The Flywheels to the Future are Female:
Increasing Returns by Increasing Impact Investment
Written by Spring and Summer DigitalDx Ventures Fellow Alexandra Davis
With investors turning their attention to existing portfolio companies and less likely to travel or hold in-person meetings, it will bring new challenges to female founders who, traditionally, have fewer established relationships with VC investors. Early-stage startups pose a greater risk, and female-led companies trend to finance later in their histories as they have developed revenue traction, projected LTV and market potential. In a study of over 350 startups, businesses founded by women delivered higher revenue — more than 2 times as much per dollar invested — than those founded by men. As a result, investors should focus on identifying female-led healthcare startups who are best poised to fulfill the unique needs created by the outbreak.
Key Takeaway(s):
- Female founders will be disproportionately impacted by COVID (i.e. investment theses will shift to undercut female founders)
- How stats & investment can be re-examined to identify female founders as a ripe group for innovation
- Ways to support, investment theses strategies
Part One: The Crunch from COVID-19
VC activity for female and other historically underrepresented founders has seen some progress in recent years, but it remains far from parity. Historically, investors have heavily relied on network effects and pattern-matching to make investment decisions. Because venture capital is such a hands-on business, interactions between founders and investors throughout the VC lifecycle include numerous in-person meetings. With travel restrictions and public health fears around meetings, some investors will likely fall back on existing relationships, potentially reversing the positive momentum the industry has seen recently outside of geographies and demographics where VC has historically been concentrated. With investors turning their attention to existing portfolio companies and less likely to travel or hold in-person meetings, it will bring new challenges to founders who do not already have relationships with VC investors.
Investors are understandably risk-averse in an unpredictable environment. Before the pandemic, VCs were already tightening up criteria for later-stage funding of startups. According to Crunchbase, “Earlier indications of funding cutbacks may be more easily seen for smaller rounds at early and seed stage, when sought-after deals come together more quickly.” In short, early-stage startups pose a greater risk. Venture capitalists also may find themselves struggling to raise money, which means less cash for young startups. During the financial crisis of 2008 to 2009, the money venture capitalists raised fell by nearly 60%, according to the report. Investments will be rare for the next few months except for startups that provide products or services that fulfill the unique needs created by the outbreak.
The capital crunch in the industry will be felt across the board, but perhaps most acutely by founders and investors in historically underrepresented groups, in emerging venture ecosystems, and smaller (<$100 million) and new venture fund managers. As overall capital retracts and lack of exits dry up the next generation of angel investors, less local capital will be available. Investors will have to prioritize existing portfolio companies amid shelter-in- place orders and restrictions affecting travel and in-person meetings, among other issues. This all means that underrepresented groups and geographies will face new barriers to access capital.
Smart venture-backed companies are deep in planning and recalibrating. As of today, venture capitalists are understandably talking to management teams about mapping out contingency plans, extending their cash runway, refocusing on mission-critical projects, ensuring higher ROIs on marketing spend, and doing more with less as it relates to head count. In recent years, some VC investors have focused on expanding networks and removing bias from investment decisions, while initiatives like DigitalDx, Harlem Capital, Venture Forward, BLCK VC, Latinx VC and All Raise have placed a priority on advancing a more diverse and inclusive ecosystem. Yet with less capital available, venture capitalists may reverse any progress that has been made to diversify portfolios by backing women founders.
Part Two: Inclusion Breeds Innovation
Some of the world’s most dominant companies were built in times of adversity. Imagine Google and PayPal succeeding amidst the dot-com bust, or Airbnb, Square, and Uber being built out of the global financial crisis. Each of these entities either launched or scaled in very challenging markets. More of these winners will present themselves in this current environment.
Downturns also give venture investors more leverage and choice. VCs can often deploy capital at lower valuations, are welcomed into more private deals, and become even more selective with their investment criteria. Today, venture capitalists are sitting on a pile of $120 billion in unused capital — so-called “dry powder” in the vernacular of the VC industry. Much of that historical record cash hoard is reserved for existing portfolio companies, and reports suggest that this “capital will not be nearly enough to blunt the negative impact of the COVID-19 crisis.”
Although seemingly antithetical given the uncertainty that exists across industries, businesses founded by women deliver more than two-times as much per dollar invested than those founded by men. Investing in women-owned companies during a capital crunch can lead to better investments for financial backers for years to come. In the same study, VCs could have made an additional $85 million over five years if they had just invested equally in both the women-and men-founded startups.
