by Phil Neuffer

The venture capital space has historically shut out founders from ethnically and gender diverse backgrounds, and with a looming recession, things could get even worse. What needs to be done to improve equitable capital allocation in this critical part of the economy and how can venture debt play a role?

Erika Brodnock founded her first company in 2012 when she launched Karisma Kidz, an educational software development firm. As the company grew and Brodnock sought financing to support its growth, she found it nearly impossible to raise funds in the venture capital space.

Unfortunately, for Black women like Brodnock, as well as other ethnically and/or gender diverse founders, such an experience is far too often the norm rather than the exception. According to a November VentureBeat report citing data from Diversity VC, a nonprofit promoting diversity in venture capital, fewer than 2% of venture capital funds in the United States are allocated to companies led by diverse owners.

“It took a while for it all to dawn on me that I was actually the main problem because despite having a company with traction, I just wasn’t able to raise any money.” Brodnock, who has gone on to found multiple companies, including Extend Ventures, which focuses on reducing bias in venture capital, and Kinhub, an employee well-being and support provider, says.

“We had published the diversity in U.S. startups data twice; the numbers had not moved from 2018 to 2021,” Sarah Millar, chief operating officer for Diversity VC, says. “The fact that not that much money had gone to underrepresented founders was frankly unbelievable.”

Barriers to Entry

As the venture capital market continues to deal with the upheaval of a pending recession and elevated interest rates, the minuscule slice of the pie reserved for diverse founders could decline even more. In the United States, there was a more than 40% drop in venture capital funding in 2022, according to GlobalData, while CrunchBase reported that venture capital funding fell by $90 billion in Q3/22 alone. With such negative trends in the marketplace, venture capitalists may tighten their purse strings, which will likely have a chilling effect on a part of the population already receiving less than its fair share of funding.

“I actually think a looming recession is a huge risk and a big negative that could really slow down the uptake of funding for diverse and underrepresented founders,” Zack Ellison,CFA, CAIA, managing general partner and chief investment officer of Applied Real Intelligence. a venture debt investment manager based in Southern California, says. “To be blunt. I think we’re going to see a lot less focus on DE&I in the next couple years.”

Ellison also expects that many venture capital funds will return to the patterns that have worked in the past, but that’s not an entirely new phenomenon, as a major reason for the egregious disparity in funding for diverse founders comes down to a historical cycle of gate-keeping and structural barriers. Brodnock, who, in addition to being a serial entrepreneur, is a PhD candidate and research officer at the London School of Economics, has studied this topic extensively and recently co-authored a book on the subject.

“Historically, over the years, the same people have been exploited by capitalism and then completely locked out of opportunities to create the intergenerational wealth that is possible through entrepreneurship and venture capital,” Brodnock says, noting that venture capital has roots in the transatlantic slave trade.

In today’s world, according to Ellison, venture capital tends to be very regional, so with the innovation economy mainly centered in the San Francisco Bay Area and some other major cities like Boston, New York and Los Angeles, there is a creation of literal physical barriers.

“If you’re in San Francisco and you’re evaluating 10 companies, none of which have revenue but eight of which you can go down the street and meet with every single week, and two of which are in Florida, why would you go to Florida and take that risk?” Ellison says.

While geographic hurdles are certainly an obstruction, there may be no greater structural impediment to venture capital than exclusionary networking practices or what Ellison calls “informational asymmetries,” which restrict the flow of information.

“Some people are part of a network that naturally makes it much easier to get funded,” Ellison says. “You’re probably going to gravitate as a VC toward companies that other investors in your network have already invested in or have introduced you to.”

“Venture capital is currently controlled by a small subset of individuals, and those individuals don’t really look outside of their networks in order to provide opportunity,” Brodnock says. “‘Talent is equal, opportunity is not.’ Never a truer phrase has been said.”

Flawed Assumptions

Class and socioeconomic standing can be defining factors in being able to break into the networking circles that influence funding decisions, according to Brodnock, who says oftentimes, when a diverse founder is able to succeed, they usually attended an elite university or have some other form of privilege in their background.

The problems run deeper than class, however, permeating interpersonal relations and even

language. For example, Brodnock argues that using terms like “minority-owned” or “underrepresented group” can have an opposite and detrimental effect to their presumed intentions. Instead, Brodnock recommends being as specific as possible and using terms like ethnically diverse founders, Black-led startups, woman-owned companies, etc.

“As long as we assume that people are less than, or that their market sizes are smaller or they’re smaller, or that they’re in any way a risk, we will continue to make the same decisions,” Brodnock says.

Compounding the potential negative effects of unintentional harmful language are the “flawed assumptions” funds can make based on how much capital a founder has or is willing to commit, according to Millar, as well as what Brodnock calls the “presumption of deficiency.”

