool to minimize risk ESG. Despite these challenges, the focus from VCs is encouraging startups and entrepreneurs to consider ESG to maximize opportunities and ethical impact, giving an advantage to those companies who adopt such practices from an early stage.

Lately, venture capitalists have accepted working closely with founders as they fine-tune their startup’s product market-fit and navigate through scalability and growth, giving venture capitalists the privilege to advise founders about ESG opportunities and possible business model integration. Having ESG aspects in the startup DNA from the inception is much easier than retrofitting ESG at much later stages.

Venture capitalists should be the leaders in promoting ESG and make it part of their mandates. The aim of venture capitalists should be to promote greater transparency about integrating ESG with founders. If done correctly, ESG implementation in VC will create better startups with a positive social impact and desirable financial returns.

ESG To Drive Business Sustainability

The United Nations’ Sustainable Development Goals (SDG) built on its earlier Principles for Responsible Investment “PRI”, which laid the foundational framework for responsible business practices in 2000. Now backed by 193 countries, SDGs provide a clear direction for sustainable development.

These initiatives, and subsequent regulations, present clearly defined ESG goals which should be embedded in business models from the early stages, saving time, effort, and money when companies become public. ESG has been lagging in VC compared with other asset classes, but it is increasingly catching up to the mainstream VC and unlike Corporate Social Responsibility (CSR) businesses should not handle ESG as a PR or box-checking exercise, which was largely seen as greenwashing. It is not about compliance; it is about proactively making a change toward a more sustainable world.

ESG has over SAR375 trillion ($100 trillion) AUM according to ESG Principles, illustrating the exponential growth potential when used with the right incentive from policymakers, and countering well-known misconceptions that ESG investing compromises on profits.

In fact, it was proven that responsible investments should still generate alpha for the investors. Research by the University of Cambridge in 2015 looked at 2,000 ESG engagements, and found that successful ESG engagements led to 7.1 percent excess returns over a 12-month period. During the Middle East Green Initiative Summit in Riyadh, Larry Fink, CEO of BlackRock stated: “The next 1,000 unicorns won’t be search engines or social media companies, they’ll be sustainable, scalable innovators – startups that help the world decarbonize and make the energy transition affordable for all consumers”.

Following HRH Prince Mohammed bin Salman’s pledge for Saudi Arabic to reach net-zero emissions at the Saudi Green Initiative Summit in October 2021, there has been an unprecedented attention in ESG locally, presenting an optimal time to incorporate ESG factors in the venture capital industry. In 2018, Tadawul became a partner exchange supporting the UN Sustainable Stock Exchanges Initiative and has since been active in promoting ESG awareness among market participants.

VCs As Innovation Catalysts

Known for being innovation catalysts and proven enablers for disrupting technologies, venture capitalists should be ahead of the curve when it comes to ESG.

This should be addressed with extra care, given that young startups are already focused on navigating their startups through hectic day-to-day challenges and we should not burden them with additional KPIs. Implementing ESG should not be a one-size-fits-all approach in VC; instead it should be a fluid process that looks at the challenges on a case-by-case basis. Identifying ESG opportunities early on is imperative given that startups scale quickly, and so do ESG risks.

Startups that are ESG-ready can stand out from the competition as they will be rewarded with higher valuation, lower costs of capital, more market share, more recognition, and a better reputation. ESG is in a race to play a significant role in shaping our future, and VC should take the lead in this transformation by displaying a positive ESG trajectory and backing the next FANGs, which should be more ESG positioned.