When it comes to newsworthy stories about tech and startups, the majority of headlines and conversations focus on funding announcements, valuations and IPOs. And yet, only a mere fraction of startups actually raise venture capital. Coupled with the appalling funding disparities for women and people of color — who already face historical, systemic inequities — the lack of access to capital further marginalizes underrepresented founders from innovation, creation and wealth-building.
As such, we shouldn’t be asking about whether people are missing opportunities based on their identities; that much is obvious. The better question is how many and how big are the opportunities that they’re missing?
Here’s what we know:
- Investors put $156B into U.S.-based startups in 2020.
- Less than a fraction of 1 percent of startups actually acquire VC funding, yet it’s the most talked-about aspect of startups and is often glamorized as the key indicator of a successful business.
- Women of color are starting businesses at a faster rate than any other demographic, having opened 89 percent of new businesses in 2019. Despite this, Black and Latina women only accounted for 0.64 percent of venture capital funding in 2018 and 2019.
Opportunity for Innovation
Through Grid110, the Los Angeles-based startup and small business accelerator I co-founded in 2015, I’ve worked with over 300 entrepreneurs, the majority of whom are women and people of color. They’re building businesses ranging from side hustles to profitable, bootstrapped companies to high-growth ventures. I’ve seen firsthand that VC is absolutely not a one-size-fits-all model.
VC is often likened to jet fuel for high-growth companies, but most companies cannot sustain that type of acceleration. In fact, it’s likely to be more detrimental to them than helpful. After all, you wouldn’t fill up the gas tank of a Volvo with jet fuel.
At Grid110, my team and I first work to understand the type of company an entrepreneur is building and then educate them on the funding pathways that make the most sense for them. Unfortunately, few viable funding instruments exist for entrepreneurs at the earliest stages of building their businesses. Therein lies an opportunity to create innovative funding models that occupy the space between traditional bank loans and VC. Yet the tech industry continues to rely primarily on a single model for advancing innovation. This narrow focus results in a bottleneck that disproportionately affects those who are already underrepresented in the tech economy.
There is a huge white space opportunity to fund the 99.95 percent of companies deemed not suitable (or that are perhaps overlooked) for venture capital. Companies led by underrepresented founders who are able to do more with less, stretch their resources and close economic opportunity gaps are particularly good places for this kind of investment.
Where do we start? With the limited partners (LPs). Institutional LPs (things like pension funds, endowments, foundations and corporations) invest in venture capital funds and are primarily focused on generating returns on their investments. So, why aren’t they prioritizing investing in diverse teams that routinely outperform their all-white, male counterparts? And what needs to change in order to see more innovation in the venture capital ecosystem?
Adjust Funding Models to Close the Gap
The first step toward fixing things is for investors to diversify the founders they choose to fund. It’s simply smart business. Women and ethnically diverse founding teams are outperforming their all-white, male peers, but they’re still the least likely to raise funding. According to a recent industry report by All Raise and Pitchbook, women CEOs have exited companies faster than their male counterparts in nine of the last 10 years.
If a fund’s focus is on the returns, why the stark contrast in funding? Studies released by First Round Capital, McKinsey and Kauffman Fellows support the claim that investing in diverse founders yields better economic returns. So, from an economic standpoint, anyone looking to invest in a company would be well-served to choose one with a diverse founding team.
This disparity also raises the question of why investors aren’t more interested in funding these companies. To truly effect change on a large scale, we need to diversify the funders. Investment decision makers are 72 percent white men, so it shouldn’t be a surprise that the majority of startups that receive funding are led by also white men. The current funders tend to invest within their similar networks and pedigrees, leading to a vicious cycle in the investment space.
By contrast, diverse funders will fund diverse founders. Organizations like BLCK VC, HBCUvc, VC Include and All Raise are working to change the demographics and diversify the career paths into venture capital from various levels. How can we support the expansion and growth of these and other, similar organizations to create more non-traditional pathways into VC, knowing that doing so will be the best way to impact the industry as a whole?
