How to Incorporate Social Impact into the Venture Capital Industry – A Literature Review

(submitted to Budapest University of Technology and Economics for the Innovation and Green Finance Course)

Abstract

Venture capitalists traditionally fund enterprises with high risk but with the ability to generate high financial gains. This positions them to fund high-risk investments that can generate high social impact since they possess experience in identifying promising start-ups and enterprises. Thus, the integration of social impact into the activities of the venture capital industry is worth investigating. This article emphasises the significant role of venture capital in funding businesses with high prospects to deliver high social impacts. It also focuses on the implementation strategies and actionable insights from past literature on integrating social impact investing into the regular activities of the venture capital industry.

How to Incorporate Social Impact into the Venture Capital Industry – A Literature Review

The traditional definition of venture capital (VC) is a type of professionally managed finance created fundamentally to address the financial needs of emerging companies, such as the technology sector, that have significant growth potential and high returns (Mason, 2020). The funds are usually granted on a medium- to long-term basis in exchange for a share of the company's stock. Investors profit from the upside by receiving a capital gain on the value of their shares during a "liquidity event," but they lose money if the firm fails. As a result, venture capitalists limit their investments to companies with the potential for rapid development (Mason, 2020).

Although, the mainstream paradigm continues to be a compartmentalized world in which venture capitalists seek to make the most money in the shortest amount of time and philanthropists seek to solve social gaps by providing money to donation-dependent charities. This paradigm is being shifted by forward-looking funders looking to integrate both methodologies (Shaffer, 2015).

Incorporating social impact in the operating model of venture capitalist means that investors will not only seek to achieve set financial objectives but social objectives as well. Impact investors, like regular investors, seek market-rate financial returns by investing in financial assets. However, unlike regular investors, they seek a social or environmental impact in addition to these financial gains (Block et al., 2021).

The intersection of Profit-Driven Investing and Social Impact Investing

Despite the prevalent notion that traditional markets only consider financial returns, in truth, the very essence of investment and return is the pursuit of an integrated value proposition made of both, rather than a trade-off between social and financial interests (Emerson, 2003).

VC firms, in general, invest private equity obtained from a variety of sources (i.e., affluent individuals, organizations, foundations, and so on) in a variety of companies, becoming their invested partner in the process and expanding their portfolio of holding/companies (Karaömerlioglu and Jacobsson, 2000). VCs continue this legacy when acting as impact investors, but they do it in the context of mission-driven enterprises that conduct business while also advancing the well-being of society and individuals both inside and outside of the business realm (Cetindamar and Ozkazanc-Pan, 2017). To explicitly incorporate the social impact model into the venture capital industry, industry leaders have to be made to realize that financial returns and social impact are not a case of either/or, but rather both/and. (Emerson, 2003) calls for a new way of evaluating investment performance and returns referred to as the blended value proposition.

Roles of Social Impact Venture Capitalists

The role of the traditional and social impact venture capitalists is quite similar. Their role starts from the recruitment stage, where they identify personnel and business with a similar vision of social impact innovation. Venture capitalists are also involved in helping start-ups, and small enterprises strategize. In addition, they monitor their investees to ensure they do not veer off their social impact mission (Holtslag et al., 2021). However, the major difference is in the incorporation of social objectives to the financial goals of venture capitalists. The table below further emphasizes the difference between traditional venture capital firms and social impact venture capital firms.

Table 1: The Differences Between the Roles of Traditional Venture Capitalists and Social Impact Venture Capitalists (Holtslag et al., 2021)

Traditional Venture Capitalists	Impact Venture Capitalists
Financing is solely for profit and chrematistic purposes.	Financing for profit but with an additional social impact mandate.
Exiting to ensure optimum financial gains	Exiting while ensuring there is no mission drift in the social objectives of the companies even when other parties acquire it.
Mentoring of businesses to ensure financial growth and sustainability	Identifying attractive, sustainable alternatives for consumers, thus, achieving the social objective and improving relationships with ecosystem participants
Lobbying activities on behalf of investees to improve their financial position	Influencing and assisting in the shaping of legislation and regulation that will benefit the impact investing industry
Ensuring accountability of founders to ensure optimal deployment of resources.	Ensuring accountability and openness thus, preventing greenwashing. Also persuading other market participants to be more conscious of their negative social/environmental impacts.

