Black lives won’t matter in tech until we fix systemic racism in venture capital
Early stage startups have a high risk of failure, leading venture capitalists to invest in the most convenient companies rather than the “best” ones. This leaves Black founders systemically blocked from receiving the capital they deserve. Here’s why it happens and how we can fix it.
Venture capital (VC) has enormous influence on our economy
A venture backed company is one that has taken in money from a venture capital firm in order to grow the business. The future of our economy will be largely driven by venture backed companies. Although their investments are less than 0.2% of GDP, their companies account for more than a third of total US employees.
Fixing systemic racism in venture capital will unlock equity downstream
Much of the discussion about diversity & inclusion in tech centers around hiring and promoting Black employees at already established companies. These are very important initiatives that need to continue so that existing companies can give more opportunity to marginalized workers.
However, if we don’t figure out how to build equity at the top of the funnel, it is extremely difficult to build equity downstream. One way to think about it is that it’s much easier to hire a diverse leadership team that will then hire diverse candidates underneath them than it is to retroactively diversify a mostly white company built by a leadership team of white males.
Structural racism in VC & tech is ubiquitous
By now, we’ve already seen a number of headlines criticizing Silicon Valley and the tech industry at large for its lack of diversity, especially in senior leadership positions. Others have targeted VCs pointing to the fact that less than 1% of funding goes to Black founders despite Black Americans making up 13% of the US population.
Despite this reality, tech companies and VCs have continuously pointed to the same few excuses, often discussing the issue as a pipeline problem.
But with external pressure from a worldwide movement to pursue human rights for Black Americans, VCs have finally started to act, with some pledging to institute trainings, hire more Black employees, or create special POC founder funds. But given the deep and systemic nature of the discrimination in this sector, many of these “band aid” solutions may not cut it.
Venture capital is intelligent gambling
To properly understand why these solutions will prove insufficient, it is important to understand the venture system and how money flows into and out of these firms.
Venture capital funds raise money from limited partners (wealthy individuals and pension funds) to create an investment fund — a giant pool of money. They then use this fund to invest in promising companies, giving the companies cash in exchange for a “piece” of the company’s value at the time. They typically invest in anywhere from 10 to 100 companies per fund to create a portfolio.
The bet they are making is that each company will use that cash to grow revenue & profits, increasing their value over the course of 5 to 10 years. By the end of that 10 year period, the company will sell to another investor at a higher price or go public on the stock exchange. Once the company sells or goes public, the venture capital company cashes out, gives some of the profits to their partners, and keeps the rest. If you’re a good venture capital fund and bet on the right companies, you can stand to make unbelievable returns.
Venture capital firms make money from 2 channels
Channel 1: Profits from selling companies at a higher value than they were at the initial time of investment
- Ex: Today if I buy 10% of a 1 million dollar company for $100K and then, 5 years later, sell my 10% stake when the company is worth 100 million, I get back $10 million, which is $9.9M in profit that I share with my partners.
Channel 2: 2% management fees charged per year to limited partners
- Ex: If I raise a $100M fund to invest, each year I charge the limited partners 2% or $2M in management fees, no matter how the fund performs.
Venture capital advocates love this model because it theoretically incentivizes investment in highly profitable companies. If most of your money is made by taking early bets on companies that later become extremely successful, you’ll want to only invest money in the best companies. But when investing in companies at such an early stage, how do you determine which are going to be the best companies in the future? By creating an investment thesis:
Venture capital investment theses create systemic barriers
An investment thesis is a short document that details the exact types of companies that a venture capital fund will invest in, the circumstances that they will invest, how much they typically choose to invest, and why. This usually includes the industries they prefer, the stage of the company life cycle they prefer, and how much money they like to put in.
One might assume that VC theses would rely heavily on financial metrics. Which companies have the most revenue? Which ones are the most profitable? However, since VCs typically invest at the early stage, there usually aren’t many quality metrics to work with.
The few metrics that companies have when seeking early investment are typically red herrings, as there is little correlation between metrics at the early stage and success later in the company’s life. Founders often pitch to VCs with just a powerpoint deck and a dream. So given the amount of ambiguity, early VC theses tend to rely heavily on their perceptions of who the best founders are.
The industry philosophy goes — you can’t be certain of the market or the competition, but if you back the right horse (founder), you can trust that they’ll be able to continue to succeed no matter what the market throws at them.
