Mainstream venture capital (VC) funds are beginning to look for a new kind of unicorn—companies that will not only provide huge financial returns, but also create huge social impact. Investors are directing increasing amounts of capital to these funds. TechCrunch reported last fall that “[t]ech solutions for such pressing issues as the climate crisis and social inequality have seen a 280 percent increase in global VC investment from 2015 to 2020,” with London and San Francisco as two of the leading hubs. Barry Eggers, a founding partner of Silicon Valley’s Lightspeed Venture Partners, characterizes where this shift is headed: “Social impact will become a new North Star for our industry.”
To be sure, a few VCs have invested exclusively for social impact for years. Think of veterans such as SJF Ventures (founded in 1999) and DBL Partners (launched in 2008), as well as firms such as Better Ventures, Rethink Education, and Impact Engine, all founded about a decade ago. But an impact mandate has been far from the norm until more recently. Now, limited partners are increasingly demanding to know how their investments in a VC fund’s portfolio companies are benefiting society. To respond, venture capitalists are seeking new ways of evaluating potential investments, adding value to early-stage companies, and measuring their impact.
Can Private Equity Show the Way?
Venture capitalists such as Softbank and A16z began to explore impact investing in earnest during the summer of 2020, when issues such as police violence against Black Americans and the unequal impact of COVID-19 on the rich and the poor brought social justice explosively to the fore. In Europe, several VCs are now spearheading efforts to develop frameworks to assess for environmental, social, and governance factors in early-stage investors.
The entrance of mainstream VC firms into the impact space mirrors how several giants of private equity (PE), such as TPG, Bain Capital, Partners Group, and KKR, have expanded their remit to address positive social and environmental impact over the past few years. They are able to manage and, particularly, measure impact using industry-recognized frameworks and standards. For example, there are the Impact Management Project’s “Five dimensions of impact,” the IFC’s Operating Principles, SASB’s (Sustainability Accounting Standards Board) Materiality Map, and IRIS+. Others are building their own variations, like TPG’s Impact Multiple of Money, to measure the impact of their investments as rigorously as possible.
These standards help PE impact funds evaluate potential and current portfolio companies and demonstrate results to investors. Yet such tools have at times proven to be of more limited value for VC impact investors. Approaches that use current data to project future impact (e.g., the Impact Multiple of Money), or that consist of exhaustive, 360° surveys (e.g., the Global Impact Investing Ratings System, or GIIRS), often prove difficult for earlier-stage businesses still squarely focused on product-market fit. “We tried [GIIRS] and our entrepreneurs hated it,” Matt Greenfield, managing partner of Rethink Education, recalls. “We found our entrepreneurs getting low scores for reasons totally unconnected to learning outcomes.”
Toward a Venture Capital Impact Framework
If the tools used by private equity impact investors are ill-suited for venture capital, then how can VCs manage and measure impact in ways that are both practical and credible? Fundamentally, we believe VC impact investors should be able to answer three questions, which feel much like those they answer about any investment:
- What matters? For conventional VCs, the answer is usually finding companies that have potential for hockey-stick revenue growth and attractive exits. Impact VCs will want to ask additional questions: What targeted, concrete impact in the world do you aspire to achieve from your investments, alongside financial return? What types of solutions will achieve that impact, and how can you spot them?
- Why you? When it comes to the social impact of an investment, why is your capital right for catalyzing real impact? How will your involvement help the company achieve its—and your—desired impact?
- Why this model and leadership? What about the specific company’s business model and team gives rise to a conviction that there is potential for a “unicorn for impact” and not just a financial unicorn?
Let’s deal with each of these questions in turn.
Having a defined perspective on what impact means and how it is generated is important for impact VCs faced with large deal flows. In order to make 10 investments, the average venture capital firm reviews approximately 1,200 companies. And more and more start-ups today are being launched as purpose-driven or social impact ventures: as an example, 37 percent of the Spring 2021 cohort of entrepreneurs at the Harvard Innovation Labs’ Venture Program identified their start-ups as “social impact/education/cultural.” This suggests that having portfolio selection criteria based on a deep understanding of what impact means and how it can be achieved is essential for finding the outliers that will achieve impact at scale for populations in greatest need.
