Increasing Diversity in LA’s Venture Capital Ecosystem

Venture capital (VC) funding is highly concentrated in companies founded by individuals from exclusive universities and networks, who tend to be members of the same, traditionally supported demographic groups. Members of the Latinx and Black community, as well as women, are particularly excluded. As innovation economies continue to expand beyond Silicon Valley, it is important to ensure that investments reflect the diversity of the population — not only to address long-standing issues of social justice, but also to improve business outcomes for stakeholders. Many leading VC firms are aware of this issue and have created specialized funds or implemented diversity and inclusion strategies, but these solutions do not make diversity central to the normal course of business and network. Approaches that broaden networks and mitigate the impacts of implicit bias can create the cultural change that is necessary to ensure lasting and meaningful inclusion in the VC industry.

INTRODUCTION

The largest venture capital hubs in the United States — Silicon Valley, New York, Boston — are notorious for their exclusivity and lack of diversity. Companies that receive VC funding control a disproportionately large portion of the economy: between 1995 and 2018, 47% of the 4,109 initial public offerings in the US were previously VC-backed, but less than 0.5% of all companies in the economy receive VC funding (Lerner & Nanda, 2020). There is indeed evidence for a causal role of venture capital in the growth of these companies, as it enables higher rates of patenting, increased sales, and decreased likelihood of firm failure (Lerner & Nanda, 2020). Because venture capital is such a powerful source of funding, the inequitable distribution of opportunity for growth significantly increases barriers for founders who already face historical disadvantages. Los Angeles is a relatively new and expanding innovation economy, so there is still time for investors to prevent ultra-exclusive networks from forming.

The problem lies in the distribution of funding, not in the talent or existence of diverse founders. The demographic imbalance of founders of VC-backed companies is not due to a lack of talent, but rather to an imbalance in access to funding. Racial minorities face unique disadvantages, including a lack of generational wealth and knowledge about how to raise funding (Piqué et al., 2020). In addition, many founders initially rely on personal wealth, and there are racial disparities in average family net worth ($17,150 for Black families and $171,000 for white families in 2016) (McIntosh et al., 2020).

“The demographic imbalance of founders of VC-backed companies is not due to a lack of talent, but rather to an imbalance in access to funding.”

Although underrepresented groups face increased barriers, they are not less talented than founders from well-represented groups. A study conducted by the Brookings Institution evaluated predictors of entrepreneurial success and found no differences between Black and white individuals (OASB, 2020). Still, underrepresented founders seeking VC funding receive less their traditionally represented counterparts. According to the SEC, in 2019, 27.6% of entrepreneurs seeking capital identified as women, but companies with at least one woman on the founding team received only 12% of VC dollars (OASB, 2020). Together, these findings suggest that the issue is not a matter of interest in entrepreneurship, so increasing access to VC funding will allow the full talent of the US population to be realized.

Diversity of investors matters. To target the issue of diversity in VC-backed companies, it is pivotal to evaluate diversity of VC firms because investors’ identities affect the demographic backgrounds of who they choose to fund. According to the SEC, startup founders are 21% more likely to receive funding from investors of the same ethnicity than any other ethnicity (OASB, 2020).

There is no evidence of discrepancies in the interest in VC investing between well-represented and underrepresented groups. Between 2010 and 2015, Black employees accounted for about 6–9% of hires in consulting and investment banking, which are two major fields that commonly feed into VC, but less than 1% of VC hires (NCVA et al., 2021). These discrepancies in representation of historically underestimated groups in investment positions, when compared to the workforce as a whole, suggest that hiring into the VC industry in particular disadvantages Black professionals.

Diversity is an asset that is increasingly important to stay competitive. Aside from the case for social justice, there are strategic business benefits of incorporating more diverse founders into innovation economies. Actively targeting bias to encourage investments in diverse teams may lead to better financial returns because teams with more variation make better decisions. In one study of price bubbles, which occur when traders make collective errors in the pricing of assets, researchers found that ethnic homogeneity is positively correlated with overpricing and irrational confidence in decisions (Levine et al., 2014). A possible mechanism for this phenomenon is that more diverse teams have less overlapping biases, reducing the effects of groupthink and correlated judgment errors, which translates to better financial outcomes (Calder-Wang & Gompers, 2017). These effects translate to financial outcomes: according to a study by McKinsey & Company on 1,000 high-revenue companies, gender-diverse and ethnically diverse teams are 25% and 36% more likely, respectively, to have above-average profitability (Hunt et al., 2020). Therefore, the diversity of a team should be a formal factor to evaluate during due diligence of prospective investments.

Limited partners and portfolio companies requested details about diversity and inclusion from VC firms in 2021 at increased rates when compared to 2018 (NCVA et al., 2021). If this trend continues, VC firms will need to focus on diversity to stay competitive and respected in the industry. The industry should leverage this trend in order to incentivize diversity but must be careful to avoid tokenism.

