It’s no secret that the world of venture capital is lacking diversity. Both in representation on the investor side and the business founders they back. This is not only bad for the world, it’s simply bad business.
Any good portfolio manager will tell you that diversification is key — hedging your bets across a diverse range of investments is critical to achieving alpha. The same principle applies to the world of venture capital – the more inclusive the investments, the better the performance of the portfolio overall.
My firm, Quake Capital, serves as one example of this phenomenon. Of the 90 companies we’ve invested in, zero have failed. And we credit that to portfolio diversity: of all our investments, 30 percent have female founders, 20 percent are minority led and 13 percent are international investments. We’re not alone. The data consistently show that diversified teams are the most successful.
A Harvard Business Review study found that venture capital firms that increased their proportion of female partner hires by 10 percent saw, on average, a 1.5 percent spike in overall fund returns each year and had 9.7 percent more profitable exits. That’s an impressive figure given that only 28.8 percent of all VC investments have a profitable exit, according to the study. This is fondly referred to as “the daughter effect” because of a phenomenon in which firms whose executives are parents of more daughters than sons are more likely to hire women.
A number of firms have come onto the scene focused specifically on one, or several, underserved communities. Backstage Capital is one example of a VC firm making a dent in the huge and appalling disparity between men and females and minorities founders. But even firms without such a focus can, and should, achieve diversity simply because it’s a smart business decision.
Data continually show that VC investment is hyper-concentrated across a variety of factors: sex; ethnicity; race; and location. The need for inclusion is abundantly clear. For a portfolio encompassing early stage startups, the importance of diversity spans beyond a difference in “asset class.” Teams and the overall portfolio should be a microcosm of the markets they serve.
A VC firm’s investments should mirror spending discretion, changing demographics and the ethnic makeup of our world. By the year 2020, minorities will be the majority in the U.S. Women hold 50 percent of personal wealth and make 73 percent of all consumer purchasing decisions. These are huge audiences, with massive purchasing power that remain vastly underserved.
If you’re not investing in businesses that serve these markets, you’re missing out on a huge potential upside. The $120 million IPO of Stitch Fix is a great example, both in backing female-focused companies and female founders. CEO and founder Katrina Lake grew the company to a $1.5 billion valuation and its successful market debut.
A number of the female founded and African American-led companies are solving real problems for their respective markets. Their perspectives, and intimate understanding of specific challenges, has birthed phenomenal ideas and stellar businesses. Aligning with the vastly changing market and landscape is not only smart investing, its inherently diverse.
Metrics as an equalizer
Colleges ask all applicants for the same quantifiers for one simple reason: they are consistent metrics by which to evaluate a candidate. The investment process should be similar in nature. While certainly not foolproof, there are measurements that hold more weight than others. For colleges, it’s a student’s SAT/ACT score and GPA. For investors, it’s monthly recurring revenue, market potential or year-over-year growth.
These metrics should be the pillar of any due diligence process. It is not only the most important criteria by which to assess a company, it provides a universal measurement for equal evaluation. It is when these metrics become secondary to other factors – like who you know or what you believe – that unconscious bias creeps in. When a review process is driven by standard, across-the-board metrics, a level playing ground is established. That way any gut-driven investments (that are sometimes masked in biases) can be matched with quantifiable metrics, which ultimately mitigates risk.
A diverse DNA
DNA, by definition, provides instructions that an organism needs to regulate, function and grow. When diversity is part of a firm’s DNA, it is integrated in all areas of operation. It is not a box that is checked. Diversity is something to be constantly conscious of and consistently strived for. This does not have to manifest itself into a minority-focused portfolio. If its integrated into the DNA, it is simply a reflection of the desire to invest in the best companies.
Whatever the execution route, the value remains steadfast: inclusion is good for business. As we move into the new year, I challenge more VCs to embrace this proven process, and let diversity be a driving value for investments. After all, the portfolios with the most diversity are the ones best positioned to succeed.