Diversity is the trendy buzz word for “the right thing” to do, but investors and founders still tend to put it low on a list of priorities.
That seems mind boggling when a growing body of research demonstrates it drives America’s economic engine and makes businesses more profitable.
The bottom line? Diversity makes a difference
Diversity is profitable because teams with different experiences, skills, and backgrounds are more likely to effectively solve problems than teams who are homogenous. Hiring people like yourself can be more comfortable but a diverse team tends to be more productive. An updated McKinsey report reveals that firms in the top quartile for racial diversity are 33 percent likelier to have better financial results. While those in the top quartile for gender diversity are 21 percent likelier to have stronger performance compared to average companies.
A small amount of diversity can make a big difference in the bottom line. According to research by Paul Gompers and Silpa Kovvali published in the Harvard Business Review, venture firms that increased female partner hires by 10% saw a 1.5% spike in overall fund returns and 9.7% more profitable exits. That’s impressive given that less than 29% of all VC investments result in a profitable exit.
This isn’t to suggest firms should hire a token woman to improve performance. What aligns best with limited partners’ economic interests is investing in diverse investment teams uncovering large, underserved markets that are best served by diverse entrepreneurs. Todd Kimmel of Montage Ventures recently told me that he looks for “entrepreneurs who are outsiders to an industry but insiders to a problem” in that industry. Design thinking calls this insider status, “empathy”. Outsiders to an industry don’t have to be new to an industry. They’re often there working as colleagues but bringing new perspectives that challenge the way things have always been done. Sometimes they’re outsiders because of immutable characteristics like gender, race, class, or life experiences; sometimes because they bring new or interdisciplinary training.
Traditional VCs might miss this distinction because VC demographics reflect the composition of the USA in 1965, not 2019. Finding new problems being solved by those who operate as outsiders/inside for the enterprise of today and tomorrow is more likely to lead to outlier opportunities. For example, a recent Stanford Latino Entrepreneurship Initiative study indicates that in 2015, the GDP produced by Latinos in the United States was $2.13 trillion, larger than the GDPs of India, Italy, or Canada. This is one example of a diverse group that is fueling entrepreneurial corporate formation in the US and represents a massive opportunity to expand the U.S. economy.
LPS behavior can change VC behavior.
When we were raising Fund II 4 years ago, diversity was not a significant topic of conversation with LPs. Now we see they are very concerned to use the wealth they manage to reflect the interests they have more broadly. For example wealthy individuals, women billionaires such as Melinda Gates and others, are using their money to help change which entrepreneurs receive venture capital and who builds companies in America.
Other institutional investors, like pension funds and foundations, are realizing they need to have managers who are investing in diverse communities because often the people who created the wealth they manage are diverse people. Foundations in particular addressed equity in society largely through grantmaking and ignored the impact of the equity of the allocation of endowment assets. Now many are recognizing change is required..
As LPs from pensions, foundations and those who manage the endowments of education and religious institutions begin making it clear they want more diversity in their investment choices, it will impact how VCs view their investment strategies. LP shift VC behavior by voting with their dollars.
Deal flow and personal networks
Deal flow and access to diversity can make a huge difference in venture capital. Diverse managers often have greater access and deal flow due to the likelihood they’ve engaged in longer term “investments” within a particular community. As a woman and a minority, I’ve always been a member or active in mainstream organizations in professional areas of my focus (the National Venture Capital Association, the American Bar Association in law or the Modern Language Association when I pursued a master’s in Latin American Literature. However, I’ve also been affiliated with women’s and minority groups in those same professions starting in high school through the present day. I’ve developed professional networks that are different and deeper than a VC who hasn’t made such commitments to these communities. Investors without connections and familiarity with these networks may not see opportunities that I do. Also entrepreneurs give preferential access to investors who have closer ties and are committed to their communities.
Does Diversity Really Make us Smarter?
As noted in an updated 2014 Scientific American article, diversity empowers science and innovation and the ensuing technology powers economic prosperity. As an investor, I see how diversity can make us smarter because we are less likely to have blind spots when we are looking at a problem with multiple lenses. Different backgrounds and skill sets on a team make the members more likely to see opportunity. Also a more diverse team has a wider array of networks, and the amount of information they have related to a given problem in society or in the world of business that needs to be solved is deeper than if only affluent white men scope of a potential market opportunity,
Diversity Can Be Uncomfortable
Margaret O’Neil, a professor at the Graduate School of Business at Stanford, has written about diversity on boards. She explains that diversity may not generate a sense of “kumbaya” in an organization. Diversity can be uncomfortable and such feelings can be hard to overcome. People may not have the same level of ease in their relationships as they do with those who are more similar to themselves. Not having a shared framework can often lead to greater conflict. Instead of actively and consciously addressing uncomfortable feelings, many teams avoid the elephant in the room. This loss of comfort may be worthwhile because it can lead to more dynamic teams, greater emotional growth for individuals and better financial outcomes.
Seeing is believing
Experience working in diverse teams that outperform and function well drives change. Consider Google in its early years. When I joined the company in 2001, I was impressed by a team that included three women and 3 immigrant VPs out of a group of 13. Moreover, the first General Counsel hired was African American and the first CFO was Cuban American. The different life experiences these folks brought to the table made for a rich and dynamic approach to solving problems. I gained a lot of respect for how differences and even conflict can encourage teams to use critical thinking, prepare more thoroughly, seek to be more effective in their arguments, and lead to better judgement calls in the face of limited information.
At Ulu, we focus on sourcing through our networks and use data analysis to make our decisions. It helps reduce cognitive bias. In Fund II, 27% of the companies have a woman CEO and 8% have a LatinX or African American CEO as of June 30,2019. And over 80% of Ulu’s portfolio companies have a historically under-represented group (HUG) on the founding team.
4 Steps to Boost Diversity in VC World
Venture firms can take four steps to boost diversity in their own ranks and in their investments:
- Hire a diverse staff within the partnership itself, including people of color and women as investment partners. Their diverse networks will broaden the opportunities and connections of the firm. At Google, other law departments often asked how we created such a diverse team at Google Legal. That diversity was directly correlated with the first three hires in the team being minorities.
- Firms can also promote diversity in their networks by helping the advancement of minorities in the broader community. For example, Andreessen Horowitz has set up a program at Stanford University’s Rock Center for Corporate Governance to help women and minorities learn the skills needed to get their first board positions. Such efforts will produce a generation of board members that will be ambassadors for the VC firm, helping partners connect with diverse investment opportunities.
- Internships and fellowships can also boost diversity. True Ventures, for example, has set up its True Entrepreneur Corps, that brings college students from across America to the Bay Area for internships. The program embraces diversity, has gender parity and encourages applications from trans women, genderqueer, cis-gender and non-binary people.
- Finally, as a VC, you can exhort the companies you invest in take to diversity seriously and promote inclusiveness. Firms wondering where to start, could connect with Project Include, a non-profit promoting diversity in technology. Kapor Capital requires its portfolio firms to sign a “Founders’ Commitment” that sets diversity and inclusion goals and measures quarterly progress against those targets. As Kapor partner Freada Kapor Klein says, “it’s easier to set the right culture at a startup than to try to fix a lack of diversity in a firm employing thousands of people.”
At Ulu we believe that focused sourcing in underserved and underestimated markets will continue to drive superior returns for Ulu’s investors. Small steps to take…. towards what can ultimately be a big payoff.