Los Angeles is uniquely positioned to change the national status quo. Rates of investments in underrepresented founders are already higher in Los Angeles when compared to the United States as a whole. According to Crunchbase, in the first half of 2021, only 1.2% of the $147B in VC investments in the US went to Black founders (Romburgh & Teare, 2021). In Los Angeles, investments are slightly more representative of the population, with an estimated 7% of VC-backed founders being Black and 6% Latinx in 2020 — and these rates are slowly increasing (Hill, 2020).

As a progressive city with a diverse population and a growing startup culture, Los Angeles is in a position to continue this trajectory to reflect its diversity in its VC investments. The government of Los Angeles has already indicated its support for growing a diverse venture capital ecosystem. For example, the Office of Los Angeles Mayor Garcetti sponsors PledgeLA, an organization with the mission of supporting diversity in LA technology and venture capital. Other geographical areas, including Atlanta and Seattle, are also growing new VC ecosystems, and Los Angeles has the potential to demonstrate to the rest of the country that investing in diversity delivers improved results.

KEY BARRIERS TO REPRESENTATION

Implicit Bias: Stereotyping and Homophily

Psychological factors, such as implicit bias, influence the choices of investors during due diligence. A 2019 study at Stanford University evaluated the effect of race on investment professionals’ evaluation of fund managers with varying track records of fund performance (Lyons-Padilla et al., 2019). They found a stronger correlation between ratings of performance and objective levels of performance when participants were evaluating white fund managers than Black fund managers. Interestingly, however, at the lowest levels of fund performance, Black managers were rated higher than equivalently competent white managers, which could be a result of increased expectations for white managers compared those for Black managers due to stereotyping (Lyons-Padilla et al., 2019). This study suggests that stereotypes may cloud investors’ judgments of founders’ competence, which may be especially harmful to underrepresented founders in the most prestigious networks.

Homophily is also apparent in hiring practices at VC firms across the country. Empirical evidence shows that VC partners with a higher ratio of daughters to total children demonstrate reduced hiring biases when it comes to gender, translating to a 45% relative increase in the probability of their team hiring a female investor when they had a daughter in place of a son (Calder-Wang & Gompers, 2017). This type of implicit bias in both hiring practices and investment prospecting contributes to the maintenance of homogeneity in VC.

Structural Barriers: Small Networks

Low turnover and internal hiring of executives helps to maintain the domination of wealthy white men in the most influential positions in VC. Firms are typically small and tend to hire internally or through existing networks (Calder-Wang & Gompers, 2017). In 2020, turnover rates were only 4% for senior investment positions and 24% for junior investment positions, which feed into senior investment positions (NCVA et al., 2021). This slow turnover makes it difficult to immediately incorporate traditionally excluded groups into leadership positions at VC funds.

The nature of venture capital investing requires the maintenance of these tight networks due to information asymmetry and trust (Stuart & Sorenson, 2005). To succeed in raising VC funding, founders must pitch with overconfidence and may withhold information or exaggerate the viability of their company. A major component of due diligence is speaking with individuals who have worked with the founders of prospective investments, and investors favor founders who are well-liked by individuals whom they trust: those that are within their existing networks (Stuart & Sorenson, 2005). As a result, outsiders are explicitly excluded, and existing networks are strengthened. The expansion of these investor networks will be crucial to increase confident investments in more diverse founders.

Generational Barriers: Wealth and Social Capital

Due to the low turnover of investment roles, professionals who have personal or familial resources to found their own investment firms often do so. This process favors those with generational wealth, further exacerbating the lack of racial diversity in VC fund managers (Lyons-Padilla et al., 2019).

When senior investment roles do open, promotion to these roles depends strongly on networking and social norms, with firms reporting soft skills as an important criterion for promotion more often than deal origination and fund performance (NCVA et al., 2021). The reliance on networks and norms for promotion in the VC industry helps maintain existing social capital and exclude outsiders, often subconsciously. Fund managers often come from a select group of exclusive universities, where students are more likely to have been exposed to the cultural norms of the startup and investing world (Piqué et al., 2020). Obscure but important best practices such as the double-opt in introduction, signal belonging in the industry. While it is not desirable or reasonable to reduce the VC industry’s reliance on these important soft skills, firms should actively acknowledge that these skills can be learned and recognize when talented individuals may be excluded due to a lack of exposure to the norms of exclusive networks.

STRATEGY SHOULD EXPAND NETWORKS AND INCREASE ACCOUNTABILITY

An Oversimplified Approach: Diversity Funds

Many large firms have created specialized funds to invest in diversity, but these funds have minimal long-term benefit. One example is Andreessen Horowitz’s Talent x Opportunity Fund. The Talent x Opportunity Fund selects startups that make “cultural innovations,” providing founders with $100,000 in addition to training and mentorship. The benefit of specialized funds is that they ensure that some capital does get allocated to underrepresented founders and provides them with the training and connections found in VC’s exclusive networks. When these funds are led by prestigious Silicon Valley firms like Andreessen Horowitz, they help bring attention to the lack of diversity in VC and show other leading venture capitalists that commitment to diversity is a competitive advantage. However, at this point, this issue is well-known, and the industry is ready for more holistic changes.

“Diversity and inclusion cannot be compartmentalized.”