Integration Strategies for Social Impact Venture Capitalists

(Van Pottelsberghe and Romain, 2004) concluded in their investigations that the social impact prospect of Venture capital is ordinarily more significant than regular private businesses or public R&D. This may be as a result of the inherently high risk and intensity zone that characterizes VC activities. As a result, VCs are perfectly positioned to deliver high social impact, and thus, the framework for incorporating social impact into the VC industry be standardized. Various literatures have written about the most important actions that need to be taken to accomplish this objective. This is discussed in subsequent paragraphs.

Paradigm Shift for Individuals and Organisations

Investors have only used traditional portfolio allocation frameworks that were only based on the evaluation of financial risk and return to make investment decisions due to a lack of awareness of the blended impact approach and the resulting difficulties in building the required capabilities (Bengo et al., 2021). However, given its dual objective, variables other than financial return and risk, such as social return and risk, should be included in the portfolio analysis. Regrettably, the bulk of funders and social initiatives have never considered how to evaluate social risk (Bengo et al., 2021).

Thus firstly, 21st-century managers must evolve. Managers who are capable of simultaneously functioning under the current tension of the double bottom line while also pushing the future's new, blended operating systems are the most desirable. (Emerson, 2003).

Selection Process and Screening Criteria

The selection process is critical to the long-term performance of venture capital investors (Gompers et al., 2020). The primary goal of the initial screening process is to find "investment-ready" companies using a variety of criteria (Mason and Harrison, 2016).

Social Impact Proposition of the Business

With their investments, impact investors hope to solve societal concerns and have a positive influence. As a result, attaining their objective is dependent on the social impact of their portfolio businesses. The social effect of investment possibilities, on the other hand, varies since not all companies assessed for possible investments have the same societal impact potential (Block et al., 2021).

Although the social impact proposition should be a critical factor for selection in social impact VCs (Scarlata and Alemany, 2011), to be sustainable, the companies should realize their social value proposition through new goods or services that provide reasonable economic returns (Leborgne-Bonassié et al., 2019).

Integration of Local Environment in Business Model

Interviews conducted by (Leborgne-Bonassié et al., 2019) revealed that the "how" is just as crucial as the "what" when it comes to societal challenges. For example, they discovered that the products tailored to the local culture performed better in terms of social and economic impact in Indonesia, where the study was carried out. As a result, VCs must consider the companies that are well embedded in their local environments and processes.

The synergy between Business and Venture Capital

(Gompers et al., 2020) believe management team qualities to be essential investment factors. Typically, the qualities taken into account are the experience or educational background of the management team. For small enterprises, the sincerity with which a founder or founding team pursues its vision is crucial for evaluation. Impact investing proponents believe that a good relationship between investors and impact investees (i.e., social entrepreneurs) helps to drive economic growth while also addressing long-standing social issues such as poverty, illiteracy, and homelessness (Markman et al., n.d.)

Evolving Performance Metrics

Although most investors and their portfolio firms believe that measuring the social impact of funds is a natural part of evaluating an impact investment, doing so remains a subjective and onerous undertaking for most (Carmody et al., 2011). There are a few well-designed metrics models out there. The Impact Reporting and Investment Standards (IRIS), created by the Global Impact Investing Network (GIIN) is a uniform framework through which investors may quantify the social or environmental impact of their investments (Carmody et al., 2011).

Tracking Systems and Information Management

Social management information and tracking tools need to be improved as new evaluation methods and a new set of metrics evolve to measure success. To achieve this, information systems and procedures that can measure the production of value in this new environment need to be created. (Emerson, 2003).

Communicating Impact

A Blended Value Proposition that combines and validates the highest possible maximization of social, environmental, and economic value inside a single company (whether for-profit or non-profit) must be continually promoted and incentivized (Emerson, 2003). Furthermore, venture capital firms have enormous financial resources and networks to influence other market participants to embrace social impact in their activities.