Ambiguity exacerbates bias
As a result, the typical VC thesis is a classical economic approach to investing, assuming on average, each founder or company is predisposed to have a relatively equal chance of success regardless of their race or background. If every founder has an equal chance, the main factors that distinguish candidates are intelligence, executional ability, and grit. Naturally, the most intelligent, best executors with unflappable grit will always make it to the top of the pack. The rest will fail, but that is a good thing — it’s the natural result of a system that rewards merit above all.
This is why we praise founders that hustle and grind, founders that have the “grit” to just keep pushing no matter the obstacles. After all, we all have the same 24 hours in a day. So venture capitalists have created an investment system designed to measure not just how well the company is doing, but how much confidence they have in the founder that is running it. Deals are often secured over dinner and drinks long before the meeting in the board room.
The problem is, a person’s “confidence” in someone else is less correlated with objective ability than it is with conscious and unconscious bias.
Unconscious bias works against Black founders
Like all humans, VCs suffer from a number of conscious and unconscious biases. Investors suffer from local bias, where they prefer to invest in companies within their geographic proximity. One study of US VC investments showed that 50% of investments in companies went to those within 233 miles of the VC’s headquarters. Venture investors also suffer from similarity bias, which puts a preference on founders who seem to have similar experiences, often in education and employment. Given the pre-existing racial disparities in higher education and housing, these biases put Black founders at a significant disadvantage.
And all of these biases are often exacerbated by overtly racial bias both conscious and unconscious. Studies have shown that White Americans tend to associate Black people with negative traits like laziness and aggression. These biases are rooted in deliberately crafted stereotypes made to justify maintaining slaves as free labor and sharecroppers as quasi-free labor. These anti-Black biases are universal, resilient to levels of income, education, and even race. And they are especially pronounced among those with few Black people in their inner circles.
Given that the typical VC is a white male from a privileged background and that 91% of White Americans’ core social networks are also white, it’s likely that VCs express these latent biases when evaluating Black founders.
Black founders are not underfunded by accident
This helps explain how despite the fact that thousands of Black founders fill VC inboxes with pitch decks each year, very few end up receiving investment. Where there is a large degree of ambiguity and an even higher amount of risk, VCs default to investing in founders that register high on their confidence measure. Founders who are in their homogenized social circles, who are familiar with their lifestyles and have gone to their educational institutions. Founders who speak their language and share their world views.
In a particularly on-the-nose example, the identical Winklevoss twins famously invested in Nifty Gateway, a company founded by identical white male twins.
Making matters worse, Silicon Valley has become a bubble of organized groupthink. As some of the funded companies go on to give massive returns to their investors, VCs retroactively analyze what made these companies successful and use it to guide their future investments. It’s a game of pattern recognition built on biased data sets, similar to that of controversial AI algorithms that reinforce systemic racism by filtering out non-white male resumes. When investing, many VCs are looking for the next Steve Jobs or Mark Zuckerberg, making it much easier for them to invest in an eccentric charismatic white man with an impractical dream about reforming office space than it is to invest in any Black founder.
Bias is more powerful than VC firm financial incentives
One might argue that the financial incentives would propel VCs to work hard at identifying the best founders regardless of their backgrounds in order to compete in the free market. After all, that $2M per year management fee doesn’t come close to the literal billions a VC firm can make from a few successful exits (company sales). And in a free market with a fixed number of limited partners to raise money from, only the most profitable funds should continue to operate.
However, the data shows that many VC firms are perfectly content to live on their management fees. VC funds measure their success by their internal rate of return (IRR). You can think of it as the annual rate that your money grows when you choose to give it to a VC fund. If I put in $100 and the fund’s IRR is 20%, I will expect to have $120 after 1 year, $144 after 2 years, etc. with my money growing by the IRR rate each year. In the industry, any IRR below 15% is considered pretty bad and anything above that is decent.
The top 2% of VC funds generate 95% of VC returns (channel 2) each year, boasting upwards of 81% IRR. The other 98% post more modest returns of around 15% IRR. Because of this, they rely heavily on their management fees (channel 1). Although these management fees may not seem like much, that $2M per year is more than enough to pay the salaries of their 7 employees. Even if on average, firm performance is mediocre, one-off success stories like Stripe and Slack continue to motivate limited partners to invest in venture funds. For these partners, at the end of the day, 15% IRR is still about double what they can get from putting their money in the public markets.
