Venture capitalists identify and finance the innovators who create our future. But there’s a problem with how some VCs are identifying the next big thing: They’re leaving out female and ethnically diverse entrepreneurs.
In doing so, VCs are leaving money on the table. By Morgan Stanley’s estimate, this funding gap is a trillion-dollar opportunity.
That’s why we surveyed almost 60 venture capitalists to find out why they aren’t investing more in diverse founders. What we discovered surprised me: The VC industry has yet to prioritize investing in women and multicultural startups despite acknowledging the opportunity that these companies present. Consider these findings:
VCs know diverse entrepreneurs are a good investment that they aren’t taking advantage of. An overwhelming majority (83%) told us they believe they can prioritize investments in companies led by women and multicultural entrepreneurs and maximize returns. A similar majority (60%) said their portfolios hold too few of these companies.
Yet, three in five VCs told us that prioritizing investments in women and multicultural entrepreneurs is not a firm-wide priority.
Even investors who say that they do prioritize investing in diverse entrepreneurs have outdated sourcing and vetting methods. They rely on connections within their existing networks, which don’t usually include female and multicultural founders, instead of using other avenues where they’re more likely to meet these entrepreneurs, like incubators, conferences and demo days.
VCs have a reputation for taking calculated “expansion risks” to invest in new and emerging markets — often with little precedent or data beyond their own due diligence. Of the VCs we surveyed, about 20% of the companies in their portfolios represent expansion risks. However, when they encounter companies founded by women and multicultural entrepreneurs, VCs are less likely to educate themselves or take the risk, especially when they’re unfamiliar with the market or product.
Still, most (88%) of the VCs we surveyed view the experiences of underrepresented entrepreneurs as a competitive advantage when it comes to identifying different problems that need to be solved. The companies these entrepreneurs create usually address a market inefficiency or need they’ve identified based on their personal experiences, making them the exact types of calculated expansion risks that VCs should be considering.
Taken together, the only conclusion I can draw from these findings is that VCs’ historical behaviors are holding them back. If they don’t start operating differently, they’ll continue to miss out.
At Morgan Stanley, we know that companies founded by women and multicultural entrepreneurs are a lucrative investment opportunity. For the past three years, we’ve been investing directly in startups led by diverse founders. It’s time for VCs to recognize this same opportunity.
Based on our research, I believe by subtly shifting their mindset, VCs can substantially increase their exposure to diverse entrepreneurs and put their money to work.
Limited partners, like pension plans, foundations, endowments and universities, can help make the shift. They can make investing with women and multicultural entrepreneurs a condition to investing with general partners. They can make sure that the VCs they invest in reflect their values without sacrificing returns.
We also discovered that VC firms with more women and multicultural fund managers, limited partners and boards are more likely to increase investments in diverse founders. This also makes them better positioned to recognize opportunities and identify pitfalls, which improves portfolio performance. I can’t think of a more compelling reason for firms to embrace increased diversity on both sides of the pitch table.
And let’s be clear: The benefits of this approach aren’t limited to VCs — improving diversity within our industry brings value to all of us. Attitudes aren’t always easy to change, but we have a responsibility to learn from each other on how to address this issue, because banks aren’t separate from society — we’re part of society.
Women and multicultural entrepreneurs represent new market opportunities as the demographic shift continues and markets that serve these communities are growing and outpacing others. It’s time VCs shift their investment perspective to take advantage of these opportunities and challenge industry norms, including their own.