Conclusion

Venture capitalists must acknowledge that financial returns and social value are not at odds with one another but rather work together to provide the blended value of an organisation. The role of venture capitalists in delivering high social impact businesses cannot be over-emphasized. However, traditional venture capitalists must undergo a paradigm shift and re-education to achieve this blended value objective of financial and social impacts. Consequently, the investment selection criteria, as well as fund performance evaluation metrics, will need to be re-considered. Furthermore, an improved social impact tracking system needs to be developed. Finally, venture capitalists have a strong influence and network which they can utilize to promote social impact missions for businesses. In conclusion, the best venture capital investments must simultaneously have positive economic, social, and environmental value.

References

Bengo, I., Borrello, A., Chiodo, V., 2021. Preserving the Integrity of Social Impact Investing: Towards a Distinctive Implementation Strategy. Sustainability 2021, Vol. 13, Page 2852 13, 2852. https://doi.org/10.3390/SU13052852

Block, J.H., Hirschmann, M., Fisch, C., 2021. Which criteria matter when impact investors screen social enterprises? Journal of Corporate Finance 66. https://doi.org/10.1016/j.jcorpfin.2020.101813

Carmody, L., Mccarron, B., Author, J.B., Arosio, M., 2011. ISSUES FOR RESPONSIBLE INVESTORS IMPACT INVESTING IN EMERGING MARKETS.

Cetindamar, D., Ozkazanc-Pan, B., 2017. Assessing mission drift at venture capital impact investors. Business Ethics 26, 257–270. https://doi.org/10.1111/BEER.12149

Emerson, J., 2003. The Blended Value Proposition: Integrating Social and Financial Returns. California.

Gompers, P.A., Gornall, W., Kaplan, S.N., Strebulaev, I.A., 2020. How do venture capitalists make decisions? Journal of Financial Economics 135, 169–190. https://doi.org/10.1016/J.JFINECO.2019.06.011

Holtslag, M., Chevrollier, N., Nijhof, A., 2021. Impact investing and sustainable market transformations: The role of venture capital funds. Business Ethics, the Environment & Responsibility 30, 522–537. https://doi.org/10.1111/BEER.12371

Karaömerlioglu, D.Ç., Jacobsson, S., 2000. The swedish venture capital industry: An infant, adolescent or grown-up? Venture Capital 2, 61–88. https://doi.org/10.1080/136910600295819

Leborgne-Bonassié, M., Coletti, M., Sansone, G., 2019. What do venture philanthropy organisations seek in social enterprises? Business Strategy & Development 2, 349–357. https://doi.org/10.1002/BSD2.66

Markman, G.D., Russo, M., Lumpkin, G.T., Devereaux, P., Mair, J., n.d. Entrepreneurship as a Platform for Pursuing Multiple Goals: A Special Issue on Sustainability, Ethics, and Entrepreneurship. https://doi.org/10.1111/joms.12214

Mason, C., 2020. Venture Capital. International Encyclopedia of Human Geography 155–160. https://doi.org/10.1016/B978-0-08-102295-5.10153-2

Mason, C.M., Harrison, R.T., 2016. Improving Access to Early Stage Venture Capital in Regional Economies: A New Approach to Investment Readiness: http://dx.doi.org/10.1080/0269094042000203090 19, 159–173. https://doi.org/10.1080/0269094042000203090

Scarlata, M., Alemany, L., 2011. Deal Structuring in Philanthropic Venture Capital Investments: Financing Instrument, Valuation and Covenants. Journal of Business Ethics 2011 95:2 95, 121–145. https://doi.org/10.1007/S10551-011-0851-8

Shaffer, D., 2015. A New Path for Social Enterprises Through the “Valley of Death” [WWW Document]. Stanford Social Innovation Review. URL https://ssir.org/articles/entry/a_new_path_for_social_enterprises_through_the_valley_of_death# (accessed 1.10.22).

van Pottelsberghe, B., Romain, A., 2004. The Economic Impact of Venture Capital.