While it is not insignificant that influential firms are making tangible commitments to inclusion, specialized funds are unlikely to foster long-term diversity because they don’t address the exclusive culture within the firms’ main funds. Earmarking funding for underrepresented founders separates investments into “diverse” and the regular course of business. This type of separation may even be harmful to the culture: some investors may view these specialized funds as promoting the inclusion of less qualified individuals only for the sake of diversity, which would exacerbate the stigma around elevating diversity within reluctant individuals in positions of power (Lyons-Padilla et al., 2019). Diversity and inclusion cannot be compartmentalized. Broader cultural changes are necessary to integrate underrepresented founders and investors permanently and naturally into exclusive networks.

A More Holistic Strategy: Diversity Riders

For a long-term impact, firms must integrate diversity strategies into deals within the normal course of business. One way to do this is through diversity riders, a concept created by USC professor Stacey Smith and the Annenberg Inclusion Initiative for the film industry in 2014. In 2020, Los Angeles venture capitalist Alejandro Guerrero introduced diversity riders to the VC industry and created a movement for firms to pledge to incorporate them into their term sheets. The diversity rider is a block of text included in at the top of a term sheet that contains a statement of intention to include underrepresented groups in venture deals:

In order to advance diversity efforts in the venture capital industry, the Company and the lead investor, [Fund Name], will make commercial best efforts to offer and make every attempt to include as a co-investor in the financing at least one Black [or other underrepresented group including, but not limited to LatinX, women, LGBTQ+] check writer (DCWs), and to allocate a minimum of [X]% or [X] $’s of the total round for such co-investor. (Act One Ventures)

This language demonstrates to both firms themselves and their clients an intention to diversify their investing teams — and makes this commitment a component of every deal. The inclusion of diversity riders circumvents the obstacle of low turnover in senior investment roles because it prompts the inclusion of investors from traditionally excluded groups even when the lead investor of a deal does not have an underrepresented team. Although the diversity rider is an internal pledge — there are no built-in consequences if the terms are not achieved — it targets the root of the issue by focusing on expanding VC networks.

Optimizing Choice Architecture

Firms can reduce psychological barriers during their hiring and due diligence processes by setting up these processes to minimize bias. One firm that has adopted this strategy is The Carlyle Group, a global investment firm. The Carlyle Group requires that at least two interviewees for each role be of diverse backgrounds, and that at least one candidate be Black, Latinx, Pacific Islander, or Native American (The Carlyle Group). This strategy is not a hiring quota: it simply brings more underrepresented individuals into consideration, nudging a more natural incorporation into the exclusive industry.

Other strategies might include partially blind due diligence processes. While the character and competence of founders is a valid consideration for the success of a company, firms can designate one or more members of the investment team to evaluate potential client companies without meeting the founders. This strategy can increase objectivity by forcing investors to clearly identify tangible reasons why they support individual founders during discussion. Focusing on choice architecture, rather than implementing explicit race or gender quotas, helps to avoid the issue of tokenism.

Accountability Partnerships

Another strategy for firms to have long-term impact is to partner with external organizations in order to hold themselves accountable in terms of their progress on diversity goals. A benefit of being located in the diverse area of Los Angeles is the strong presence of individuals and organizations with a central mission of promoting diversity in VC. One example is PledgeLA, which partners with the Annenberg Inclusion Initiative. Based on their regular evaluations of diversity efforts and statistics, PledgeLA member firms are more successful than non-member firms in increasing diversity in investments: compared to national averages, their partner firms have invested in twice as many women, six times as many Black founders, and eight times as many Latinx founders (Hill, 2020). This data suggests that accountability and tangible, external commitments to diversity may be effective in translating intention to results.

SUMMARY OF RECOMMENDATIONS

Effective solutions to increase diversity and inclusion in the VC ecosystem will acknowledge the low turnover rates of investment professionals who often entered their positions via exclusive networks and make this fact central to the solution. A multifaceted approach that targets implicit bias, fosters broad cultural change, and ensures accountability will be most effective.

Diversity Riders: Committing to Expanding Networks

Due to the centrality of networks in the VC industry, it is important for firms to consciously include those who have been historically overlooked. By incorporating diversity riders into their term sheets, firms can diversify their networks, which are crucial to success in VC.

Choice Architecture: Reducing Bias

Firms should leverage behavioral economics to set up their hiring and due diligence processes to avoid inevitable biases. When hiring investors, firms should consciously include diverse candidates in their interviews. When sourcing deals, investors should consider a partially blind due diligence process.

Accountability: Partnerships and Transparency

To ensure delivery on intentions, firms should partner with external organizations to help them track and evaluate their progress. If formal partnerships are not formed, publishing diversity statistics to both portfolio companies and the public will also increase accountability.

REFERENCES

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Calder-Wang, S. & Gompers, P. (2017). And the Children Shall Lead: Gender Diversity and Performance in Venture Capital. https://doi.org/10.3386/w23454

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van Romburgh, M. & Teare, G (2021). Funding To Black Startup Founders Quadrupled In Past Year, But Remains Elusive. Crunchbase News. https://news.crunchbase.com/news/something-ventured-funding-to-black-startup-founders-quadrupled-in-past-year-but-remains-elusive