Sustainably Diverse Portfolios: 3 Strategies for VCs

The Persistent Challenge of Diversity in Venture Capital

Data indicates a significant disparity in venture capital funding, with Black and Latinx founders collectively receiving only 2.6% of total funding in 2020. Furthermore, teams led by women secured almost 30% less funding in the same year compared to 2019.

A System Built on Familiarity

For many years, a tightly connected network of individuals with similar backgrounds has shaped the venture capital landscape. This system, prioritizing pattern recognition, has consistently favored high-growth companies with leadership teams lacking in diversity. This approach was often presented as meritocratic.

Founders who didn't conform to established norms were often implicitly, or explicitly, led to believe they lacked the necessary qualifications. Access to capital is crucial for scaling any business, and a perceived lack of “what it takes” can become a self-fulfilling prophecy, regardless of a company’s potential.

Recent Awareness and Shifting Perspectives

Historically, the lack of diversity within the venture capital ecosystem primarily impacted those directly affected. However, the impactful #metoo and #BlackLivesMatter movements brought the issue of underfunding for women and minorities into broader public consciousness, highlighting its problematic nature.

It is increasingly recognized that underrepresented founders represent a significantly undervalued asset class within the United States. Investors are beginning to understand that fostering diversity isn’t simply an act of charity, but a sound economic strategy.

The Economic Benefits of Diversity

Consider the performance of women-founded startups. According to First Round Capital, these ventures deliver a 63% higher return on investment (ROI). BCG research demonstrates they generate twice the revenue for every dollar invested. Moreover, PitchBook & AllRaise data reveal a one-year faster exit time compared to other startups.

Founders who overcome greater obstacles often build more resilient companies, ultimately delivering superior results for investors. Perseverance in the face of adversity fosters strength and innovation.

Initial Responses and Limited Progress

Recent events have prompted some action within the industry. Following the murder of George Floyd, a surge of pledges, micro-funds, and investments aimed at supporting Black founders emerged. These founders suddenly found themselves in demand for meetings and speaking engagements.

While some secured funding and forged valuable relationships, the timing proved unfavorable for many. The initial enthusiasm waned, and ultimately, only 3% of 2020 venture capital deal volume went to companies founded by Black entrepreneurs.

A Founder’s Perspective

Ashlee Wisdom, co-founder and CEO of Health in Her HUE, a digital health platform, shared her experience.

“Initially, I received a large number of inquiries from investors last summer, which was encouraging,” she stated. “However, being new to the venture capital process, I lacked a fundraising strategy. Many investors were interested in companies at a more advanced stage than mine. Despite our traction, no one was willing to invest in our pre-seed round. Fortunately, I connected with many helpful investors who provided introductions to pre-seed and early-stage funds, and some of those later-stage investors are now monitoring our progress.”

The Risk of Superficial Change

It remains to be seen whether the progress made last year will be sustained. Historical evidence suggests that isolated, cosmetic efforts toward diversity rarely yield lasting results. The recent trajectory of venture capital funding for women serves as a cautionary example.

A Pattern of Regression

Following the #metoo movement, investors and corporations initially responded with increased efforts to support women-founded companies. Investments gradually increased for a period. However, with the onset of the COVID-19 pandemic and a return to trusted networks, funding for these ventures experienced a significant decline.

Crunchbase data shows that female-founded startups globally received $4.9 billion in venture funding through mid-December 2020, representing a 27% decrease compared to the previous year.

The Need for Systemic Reform

The key takeaway is that superficial changes within the venture capital landscape are ineffective in the long term. While many are now taking action, achieving genuine, lasting improvement requires fundamental changes to the core investment process. Diversity must be integrated into the primary investing framework.

While immediate results may not be apparent, these changes will be more sustainable and, as data suggests, ultimately more profitable for venture capital funds. Here are three concrete steps VC firms can implement:

Cultivating Diversity: Recruiting BIPOC and Female Investors

Recent analysis from PitchBook indicates a strong correlation between investor demographics and funding patterns. Specifically, female investors demonstrate a twofold increased propensity to fund companies led by female founders, and a threefold increase when the CEO is also female. Despite these findings, women constitute less than 10% of all venture capital partners.

Furthermore, data from BLCK VC reveals that over 80% of venture firms lack even a single Black investor within their teams. Consequently, it is unsurprising that only 1% of venture-backed startup founders identify as Black.

The Benefits of Representative Hiring

Actively recruiting from the communities you aim to invest in, and providing comprehensive support for new hires, is crucial. This approach expands dealflow, fosters valuable relationships, and provides unique insights into emerging markets and diverse customer bases.

The outcome is a more inclusive portfolio and a more robust investment team. Such a team is better equipped to effectively serve the needs of all companies within its investment scope.

Assessing the Initial Stages of Your Investment Pipeline

The quantity of potential investments entering the system directly influences the resulting outcomes. Venture capital firms must prioritize building robust connections with founder communities that are currently underrepresented to cultivate greater diversity within their initial deal sourcing efforts.

Actively partner with, provide sponsorship for, and make investments in organizations such as Female Founders Alliance, SoGal Foundation, and Black Women Talk Tech, among others. Proactively seek opportunities to participate in relevant events, request introductions to founders, and arrange informal meetings to expand your network.

Meaningful relationship building within these networks is crucial. This proactive approach will establish a foundation for a consistent stream of high-quality investment opportunities for years to come.

Direct Investment in Budding Fund Managers

A significant number of new funds, frequently managing under $50 million in assets, offer unique access to untapped founder talent. These general partners cultivate genuine, trust-based relationships with entrepreneurs who may be hesitant to engage with established venture capital firms.

For larger VC funds, proactively investing in these emerging managers is a strategic move. They can effectively function as your talent scouts, and your investment simultaneously contributes to the growth of the broader venture ecosystem.

The Economic Impact of Diversity in Venture Capital

The current underrepresentation of diversity within venture capital presents a substantial, generational opportunity for early investors. Equal investment in women-led ventures, mirroring that of male-led ventures, has the potential to stimulate the global economy by as much as $5 trillion.

This represents a considerable potential return that a non-diverse portfolio risks overlooking. A lack of diversity inherently limits access to a wider range of promising investment opportunities.

Sustainable Diversity Through Internal Change

Many investors recognize the value of diversity and express a sincere desire for improvement. Increased awareness and a sense of urgency often lead to the creation of independent programs aimed at addressing inequalities.

However, while these initiatives can be beneficial, they often lack long-term sustainability. The most effective approach to building a consistently diverse investment portfolio involves dedicated, ongoing internal reform and a commitment to systemic change.