In fact, women-owned businesses are growing much faster than all businesses. From 2007 to 2018, women-owned businesses grew by 58% in terms of the number of firms and 46% in terms of revenue. More specifically, women of color are the ones driving these numbers. Women of color, over that same period of time, were starting businesses at a much faster rate. The number of firms owned by African-American women has grown by 164% since 2007. There is a strong and statistically significant correlation between the diversity of management teams and overall innovation. Companies that reported above-average diversity on their management teams also reported innovation revenue that was 19 points higher than that of companies with below-average leadership diversity — 45% of total revenue versus just 26%. Moreover, more diverse companies have 22% lower turnover rates. Less staff turnover, paired with greater revenue, create a stronger company that can grow immensely and rapidly.
Part Three: Investing in Inclusion
Last year was a blockbuster year in terms of how much capital VCs raised. Many VCs still endeavor to carry forward this momentum and remain in active new deal sourcing mode. The evolving market cycles will make it even more imperative that female founders who do receive financing are able to stand on their own two feet. Whether a VC fund looking to invest or cut expenses, now is a good time to reinforce solid investment practices that advance the progress underrepresented founders have already made, despite uncertainty:
1. Reevaluate your line of sight and potential implicit biases.
Laura Chau, a VC at Canaan, remarked that natural implicit biases may exist when most VCs are male. As VCs become more conservative in their capital, these biases are even more exacerbated. To Chau, management teams must be clinically realistic and able to articulate and execute upon clear and measurable investment criteria.
2. Lean into your portfolio winners.
Many startups need additional financing. Chau poses an imperative question VCs must ask: “What is the risk tolerance of any founder during the recession?” Founders of lower socioeconomic status, especially first-time founders, may not have the same cushion to fall back on as repeat founders. In Chau’s role at Canaan, she emphasizes that investors must ensure that underrepresented founders have the best talent pools for hiring, as well as connections for fundraising. It is not enough to support just one underrepresented founder or funding pipeline, but rather, entire sectors that must further support the innovation that diversity brings.
3. Redouble your efforts to access quality investments in innovation.
Women were the sole or majority owners of an estimated 12.3 million U.S. businesses at the beginning of 2018, and were starting additional businesses at a rate of more than 1,800 (net) per day. Despite these achievements, implicit biases still hinder many women from fundraising. For example, across 180 entrepreneurs and 140 VCs at the TechCrunch competition, men were consistently asked more ‘promotion’ questions (highlighting upside and potential gains), while women were asked more ‘preventive’ questions (highlighting potential losses and risk mitigation). Entrepreneurs who addressed promotion questions raised at least six times more money than those asked the prevention questions.
4. Identify rounds led by the conviction of outside, fresh capital over safety rounds led by investors.
According to Golden Seeds, many women-led startups are led by serial entrepreneurs bringing a wealth of experience to companies that need to scale quickly. In 2017, serial entrepreneurs were 1/3 of the women-led companies in which Golden Seed’s network invested, marking a significant shift. Companies in the MSCI World Index with strong women leadership generated a Return on Equity of 10.1% per year versus 7.4% for those without strong women leadership, according to MSCI ESG Research.
Amidst the capital crunch, VCs deploying capital will, assumingly, have lower valuations for potential new investments. For fresh capital, VCs can look for seniority in capital structures and other structured terms to help protect their investors should the uncertain macro-environment persist. With capital becoming more selective, VCs can also look to back entities with long operating runways and demonstrated capital efficiency. Earlier-state startups pose greater risk and warrant lower valuations, but female-led startups typically finance later and thereby with greater revenue traction, projected LTV and market potential. Should VCs want to invest in innovation, paired with greater proof of concept, the target founder demographic is clear.
Conclusion
The unicorn-value question still remains: What can the VC community do to help better support underrepresented founders now?
Despite the title of this article, this isn’t an article about representation, gender equity or privilege. Crisis has a way of exacerbating privilege, but beneath it lies the root cause of this challenge. It is nature for VCs to hire, back and choose people like themselves or from their tight networks. This is, rather, an article about the opportunity cost that underrepresentation breeds. The data remains clear: diversity drives superior outcomes as measured by revenue, exits, and overall returns. Diversity in VC funding is not just fair business — it’s profitable business.
