Sustainability Disclosure Requirements in Venture Capital: Rewriting the Rulebook on Transparency

”Sustainability” and ”innovations,” as well as entrepreneurs building innovative sustainable solutions to address existing environmental and social issues with their own hands and very little money, have recently been on everyone’s lips. In turn, venture capital (VC) has shown to be a reliable source of funding for such businesses. Given the recent increase in the number of green startups [1], ever more stringent sustainability standards, and prominent greenwashing cases at all levels, the matter of sustainability disclosure requirements in venture capital appears to be an important issue.

Allure of VC Funding

Raising funds for an early stage startup can be tricky in a high-risk environment with limited resources. Developing innovations costs (a lot of) money, so getting a loan from a bank, borrowing enough money from FFF (family, friends, and fools), or using crowdfunding may not be enough. This is where venture capital – that has been booming in recent decades, annually deploying around $300 billion dollars worldwide [2] – comes into play. VC funds invest substantial amounts of money at startups, including those at early stages, helping them to grow and mature prior to an exit, like an initial public offering (IPO) or a Merger and Acquisition (M&A) process.

Getting the green light from VC is a drawn-out procedure, but if entrepreneurs persevere and approach it wisely, their efforts eventually pay off. However, eventually only a small percentage of businesses make it through the tough screening procedure [3]. Still, inspired by the smashing success stories of multi-million investment rounds, entrepreneurs are now under pressure to raise massive amounts of cash from venture capitalists [4] and become the next unicorns (companies with valuation of $1+ billion) [5]. As a result, we now see a race for VC funding. Venture capital is hard to get but very enticing because startups receive not just money but also expert support and access to networking, both of which are critical at the early stage.

What is different today

As the global economy shifts to a more sustainable and responsible model with stricter regulations, the number of start-ups identifying as ”sustainable” and seeking to meet changing market demands has increased significantly, emphasising the critical nature of sustainable innovations in entrepreneurship [6]. Simultaneously, early-stage investors have become more willing to fund less established (but potentially high-return) ideas, including those around sustainability topics (for example, investments in clean energy startups alone increased sixfold in 2019-2023 [7]) through a “spray and pray” investment strategy in which they provide smaller funding amounts to a greater number of startups [8].

As the focus on sustainability becomes more prevalent among entrepreneurs, the current rulebook of the startup sector adapts accordingly. Originally, the primary goal of startups is to make money and deliver the best quality product. While sustainability-focused businesses strive to make money too, they also promise to generate their profit by creating positive value for the environment or society. In this case, when investors evaluate not only the possible return on investment but also positive external effects, the following question arises:  should the existing VC industry approach change to ensure that startups achieve not only positive financial metrics but also the originally promised sustainability objectives?

As is well-known, whenever something appears to become mainstream, there is a long queue of those willing to profit from it. In fact, according to research, investors today tend to make investment decisions not because sustainability is integrated into their decision reasoning and not because potential portfolio companies must go through a special due diligence procedure. Instead, they tend to make decisions based on a higher emotional connection to the topic and are prone to emotional contagion from entrepreneurs’ business plans [9, 10] – does it mean that developing a compelling storyline and a roadmap might be enough to gain investors’ trust? Since we have already been flooded with greenwashing on all levels, including the startup industry, how can investors ensure that they are investing in impact-generating ventures rather than just savvy slogans and promises in this case?

How it works now

Before making an investment decision, VC funds carry out due diligence to screen out factors like business model, team, industry, risks, and many more to evaluate a company’s potential. If all goes well, startups eventually obtain funding in exchange for an equity stake. At the same time, while VC funds are quite selective, their approach can be described as planting seeds (money) in multiple pots (startups), with only a small percentage of those seeds eventually growing into a dollar tree 7-10 years after investment, when the resulting profits are channeled back to VC limited partners [2].

It is a step-by-step process, beginning with smaller funding amounts (usually up to $2 million) at the seed stage for developing the product, achieving market-fit, acquiring first customers, and then building momentum with larger investment amounts once startups are securely standing on their feet. As it advances to larger and more significant investment rounds (Series A+), financial performance gets increasingly critical and is rigorously scrutinized through various metrics (e.g., IRR, cash flow multiples, etc.). In other words, in order to secure more funding, startups must demonstrate consistent performance towards their primary goal – more profit.

What it might look like

But what about startups claiming not only to generate a lot of money, but also to create valuable environmental or social value along the way? One could believe there must be special procedures to ensure that such companies have indeed made progress towards their sustainability promises. However, as of today, there is no widely accepted framework in the VC industry requiring startups with any sustainability label to disclose the actual figures behind their sustainability claims [11] as part of the pre-funding procedure or to report on the progress towards meeting their short- or long-term sustainability targets [12]. It has yet to be agreed on how to ensure that portfolio companies follow their sustainability promises and create reliable mechanisms to verify their real impact [13].

