5 things to consider before investing in an ESG-focused startup

Lately, VCs and angel investors seem to express growing interest in startups that focus on ESG – environmental, social and/or governance sustainability. This is great and commendable. We need new solutions to help tackle the world’s wicked problems,and startups can and should contribute.

Investing in sustainability solutions, however, is very different from investing in, say entertainment or enterprise software. There are some key concerns that an investor needs to pay attention to when evaluating an ESG startup.

1.Does it comply with regulation?

ESG is a very regulation-driven field. Companies need to adhere to a multitude of national and international rules, laws and standards. Market demand for many sustainability solutions is entirely created by companies struggling to meet the demands of new regulation.

At the moment, for example, companies operating in the EU are preparing for the corporate sustainability reporting and corporate sustainable due diligence directives that will take effect in the coming years.

So, in order to assess the market potential of an ESG startup, the first questions to ask are: does it comply with current regulation and will upcoming regulatory changes affect market demand. Even the most elegant ESG solution has no market if it doesn’t account for regulatory demands.

2.Is the science behind it sound?

Especially when dealing with environmental impact, there is no room for solutions that are not backed up by rigorous scientific research. 

If, for example, a solution claims to create emission reductions, the company has to be able to back up the claims with a environmental product declaration (EPD) that has been done by a reputable party with the necessary qualifications.

3.Is it solving a real problem?

Unfortunately all ”sustainable” things are not equal. One all too common approach is to pinpoint a single issue and fixate on that, ignoring the overall impact. 

A company may claim, for example, that a product is sustainable because the material that is used in making said product is in some respects superior to other products in the category. Such a claim, however, overshadows the product’s entire life cycle, which really should be the focus. Sometimes it’s not a question of what material to use, but whether this product category should exist in the first place, or whether the entire business model is sustainable or not.

4.Is it a good solution to this problem?

Let’s say that you have found a startup with a product that is in line with regulation, has good science to back it up and solves an actual sustainability problem. The next question to ask is, whether it is a good solution.

What makes a good sustainability solution? Positive signs could include: Is it somehow easier to use, more cost-efficient, less material-intensive or otherwise superior to existing solutions? Does it reduce the need for rare earth minerals or other scarce resources? Is the entire lifecycle and ESG impact properly mapped? Is the value chain sustainable with e.g. human rights and health and safety risks minimized? This is by no means an exhaustive list, but you get the picture.

5.Is it holistically sustainable?

A truly sustainable startup performs in all aspects of ESG: environmental, social and governance. Unfortunately, in recent years we’ve seen some high-profile cases of startups focusing on a product or solution with a positive environmental impact, but performing poorly on the social or governance side. Workplace harassment, unfair wages or human rights violations are not excusable because the company claims to be saving the environment. ESG-minded investors need to be diligent in checking the company’s operations against all key sustainability criteria.

Does this sound like a lot? Assessing scientific data, life cycle assessments and supply chain sustainability may not be in every investor’s skill set. If this is the case, it’s a good idea to enlist a specialist for the ESG due diligence and/or risk assessment.