Diversity: The Trillion Dollar Opportunity Hiding In Plain Sight

Over the last several weeks, I have participated in a number of candid and thought-provoking conversations around the diversity gap for founders of color in venture capital (VC). These calls were hosted by champions of diversity in VC and tech more broadly. One discussion in particular, co-hosted by Lo Toney of Plexo Capital and Freada and Mitch Kapor of Kapor Capital was particularly insightful. This discussion made me reflect on my personal experience as both a General Partner (GP) of color and as an investor in diverse founders.

Below I offer my thoughts on the lack of diversity in VC and some suggestions on how to address this issue, drawn from my personal experience and recent learnings.

The Diversity Gap In VC Represents A Massive Opportunity Cost for Investment Returns and the US Economy

The diversity gap in VC is daunting. To summarize:

• Only 1% of all venture capital is invested in Black founders. Less than 2% is directed to Latinx founders. Let this sink in for a bit: less than 3% of all venture-stage funding goes to Black or Latinx founders, combined. This is the “funding gap” for founders of color in VC.
• It is even worse for women of color. Black and Latinx women founders receive less than 1% of all venture investments, combined.
• This funding gap for diverse founders is mirrored by the lack of diversity within VC investment professionals. Unsurprisingly, less than 3% of investment professionals at venture firms are Black or Latinx, combined. This is the “hiring gap” for investment professionals of color in VC.

The fact that the diversity gap in VC remains so stubbornly wide is particularly problematic. In December 2018, Morgan Stanley outlined how VCs are missing out on as much as $4 trillion in value by underinvesting in minority and women founders. Separately, a 2020 research report by the Stanford Latino Entrepreneur Initiative noted that if Latinx-owned businesses were to grow to match the size of non-Latinx owned businesses, it would add $1.5 trillion to the US economy.

The lack of diversity presents a conundrum in VC. As venture capitalists, we are economically incentivized to generate the best possible returns for our investors. We attempt to achieve those returns by identifying and investing in founders, ideas, and companies that will transform entire markets, often by challenging the status quo. And yet, the lack of investment in founders and GPs of color seems to be at direct odds with the fundamental role of venture capital given (1) the data suggesting that increased diversity amplifies returns and (2) the opportunity to drive transformational change through investing in diverse communities.

Figure 1: VCs Can Tap Into A Trillion Opportunity By Prioritizing Diversity

Source: Morgan Stanley Research

Capital Is Necessary but Insufficient

Let’s be clear, in order to improve the funding gap, founders and GPs of color need more investment. If you are a GP at a VC fund and want to move diversity beyond the 3%, invest in founders of color. If you are a Limited Partner in funds and you want to help move the needle beyond the 3%, allocate capital to GPs of color.

But, we cannot systematically improve the “funding gap” without improving the “hiring gap” simultaneously. In addition, diverse participants in the VC industry are not just starved for capital, they find themselves isolated from “standard industry practices” that make raising subsequent financing rounds, collaboration and getting hired significantly difficult. Capital is necessary but insufficient.

How can GPs of all backgrounds help?

If you are a GP, here are some key items to consider beyond investing in founders of color:

Hire diverse investors to build a diverse pipeline of founders and co-investors.

As VCs, we tap into our existing networks to build our pipeline and share insights/opportunities with our trusted peers/industry connections to help us quickly and efficiently assess these opportunities. And — whether we care to admit it or not — we are more likely to invest in people we can relate to and products/solutions that are addressing issues we can directly relate with. Moreover, we avoid what we don’t understand, and risk aversion is a well documented behavioral bias that leads to status quo reinforcement (see the “status quo bias” identified by Nobel Laureate Richard Thaler). This is particularly the case when you assess the very early stages of a startup.

Diverse investors leverage their existing networks as well. If you are having trouble building a pipeline of diverse founders, hire diverse investment professionals, who might see the world from a different vantage point. If you bring on these diverse investors, the chances are really high that your pipeline will begin to look more diverse, the insights you have on these opportunities will be different, and the deals you eventually execute will be unique, all of which can yield a competitive edge among peers.

Create the right environment for diverse founders.

One of the most counterproductive things you can do as a VC, however, is to hire Black and Latinx investors and not create an environment that encourages these diverse investors to leverage their unique networks. I personally know several diverse investors who are reluctant to source diverse founders in their firms out of concern that they will be seen as biased or labeled as the “diversity person” and get left out of high-quality deals without a diverse founder. This was exactly the situation that one anonymous VC investor spoke to in a Dot.LA article on diversity.

This is problematic as it could both hurt the career trajectory of the diverse investor and not generate the desired increase pipeline of diverse founders for the VC firm. In order to avoid this, VCs should clearly state their commitment to diversity, hold all levels of the firm accountable to that commitment and encourage diverse founders to leverage their networks to help the VC firm execute on that commitment.

Rethink some industry practices on how we source opportunities.