Of course, a new investment branch that has emerged in recent years cannot be overlooked – sustainable investing takes into account social and/or environmental impact in addition to financial profit [14]. It has evolved into an overarching concept that includes ESG, impact, socially responsible, ethical, and green investing, each with a focus on a particular aspect of sustainability (e.g., green investing focuses on natural resource conservation, whereas impact investing seeks to harvest measurable social and environmental impact while also generating financial return). As a result, there are funds that specialise solely on such investments that employ special procedures and have specific requirements to make sure that additional positive impact is guaranteed by their portfolio companies (e.g., they may even seek concessionary returns). However, since such funds are smaller and there are not so many of them, they still remain more of a niche [15].

In turn, larger VC funds may invest in sustainability startups without making it their priority. As a result, there is no obvious need for them to design special sustainability due diligence procedures. It means that, while funds with the focus on sustainable investing may impose some stricter requirements for their portfolio, it will only apply to their decision-making processes and will not affect every sustainability startup seeking any other VC funding. As a result, there is always a workaround for the ones with hazy intentions.

On the one hand, one may argue that it may be easier for startups with limited resources to go through a lengthy and resource-intensive disclosure process requiring meticulous data collection and preparation, as well as substantial expenditures. However, it sets the stage for anyone looking to cash in on the sustainability mainstream. Given the time constraints for achieving sustainability goals, it becomes even simpler to promise a lot but never deliver – ”there is an urgent problem: we have a solution but we do not have time to explain it in the smallest detail”.

Lessons learned

However, lessons have been learned, and there is now a growing interest among all types of investors in the material importance of their portfolio companies’ social, environmental, and governance factors, as well as pressure from asset owners to demonstrate how one company’s practices are materially more sustainable than those of the other. As a result, the need for more well-defined requirements for startups on measuring their sustainability performance and progressing towards their sustainability goals has become clear.

• From the investor’s perspective, changes to funding processes should be made to screen out greenwashing claims and to link companies’ sustainability impacts with their post-funding performance.
• From the standpoint of the state, there should be tougher regulations on which companies may be dubbed ”green”, ”sustainable”, and so on. This is not only a technique to sift out greenwashing from possible funding (since the existence of official regulations per se makes greenwashing more complicated), but it is also a tool to measure startups’ contributions and determine whether this is something that requires additional state support.
• From the startups’ point of view, this is a way to find out whether they indeed generate additional positive value, distinguish themselves from what already exists on the market, and provide potential customers and investors with potential tangible outcomes.

Why try

One could wonder why so much emphasis is placed on impact when the fundamental purpose of venture capital is still profit – after all, it is all about cash and it does not really matter how much emissions have been avoided along the way. It is true from a conventional standpoint. However, if we take a step back and look beyond a profit-driven perspective, we will notice that one of the two sides involved has been distancing from this perspective. If the demand side (startups) has already started shifting its offering to be more sustainable, should the supply side (VC funds) also adjust and shift its focus from profit creation only?

1. All roads lead to VC. In fact, VC funds may fall victim to greenwashing themselves by labeling their portfolio sustainable without providing any evidence. Furthermore, if their portfolio companies get into greenwashing troubles, VC funds get instantly exposed to any associated risks as well. As a result, it is in VC’s best interests to be cautious and have tangible impact measurement of their portfolio in order to protect its reputation.
2. Regulations are tightening. As the situation with sustainability reporting for larger companies (i.e., the Corporate Sustainability Reporting Directive) and financial market participants (i.e., the Sustainable Finance Disclosure Regulation) becomes more stringent in the EU, other countries might follow the lead soon and require more thorough disclosure from investors, who will then demand their portfolio companies to do the same and provide the necessary data. As the industry rules change at such a rapid pace, it is best to start preparing now, as even stricter changes will inevitably occur sooner rather than later.
3. Finally, it is an opportunity for startups. Being proactive and collecting sustainability performance data for reasons other than sales and marketing may help them gain a competitive advantage and differentiate in the market, securing stronger funding and boosting reputation among stakeholders, as well as guide their product development strategy in the right direction that will provide more tangible results.

As there are already a number of widely used sustainability disclosure frameworks and some pioneering funds incorporating disclosure requirements in that regard, identifying best practices for both startups and VC funds ahead of time may prove to be a beneficial strategy for both parties. As the past has shown, those who foresee upcoming trends and implement necessary measures eventually win. Since everything indicates that stricter requirements will be applied sooner or later, now is the moment to step on the windy but necessary path of making ‘’sustainability’’ a tangible result, not a buzzword.

References

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