“People are surprised if I’m articulate or if I say to them that I run a tech company,” Brodnock says, adding that this supposition forces her to overcompensate to prove she belongs. Making matters worse, when diverse founders are able to raise money, which already carries a steep difficulty curve, they often receive less money than their white male counterparts. “They’re expected to be excellent and to do more with less. Having to be excellent all the time is exhausting, and no one else has to do it.”

Catching the Train

Unfortunately, many of the same unconscious biases limiting funding for diverse founders often dictates how these problems are addressed, according to Brodnock, who says the onus to change is frequently put on the founders who are being excluded rather than on the funds and the systems doing the excluding.

“I think that the approach that we’ve taken up until this point isn’t working. If we were doing anything else and that was the case, we would stop doing it and try a different approach,” Brodnock says. “With this, we just keep doing more of the same. And I think that there’s something quite telling in that.”

By failing to address the root of the problem, the venture capital funds are harming the prospects for diverse founders as well as their own bottom lines and society as a whole. According to Millar, companies started by ethnically diverse founders “have been demonstrably shown to outperform” non-diverse companies. In addition, with much of its funding fueling the technology startup industry and innovation economy, the venture capital space has an oversized impact on what life will look like down the road.

“People that create technology, particularly in this time, are creating the future,” Brodnock says. “I think that it’s important that that future is continually created by everyone that has to partake in it, because otherwise, the future will only be for the few.”

It’s not as if there hasn’t been opportunity to reverse these trends either. Despite more than a decade of a bull market and gallons of ink being spilled about DE&I initiatives across many industries, not just in venture capital, by continuing to provide incremental steps rather than giant leaps, wealth generation will continue to be siloed off.

“There will be no catching up. The train will have left the station,” Ellison says.

Send Wires, Make Hires

To eliminate some of the most remedial steps to improving DE&I in general, firms need to stop calling for data to assess the problem and pigeonholing diversity as purely being about hiring.

“We don’t need to know how bad the data is to know that the data’s bad,” Brodnock says. “Let’s look toward fixing the problem, rather than calling for endless pieces of data to verify a problem that we already know exists.”

While hiring a more diverse group of people is important, funds need to take things much further. As Brodnock explains, in the world of venture capital, where close-knit personal networks often control the flow of funding, helping diverse founders make connections through “warm introductions” is critical.

“Introduce them to venture capital funds in a way that lets the fund know that, actually, this is a diverse candidate that you could hire in your fund,” Brodnock says. “If we stop providing mentoring programs and we start to encourage people to be allies and to sponsor people from diverse backgrounds so that they have a vested interest in their success in the same way that they would if this was their friend’s [child], that would be a strong way of starting to solve the problem.”

Brodnock also suggests blind CV recruiting and blind pitch decks as “fantastic ways” to start allocating capital more equitably. In addition, Brodnock believes limited partners should take a more active fiduciary role by encouraging general partners to make investments more fairly, while Millar suggests implementing a mandate to invest in diverse founders. Ultimately, of course, the most impactful step any fund can take is cutting checks to diverse founders. As Brodnock says, “let’s start to send wires and makes hires.”

“People can talk all they want, but until you write a check, you’re not really moving the needle as much as you could,” Ellison says, noting that it’s important to do so far before a company is ready for a Series B or C round. “What happens in the early rounds basically defines the opportunity set for later rounds.”

Venture Debt’s Role

Early-stage founders don’t necessarily have to wait for the venture capital world to open up on its own, as universities, angel investing networks, family offices, industry associations, service providers and other startup founders can also help provide the education and introductions needed to get in front of funding providers. In addition, there are various other forms of financing, such as grants and revenue- based financing, but Brodnock wonders whether this approach simply moves the buck from venture capitalists and back to the founders who are on the other side of the equation.

The venture debt industry can also play a role in producing more diverse and equitably funding allocation in the venture capital space. While venture debt funds require a company to be generating revenue to lend, it is in their best interest to support early-stage founders in order to provide financing down the road.

“A big part of what we’re doing is trying to create more access at the earlier stages so that the funnel is much bigger and we have more opportunities to get involved later,” Ellison says. explaining that A.R.I. focuses on two “pillars” when working with early-stage founders: education and connection. On the education front, venture debt funds like A.R.I. can provide guidance to founders on how and when to raise capital, what to expect throughout the process and how to plan for each funding round so they are in the best position to eventually access cheaper and more expedient forms of funding, such as venture debt.

“It’s important to start early on any business initiative, but with venture debt, it’s very important,” Ellison says.

Although education is a key step, as noted earlier, facilitating connections is even more vital for increasing funding access for diverse founders, and the venture debt community is positioned to help make those introductions, particularly if they can coordinate with venture capital partners. This will help founders, venture capital funds and venture debt firms alike.

“If everybody’s not rowing in the same direction, we’re not going to get there either,” Ellison says. “I know there’s a huge percentage of the population that’s champing at the bit to go succeed. They just need a shot and they’ll do the rest.”

“I think that if diverse founders are afforded equal opportunities to access the capital, connections and contracts they need to get their business off the ground, that will level the playing field,” Brodnock says. •