The prevailing approach to racial equity in VC is not working. Not only do most funds generate mediocre returns, they are also actively discriminating against women, Black Americans, other people of color, and just about anyone who isn’t a white male. VCs are not investing in the “best” companies as they claim — they’re investing in the convenient companies, in a bid to minimize risk.
So what do we do about it?
Traditional reform measures miss the root of the problem
Diversity training is not enough
Instituting diversity training for venture fund partners will not change the intersection of risk minimization and unconscious bias that creates this inequity. Diversity training has proved to be largely ineffective at companies and even in police departments. Such trainings are unlikely to meaningfully increase capital deployed to Black founders, especially since systemic barriers to acquiring funding usually filter out Black founders before they ever get an in person meeting with VCs.
Tokenizing Black hires is not the answer
Hiring Black employees at VC firms will likely miss the mark as well. Measures like this often rely on tokenism. Studies have shown that despite being more likely than white professionals to be ambitious, over 33% of them intend to leave their companies in part because of lack of access to adequate mentorship and promotional opportunities. They are also more likely to face racial prejudice at work. Without reforming the culture within these firms, adding additional Black employees will do little to move the needle.
Special diversity funds are only one part of the solution
Even creating special funds for Black founders will not change the underlying conditions. On the one hand, the capital from these funds will, by definition, go to “diverse” founders, which is a step in the right direction. However, the funds will likely go to the most convenient “diverse” founders — those who most resemble the investors in appearance and background. Like “diverse” funds before them, these investment vehicles will likely churn out companies founded by majority privileged men with backgrounds from elite educational institutions.
Here are 5 steps to solving systemic racism in VC
1. Acknowledge the systemic inequities in VC AND our personal roles in creating them
The industry has to not only realize that a problem exists, they have to take ownership for their role in creating this inequity. This is important because it’s difficult to commit genuine time, money, and effort into solving a problem that does not feel deeply personal. We are only human and have too many things jockeying for our attention. We respond most to the things that feel most urgent, so we have to create a sense of urgency about systemic racism in VC.
2. Elevate Black voices advocating for systemic change
One of the biggest misconceptions about racial justice issues is that they are new. Scholars and diversity & inclusion experts have been studying this topic theoretically and empirically for decades. There exists a wealth of knowledge and experience from Black professionals on how to understand, engage with, and solve these problems. Hire these people and elevate their voices inside and outside your organization.
3. Destroy your current investment thesis and rebuild it from scratch
BLCK VC said it best, if you’re not investing in diverse founders, you’re a bad investor. Beyond the moral argument for being more racially inclusive, firms have a fiduciary obligation to their LPs to do a ground-up reform of their investment strategy to assure that a representative set of their portfolio companies are headed by Black founders AND that their portfolio companies are hiring Black workers. Diverse companies are more profitable.
4. Hold your firm accountable for hiring Black staff and funding Black companies
- Hire or wire is a great start, but real change comes from accountability. A great rule of thumb is to use this frame: “If my company would go bankrupt unless I solved this problem, what would I do?” Typical business leaders would first quantify the problem, set a target goal, institute policies to guarantee meeting that goal, and evaluate performance routinely to assure adequate progress. Few would instead utter some platitudes about hoping the problem gets solved and then move on. Solving systemic racism in business just like solving any other business problem.
- It is important to note though that hiring Black staff is not enough — you also have to make sure that they are supported, promoted, and valued so that they can bring their best selves to work. This will not happen naturally and will require every person at the organization to work at it each day. It will also require embedding accountability into company policies, like tying manager raises and promotions to success measures.
- Accountability applies to funded companies too. Saying “we’d like to fund some more Black companies” is unlikely to result in increased funding to Black companies. Saying instead “We will cut bonuses in half if we do not fund 5 Black companies this year” is much more likely to work. Accountability looks different at different organizations — figure out what works for you.
5. Maintain accountability every single year
Systemic racism does not disappear overnight from one or two initiatives. It requires careful constant effort on the part of the entire organization over the course of years. Given the timeframe, it is important not to give up on the initiatives or let them be de-prioritized for more pressing matters. Keep up the energy even when it’s not mainstream to do so and you’ll successfully reform within your organization.
Hear from Black venture capitalists and founders discussing these issues at the Yale Black Venture Summit.
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