Rethink Education—to take that fund as an example again—has spent years refining its impact theses based on what it believes will have the greatest impact on student outcomes. Given its thesis that education products and services should not widen inequality, the fund invests in workforce and B2B/enterprise edtech solutions, rather than in companies offering products to individual students, some of whom may not have the resources to purchase them. As Matt Greenfield puts it: “By focusing on platforms that sell to districts or enterprises, we can try to ensure that every consumer benefits on an equal playing field.”
Whether you’re a larger fund taking a seat on a company’s board, or a small fund getting into a funding round led by a mainstream player, you need to know why you are the right investor to help entrepreneurs create the impact you both aspire to achieve. Take the example of Alter Global, a small, first-time fund with a model of bringing Silicon Valley resources to entrepreneurs in emerging tech cities. Alter doesn’t pretend to have expertise in every local market, but instead offers founders something that is hard to come by in their local ecosystems: talent and resources from Silicon Valley.
When Alter Global invested in Kargo—a B2B trucking logistics company in Indonesia, where the potential for impact from enabling efficient transport of essential goods and services is huge—it was not a lead investor and didn’t have the name brand of a Sequoia or Lightspeed to unlock significant outside capital. Yet Alter had an outsized impact on Kargo by giving the company access to nearly a dozen “fellows” from leading Silicon Valley tech and US consulting companies to help build and support the company through key moments of growth.
Why This Model and Leadership?
Impact VCs are looking not just for financial unicorns but also for impact unicorns. In this quest they, like their more conventional VC counterparts, depend on developing conviction about a potential portfolio company’s model, market, and—arguably most importantly—founder.
That said, here are a few underlying principles VCs might consider when assessing an early-stage company’s potential for impact:
- Understand how the business model and mission relate to impact. Critically examine the company’s mission and how its business model might evolve. For example, if the company finds a more lucrative market for its product or service than the one it originally targeted, how would that change its impact and how would the company go about evaluating a pivot? Or, if it develops a new product or service that is not impact-focused but proves popular in the marketplace, how might its mission guide its next steps? Pivoting is not necessarily a bad thing, though it can lead to very different social and environmental impacts within—or beyond—a company’s original mission. It is helpful to form an idea of what the potential pivots for a company might be, and whether under different scenarios a pivot will still create meaningful social or environmental impact for populations that you, as an investor, want to reach.
- Determine what data is available to assess impact. Rigorous assessment is valuable for impact investing. However, randomized controlled trials (RCTs), which can be costly and difficult to use with new concepts, aren’t the only way to go about it. For example, a company could already be well aligned with what is known to work from existing research and data, or with what customers are saying works. The CEO and founder of Rethink’s portfolio company AllHere relied on extremely valuable data from interviewing countless school district leaders, learning more from them what was needed to build an effective intervention for truancy than an RCT could have provided.
- Finally and most importantly, bring it back to the leader. A VC knows that an early-stage company’s five-year financial projections are little more than, well, projections. Yet no VC would invest in a founder who hasn’t gone through the exercise of doing them. And when the unexpected comes along—as it almost certainly will—the character of the founder can be an especially critical piece for a mission-driven company. After Alter Global invested in Kargo, for example, its founder independently pledged part of his salary for a COVID-19 relief fund for the company’s truck drivers (an initiative an Alter fellow helped run). Alter didn’t know this would happen. But it sensed that the founder’s character would lead him to make values-driven decisions while he steered the company through the crisis.
It’s exciting that more and more venture capital is now flowing to companies with potential for high impact. But as more such companies seek early-stage funding and more VCs enter the impact space, they will need tools for impact measurement. The tools that work for other impact investors may not work quite so well for impact VCs, but we know VCs will develop their own. These capital providers have tremendous potential to create impact in the world by shifting their focus and doing what they are best equipped to do: be early strategic champions for companies they can help build and position for scale, growth, and dramatic action for the betterment of society and the planet.
Jordana Fremed and Michael Etzel are a consultant and partner, respectively, at The Bridgespan Group based in Boston.