LPs should prioritize this type of diversification from their current funds and continue to seek out to support diverse emerging fund managers who will change the landscape for the better.
Developing New Models
You might conclude that venture capital is not meant for 99 percent of businesses. It is most suitable for a specific type of business that has the ability to accelerate growth in a very short period of time, resulting in an exit (either by IPO or acquisition) in order to provide investment returns back to the fund. Finding these companies is essentially a venture capitalist’s job: They want to invest their LPs’ money in places that will result in outsized returns.
But most businesses are not built to sustain this type of growth in the target time frame. And even worse, most venture-backed businesses won’t even achieve the outsized returns expected of them, and 75 percent will fail altogether. For an industry that invests billions of dollars annually with these results, the fact that there has been so little exploration of alternative models in this space is really surprising. We need to revolutionize outdated models and structures to keep up with emerging opportunities in the market.
Some people in the VC world have made efforts to establish alternative models of capital. Examples include revenue-based financing (Lighter Capital), rewards-based crowdfunding (Kickstarter, Indiegogo) or equity-based crowd investing (Republic, WeFunder, Start Engine). But some of these have fallen short of LP expectations.
For example, after investing in companies for six years through what began as an experimental funding strategy, IndieVC recently announced it would no longer be investing in companies through its innovative funding model. Indie preferred real businesses focused on sustainable growth and profitability. Although its portfolio showed returns on par with more traditional investments, it faced increasing difficulty in getting LPs to commit to this model. Still, IndieVC and its GP Bryce Roberts have proven to be a pioneer in this space, igniting the conversation and paving the way for alternative funding models like Earnest Capital, Chisos Capital and Collab Capital.
There seems to be a shared sentiment that the industry can’t change unless institutional LPs actively change it. If LPs feel both that diversity matters and that returns benefit from it, then more of them should be mandating it from their funds or investing in funds intentionally focused on diversifying the industry through economic inclusion like Backstage Capital, Harlem Capital, BBG Ventures, MaC Venture Capital and Slauson & Co. These are a handful of examples of what’s possible, but there should be more. This type of focus on diversity should be the standard.
Changing the LPs
After all, the golden rule says that those who have the gold make the rules. LPs can be the biggest drivers of change, but they seem to be averse to changing their own habits. But perhaps there’s another way to look at it: Instead of changing what the LPs believe, how do we change who the LPs are?
In just a few short years, equity crowd investing platforms have shown that there’s an appetite among everyday people to become retail investors. In 2016, the SEC made changes that enabled non-accredited investors to invest money into companies through platforms like Republic and WeFunder.
The most recent batch of changes increased the limits of how much companies could raise through these types of campaigns. Backstage Capital raised $5M (the new limit) in just seven days to support the operating arm of their fund. So, what would need to happen for the SEC to allow retail investors to invest in actual funds through these same platforms?
Paige Finn Doherty wrote a brilliant piece entitled “The Essential Guide to Syndicates” that outlines how anyone (even a non-accredited investor) can organize a special purpose vehicle or syndicate for other investors (e.g., angels, VCs or even traditional LPs) to invest directly into a pop-up fund for a company. Similar to equity crowd investing, this path is another way to democratize access to capital for founders that also creates new opportunities for funders. Rather than having to raise a traditional venture capital fund, an organizer can rally support for one-off investments in companies using a platform like Assure, which handles all of the back-end fund administration. The good news is that, in this model, the organizer doesn’t have to be accredited themselves or have the track record needed to raise a traditional fund.
A Better Landscape Starts Here
VC is largely focused on growth at all costs, but it continues to shy away from growth opportunities for itself. The sector has largely eschewed innovation in its own niche by overlooking new funding models that could benefit both those companies that are already in the market and those trying to enter. Changing this structure will allow for greater diversity in the economy as a whole and will prepare VC firms to capitalize on a changing marketplace.
Although we have quite a long way to go in changing the equity in funding gap, there are emerging, innovative opportunities (if able to scale) that could bring about meaningful change to the industry. We need more education, accountability and amplification/attention to the voices on the ground that are closest to the problem at hand.