The Diversity Gap in Venture Capital Funding

If you knew that you could make one trillion dollars, would you ever say no? According to an October 2019 study published by Morgan Stanley, Venture Capitalists (VCs) underinvest or don’t invest at all in women and minority-owned businesses, missing out on a potential of one trillion dollars in profit

Venture capital (VC), put simply, is a form of financing that is used to fund small, early-stage firms that have huge potential for growth. They usually work with the company from the VC’s initial investment, to help it expand and grow and sell it through an acquisition or make it go public through an initial public offering or IPO. The potential for start-ups to go big incentivizes VCs to employ capital so they are hopefully able to generate colossal returns in the future.

But the issue with start-ups is that they’re risky. Very risky. The infamous statistic, 9 out of 10 start-ups fail holds up to the realities of venture capitalism. As a result, VCs become involved with promising firms that can generate 10x the return on their investment. Since VCs typically invest in multiple small businesses at once, if one of them succeeds massively, that can offset losses of other companies in the portfolio.

Despite the risk, VC funding can be critical for a start-up’s success and emergence in the mainstream business world. Think about Facebook, Google, Spotify, and Snapchat. All of these hopeful seed-stage firms immensely benefited from an injection of capital from venture capitalists. If you’re leading a small business, money can be immensely important for the company’s trajectory.

By failing to invest in minority and women-led businesses, VCs are impeding diverse firms from potential success, and they’re limiting the growth of their own bottom line. But why are VCs passing up the opportunity to change this? 

It’s important to first look at who comprises VC firms and therefore who decides where the money goes. A Morgan Stanley study found that a majority of venture capitalists are not women and are not from underrepresented communities. Only 29% of VC firms have a female partner, and black and Latino investment professionals only comprise 2% and 1%, respectively, of the VC industry. Those are crazy numbers, but they’re very telling of investment patterns amongst venture capitalists. It may also explain a part of the diversity funding gap in entrepreneurship. 

Expectedly, diverse VC firms tend to have more women and minority-led businesses in their portfolios. Of the 200 VCs surveyed, 71% of the VCs that have more diverse fund managers, Limited Partners, partners, or board members invest in more diverse entrepreneurs. But only 13% of white male VCs surveyed say that investing in multicultural founders is a priority for them and 33% when it comes to women business owners. When looking at investment priorities of diverse VCs, the numbers are vastly different. Women and nonwhite VCs surveyed are almost twice as likely as white male VCs to prioritize investing in multicultural founders.  It’s also frustrating that 60% of the VCs surveyed acknowledge that there aren’t enough women and minority-led businesses in their portfolio. And 83% of VCs also agree that investment strategies that invest in diverse businesses can still maximize returns. But are they investing in more diverse entrepreneurs? Not nearly enough. 60% of investors don’t believe it is a priority to invest in female and minority-led businesses. 

Generating high returns is also a non-issue when investing in diverse firms. In a 2018 study, Boston Consulting Group found that among 350 startups in Boston, women raised less than half as much as male entrepreneurs. But women earned 78 cents per dollar invested, whereas men only earned 31 cents. With less capital, women were able to generate higher returns. If diverse firms have a high potential for high return, why aren’t VCs investing in them? 

VCs often resort to issues of ‘fit’ for not choosing diverse founders. Morgan Stanley’s study also detailed the most common struggles faced by founders when approaching investors. Over half (57%) of founders surveyed reported that investors didn’t think their strategy aligned with the start-up. 51% of founders noted that “investors were not interested or excited by the market” for their business. It’s surprising that “fit” inhibited VCs from investing in diverse firms because their approach is to invest in new and emerging markets, riskier businesses and untapped potential. In this approach, VCs are leaving money on the table - one trillion dollars to be exact. 

There are investment firms that are focused on equipping diverse businesses, projects and funds to generate higher than market rate return. Glenmede’s Impact Investing program helps direct investors’ capital in alignment with their values. Whether it be prioritizing renewable energy, food sourcing, social justice, or faith-based investing, Glenmede offers solutions. Glenmede invests in companies whose core mandate of business is social impact and those that generate high returns. As a result, Glenmede often does not invest in early-stage, riskier start-ups. But City Light Capital is a VC firm that invests in early, impactful companies. The firm’s City Spark portfolio is focused on seed investment, providing capital to firms that are “earlier in their life, but every bit as focused on building category-defining companies that will reshape the world we live in.” Global asset management firms such as AllianceBernstein have funds focused on social impact. The AB Muni Impact fund recently invested in Temple University Hospital which would bring access to healthcare in some of the most impoverished parts of Philadelphia. 

Above are only a few examples of impact investing firms empowering women and minority-led businesses, as well as socially impactful firms that maximize returns as well. However, not all firms invest in small, early-stage startups, which is why venture capital is necessary in order to provide promising firms a chance to succeed. VCs need to tap into diverse entrepreneurs because they serve the needs and wants of growing consumer bases. In the US, women drive 83% of all consumption through their buying power and influence. Annually, African Americans spend nearly $1.2 trillion, and the buying power of Latinx consumers’ is estimated to reach $1.7 trillion next year. As a result of demographic forces and trends, it makes sense for VCs to mitigate the funding gap by ensuring aspiring innovators are empowered with capital to shape our future. 

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