Venture Capital Needs to Diversify for Greater Returns
There is an area of improvement in one of the world’s most prestigious and impactful industries: venture capital. That area is diversity. Diversity in a workplace is defined as having people from different backgrounds: gender, ethnicity, orientation, age and nationality. However, research from several recent studies shows that the global VCs are underperforming on the metric of diversity.
According to a report by the Information, 92% percent of the senior investment teams at top-tier venture capital firms are male and 78% are white. These results are way worse than the diversity breakdown at major tech companies, where 23% of leadership teams are female. 42% of senior investment team members are over the age of 46. In terms of ethnic diversity, a recent study of 200 venture capital firms found that fewer than 2% of senior investing professionals are black.
Diversity matters in investing because it offers different viewpoints which leads to better decision making and it is also correlated with better performance. For example, if we look at funding decisions around consumer products, investor diversity mirroring customer diversity helps investors better understand use cases and the potential traction a product might have with different demographics.
It is a well-documented phenomena across the business and social world that we gravitate towards and tend to have higher levels of trust in people we view ourselves as similar to. Homogeneity in VCs can and often does lead to homogeneity in founders that successfully get funding. Given the predominance of male leadership among many VCs it is unsurprising that only 2.7% of venture capital-backed companies have a female CEO. According to a paper by HBS Professor Paul Gomers, investors also tend to choose partner investors at other firms who come from similar backgrounds and this hurts financial returns in the long term.
Research has shown that performance of VC firms is a team effort rather than individual game. It’s more like cricket rather than chess. Therefore, it makes business sense to create a diverse employee pool at VC firms.
If more diversity leads to better informed and thus improved financial decisions for VCs then how should it be improved? VC firms are very small (typically less than 10 employees) and do not have structured recruiting processes or HR departments to take into account diversity. Hiring happens serendipitously and through personal networks which in tech are often male dominated.
Some ways to increase the diversity could be to have a dedicated number of spots for people from different ethnic background, gender, and orientation etc. that mirrors the consumers of the products in those regions.
As many VCs prize successful start-up founder experience when hiring, the solution and problem are intertwined. How can we create an environment where there are more female and minority entrepreneurs? There are some promising signs with funds dedicated to female founders and minority entrepreneurs, and VCs pledging to advance inclusion.
VCs can also explore bringing in talent laterally from adjacent industries which offer relevant skills and have higher diversity comparatively. Another idea might be to include more consultant/ non full time hires to encourage flexible schedules.
As business schools are increasing their student diversity, VCs also have a greater funnel to choose from now compared the last few decades. A more long term strategy is to encourage girls and other underrepresented groups into STEM from the school level.
In summary, if we want VCs to have a profound impact on the world by funding the great ideas of future and not invest in a predictable fashion i.e ‘hot sectors’, they need to gradually transform themselves into a more diverse community representative of their market. If they do not, then there is a severe risk of missing out on some great companies that could make a huge difference to our way of life.