Diversifying startups and VC power corridors

Jennifer Fan is an assistant professor of law and director of the Entrepreneurial Law Clinic at the University of Washington School of Law.

Startups have a seemingly intractable problem: a lack of diversity. Despite research showing that diverse founding teams have a higher rate of return than white founding teams, one characteristic of startups remains relatively unchanged: the dearth of BIPOC and women founders, investors, board members, and counsel in the venture capital (VC) ecosystem.

Why should we care? Venture capital has provided early funding for the most innovative and profitable companies of our time — Apple, Amazon, Google (now Alphabet), just to name a few. These companies have changed the way we live, work and play by impacting how we communicate, how we process information, and how we buy goods. With approximately one-quarter of U.S. professionals employed by the high-tech sector — comprising about 5% to 6% of the total workforce, according to the U.S. Equal Employment Opportunity Commission — imagine how much more innovation could happen with more diverse individuals at the table who bring different life experiences and perspectives. And we’re already seeing states enacting laws, and companies changing their practices, to help make this happen in the public company realm.

Many founders of VC-backed startups are white, male, and Ivy League or internationally educated. Women-founded companies receive a fraction of VC investments compared to all-male founded companies. In 2020, women-led startups received only 2.3% of all VC money. As of June 2021, less than 20% of total VC deals went to a startup with at least one female founder.

When looking at BIPOC representation in the VC ecosystem, the numbers are even more abysmal. Three percent of VC investors are Black and 1.7% of VC-backed startups have a Black founder. The number of Latinx founders in VC-backed startups is even lower — 1.3%. Plus, only 2.4% of funding was allocated to Black and Latinx founders from 2015 to August 2020. And, on the startup boards of high tech companies, women hold a mere 8% of the board seats.

But the lack of diversity extends beyond who gets funding or who is in the boardroom; it is also a problem in the executive suite. In California, Asian Americans were among the least likely to be promoted to manager or executive positions, and less than 2% of high-tech executives are Black.

This lack of diversity in the VC ecosystem is a structural problem that has no easy solution. While some VC firms have begun allocating funds for trainings and mentorship programs, additional steps need to be taken.

For example, laws on board diversity have already passed in a few states, but they apply only to public companies and typically focus on gender diversity. The laws generally fall into one of three categories — they mandate, encourage, or require disclosure of board diversity. In 2018, California led the way with SB 826, California’s board gender diversity law, which required public companies headquartered in California (irrespective of where they were incorporated) to have a minimum of one woman on each of their boards by the end of 2019. By the end of this year, the minimum threshold increases to two if the board has five directors and three if it has six or more directors. (In the statute, female is defined as “an individual who self-identifies her gender as a woman, without regard to the individual’s designated sex at birth.”)

The law has already had an impact: between 2018 and March 2021, the number of board seats held by women in such companies increased by a whopping 93.6%, but the law is currently being challenged in the courts.

While legislation regarding gender diversity on public company boards has been passed in certain states, even fewer laws address the issue of the lack of minorities on boards. Only 12.5% of the board members of the 3,000 largest public companies come from underrepresented ethnic and racial groups despite the fact that these groups comprise 40% of the U.S. population. Deloitte and the Alliance for Board Diversity reported data that Fortune 500 board seats were held by individuals identified as African American/Black, Hispanic/Latino(a), and Asian/Pacific Islander at the rates of 8.7%, 4.1%, and 4.6%, respectively, in 2020.

In order to address this underrepresentation, California’s AB 979 requires that a public company headquartered in California has at least one director from an “underrepresented community” by the end of 2021, with the minimum number increasing by the end of 2022. That definition includes someone who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian or Alaska Native, or who self-identifies as gay, lesbian, bisexual, or transgender.

In addition to California, Colorado, Illinois, Maryland, New York, Pennsylvania, and Washington have also enacted some type of board diversity measure. Connecticut, Hawaii, Massachusetts, Michigan, New Jersey, Oregon, and Ohio have proposed legislation, too.

Non-governmental initiatives are also being considered. As an example, NASDAQ proposed new listing standards to the SEC requiring disclosure of board diversity. Goldman Sachs announced that it would manage initial public offerings only for companies with at least one diverse board member.

These kinds of laws, however, may be difficult to implement in startups. In order to change the narrative on diversity in startups, change cannot be limited to the board but rather should have a multi-pronged approach focused on diversifying (1) employees in middle and executive management, (2) directors in the boardroom, and (3) the VC firms and other funders.

With startups, board diversity mandates similar to the one passed in California would likely not work in the early stages given the size of these boards. However, creating a culture where diversity is prioritized can manifest itself in other ways.

For example, limited partners who invest in VC funds could contractually obligate their general partners to consider diverse candidates for their firms as well as the board and management of any portfolio companies. VCs can also continue to diversify the limited partners that invest in their funds by eschewing their immediate networks and more actively reaching out to groups historically underrepresented in the startup ecosystem, such as HBCUs. In fact, some VCs are using diversity riders in term sheets to do just that. VCs also need to take a hard look at what type of questions they ask their BIPOC and female founders and consider how they may differ in ways that are detrimental to those historically underrepresented in startups.

We are missing opportunities to foster further innovation by not taking more concrete action to add diversity to the startup ecosystem. There is no magic bullet to address the lack of diversity in the startup ecosystem. However, there are steps that founders, VCs, and limited partners can take to make strides in the right direction.