This is also a good time for VCs to reexamine some of the standard industry practices that may inadvertently present barriers to founders of color. These are just two examples — both of which Freada Kapor addressed during a call on diversity:

• Warm Intros: In efforts to either (a) manage hectic schedules and (b) help filter potential leads, VCs typically prefer warm intros to founders. These warm intros come from a VC investor’s existing network, including founders from an existing portfolio company, a limited partner, a co-investor or trusted industry connections. But the industry’s reliance on warm intros can close the door on founders of color. On the one hand, these founders of color are less likely to have an existing network that can make those critical warm intros. On the other hand, if a VC’s existing network does not include a lot of diverse people, then changes are they won’t receive a lot of warm intros to diverse founders.

In VC, your network is part of your competitive edge. So the point here is not to stop leveraging that network. It is more about expanding that network to uncover potential blind spots. One idea is to actively bring more diversity into your network of trusted peers — actively engage with VCs focused on founders of color, organizations that have a wide reach into diverse founders or thought leaders in a particular industry who happen to be diverse.

Another idea is to simply allow founders of color that fit your investment themes/strategy to contact you directly for a defined window. For example, Jason Lemkin from SaaSTR and Nihal Mehta from Eniac Ventures recently put out a call for black founders to reach out without an intro.

• Skill-based Assessments: Develop a “skills-based assessment” of talent when making hiring and investment decisions. As Freada Kapor pointed out in a recent discussion, “investing in Stanford graduates with an experience in Google” is not a skill-based assessment and it is a very narrow criteria for hiring or investing. This criteria, moreover, is likely not explicitly stated anywhere on a VCs pitch deck or shared through internal memos. It is something that VCs need to be conscious of nonetheless, and take actions to ensure that everyone is doing their part to create a “skills based assessment” because as Freada and Mitch Kapor rightfully assert: “Genius Is Equally Distributed by Zip Code, Opportunity is Not”.

How Can Limited Partners of all backgrounds help?

If you are a Limited Partner in VC, here are some key items to consider beyond investing in GPs of color:

Co-invest alongside a GP of color to build the relationship.

One effective way for institutional investors to foster new relationships with diverse GPs is by co-investing alongside them. By doing so, Limited Partners can have a direct look at the diverse GP’s pipeline, investment process and ability to add value following an investment.

In addition, diverse GPs will likely bring a different set of opportunities that at the least will further diversify the underlying assets in your portfolio and potentially amplify your returns due to the ability to co-invest in some of the most attractive deals that perhaps other VCs will overlook. Institutional LPs can manage these co-investments directly or require that it is implemented as part of existing Emerging Manager programs.

Invest in GPs of Color, through a Fund of Fund allocation.

One of the most efficient ways to get more capital into founders of color is through a carefully designed Fund of Funds (FoF) strategy.

If you create a Fund of Funds that invests in ~20 VCs focused on diverse founders, and each of those VCs invests in ~20 companies, you could indirectly fund up to 400 diverse founding teams. If instead of creating a FoF yourself, you invest in 10 FoFs with an underlying focus on diversity, you could indirectly fund 4,000 diverse founding teams. And this can be done in a period of 3 -5 years.

Hold VCs accountable for lack of diversity.

Limited partners can hold VCs accountable for lack of diversity in their firms and in their underlying portfolio. Diversity amplifies returns and thus it is both an institutional LP’s and VC’s fiduciary duty to take diversity seriously. This goes beyond just the largest pension systems. Endowments, foundations and family offices can exert significant influence — particularly on small and mid-sized VC funds.

Leverage existing networks to build a pipeline of diverse GPs.

Limited partners should establish meaningful relationships with organizations such as Blck VC, Latinx VC, New America Alliance, Kauffman Fellows and others to expand their pipeline of talented emerging managers. In addition, larger institutional investors that outsource some of their Emerging Manager initiatives could ensure these FoF manager programs are leveraging these same networks to build out their pipeline of Black and Latinx GPs.

Let’s Follow our Female Colleagues’ Lead to Finally Move the Needle on Diversity

I understand and share the frustration that many of my diverse VC colleagues have voiced in recent weeks on the diversity funding gap. But I am also hopeful that as a VC community we can learn from the leadership that women have shown despite facing significant underrepresentation. In a January 1, 2020 article, Forbes reported that while the 2010s saw some incremental progress in funding for female founders, the 2020s will likely see accelerated improvement in the gender funding gap.

Between 2008 and 2020, the percentage of VC capital invested in a team with at least one female founder nearly doubled from 6.5% to 12.6%. Similarly, according to All Raise — an organization focused on increasing female representation in VC and tech — the percentage of female decision-makers in VC reached 13% in 2019. Coincidence? I think not. These numbers move in parallel. Similarly, we cannot improve the funding gap without narrowing the hiring gap for founders of color.

These results are not cause for a victory lap, as 65% of US VC firms still do not have a single female partner. But a win is a win. And if we can move the percentage of VC Funding in Black and Latinx founders to 13%, I think we can all agree this is a step in the right direction.

The window of opportunity is as open as it has ever been. The time to move diversity in VC beyond the 3% is now.