The other day I came across Aileen Lee’s tweet about how the next tech giants will be cofounded by women and POC and that will change the world. I could not agree more and overall, I firmly believe that diversity improves performance in all of its aspects, and there is research to back up my statement (I will get back to that later).
Myself, I am an investment manager at Wave Ventures, a student-run VC fund in the Nordics. One of the things I am extremely proud of is that we are such a diverse investment team. Our team is equally gender-balanced and we have different educational backgrounds and varying interests. This has allowed us to see things from multiple perspectives and to always question and challenge each other's thinking. In the VC industry, being able to do so is incredibly valuable. With this in mind, I started thinking about the diversity of our dealflow and how we best can attract a diverse set of startups.
Let’s start with the basics of dealflow, why it is important, and then move on to how we can increase our odds of coming across the next startup unicorn.
Dealflow can mean slightly different things depending on the industry you are looking at M&A, Venture Capital (VC), or Private Equity for instance. In this post, I will limit myself to venture capital only. Nonetheless, dealflow can be defined as the stream of investment opportunities or pitches being received by a VC. In other words, it is a funnel for VCs to see and review startups.
Now you may ask: Where does dealflow come from. Well, there is not any specific set of guidelines or rules on how VCs get in contact with startups but some of the most common channels of deal flow are:
- Network referrals from other investors, entrepreneurs, lawyers, etc.
- Industry events
- Inbound email
- Any other way investors come in contact with startups
The former being what we call a warm introduction. You may have heard of warm introductions, the referral of a startup to an investor from a contact who is familiar to both. Evidence shows that warm introductions are damaging the diversity of who gets funded.
Founders without direct relationships are at a significant disadvantage. Keep this in mind, we will come back to it in a moment.
Why is dealflow important?
In his book Secrets of Sandhill Road, Scott Kupor, managing partner at Andreesen Horowitz states that “in VC, all we really care about is the bats per home run”.
As you might guess, these bats per home run (a return of more than ten times on VCs investment) are pretty rare.
Having a wide funnel will allow VCs to screen through more opportunities. However, where your dealflow comes from matters a lot for which opportunities you get to see as an investor. Naturally, you would like to diversify your dealflow to increase your odds of coming across the next big thing.
This comes down to one of the major problems in the industry: access to funding for startup founders is not equal. Let’s take a closer look at this.
Diversifying deal flow pipeline
You may also have heard arguments of there being a “pipeline problem”. Let’s make it clear: there is none. The pipeline problem argument is simply a lazy excuse for not investing in diverse founders.
These investors are missing out on a tremendous opportunity and that’s their loss. For example, there’s a trillion-dollar opportunity to invest in female entrepreneurs.
Now, let’s look at concrete actions you can take to diversify your dealflow pipeline.
The Network Effect
We already mentioned the warm introductions — investors’ strong desire for dealflow from their network. We also already saw that this is a disadvantage for diverse founders.
As an investor, you cannot have differentiated dealflow if you only use your existing sources. Certainly, there are positive signals in where a founder has previously worked, or which investor has invested, etc. however, this leads to systematic pattern-matching.
In VC pattern-matching is very much the expectation of a hoodie-wearing Harvard drop out (often also male and white) founder. This bias leads to a constant cycle of same kinds of investments, and the same kinds of founders being funded.
Also, VC is an industry built on risk-taking. So, if you are trying to mitigate risk by pattern-match investing in white male founders, you are actually decreasing your expected returns.
Research has shown over and over again that diverse founding teams perform better than homogeneous ones. For example, Kauffman Fellows found that: “Diverse founding and executive teams generate higher median realized multiples (RMs) on acquisitions and IPOs than all White founding and executive teams (3.3x to 2.5x and 3.3x to 2x respectively)”.
Existing networks may be blind spots for investors. Investors who have cleared up on their blind spots have a competitive advantage. To reach these founders requires actively connecting with people beyond one's immediate network.
Homophily is a real thing, we tend to interact with people similar to ourselves. Not only does this apply to investors' overall networks, but also to how internal recruitments happen at VC firms.
Diverse Investment Teams
So, who makes the investment decisions? Well, I will simply leave it at this statement from an HBR research: ”Only 8% of US investors are women. Racial minorities are also underrepresented — about 2% of VC investors are Hispanic, and fewer than 1% are black.”
Unfortunately, all too often a similar pattern of relying on your immediate contacts and people who are similar to you happens with internal recruitments at VC firms. However, as in the case with diverse founding teams, having diverse investment teams significantly improves VCs’ financial performance and overall fund returns.
I find this particularly interesting:
”To understand why homogeneous teams have worse investment outcomes, it’s critical to determine exactly when decision making suffers. Interestingly, projects selected by both homogeneous and diverse sets of investment partners were equally promising at the time the decision to invest was made. Differences in decision quality and performance came later, when the investors helped shape strategy, recruitment, and other efforts critical to a young company’s survival and growth. Thriving in a highly uncertain competitive environment requires creative thinking in those areas, and the diverse collaborators were better equipped to deliver it.”
We have long known that diverse teams outperform, McKinsey & Co already in 2015 found that:
- In the US, there is a linear relationship between racial and ethnic diversity and better financial performance: for every 10 percent increase in racial and ethnic diversity on the senior-executive team, earnings before interest and taxes (EBIT) rise 0.8 percent.
- In the UK, greater gender diversity on the senior-executive team corresponded to the highest performance uplift in the data set: for every 10 percent increase in gender diversity, EBIT rose by 3.5 percent.
The bottom line is that for a return maximizing investor, having a diverse investment team is the alpha and omega.
Online presence and reputation
One thing that you as an individual investor can do is to be present and visible in the startup community. Leverage your online and social media presence to be helpful for founders. Because founders will definitely look you up online. Similar to you as an investor doing due diligence on founders, founders will do their due diligence on you.
If you provide valuable resources and content online you are more likely to be contacted by founders. By being active on Twitter or having a blog are great ways to attract founders.
I recommend reading Mark Suster’s blog post “The Importance of Proprietary Deal Flow in Early-Stage VC”. He states:
”I eventually stumbled on to the best source of high-quality deal flow imaginable — blogging. The sheer number of relationships I’ve built through being public, transparent, and being willing to engage in comments and through social media has enabled me to get to know entrepreneurs even before they launch their next company.”
Lolita Taub is a good example of an investor who goes above and beyond to be helpful. She has created different tools for connecting investors and founders and brilliantly utilizes her Twitter account.
Something I think is evident but should be highlighted is that your content needs to be transparent, genuine, and authentic. If you are not willing to do the things you talk about, don’t write it in the first place. Be mindful of your reputation.
Ultimately what I want to say is that there is no change without action. Make sure you are not providing empty words because your words are only as powerful as the actions you take. Take the time to expand your network and meet with founders. Make the investments and make the hires.
With many of us working from home our world has become more connected and global than ever before. At this point, we are all used to virtual meetings. Hence, there are simply no excuses to not meet founders outside your bubble.
The conclusion is that not having a diverse dealflow may hold VCs back on having outperforming returns and the consequence is that the industry is not performing as well as it could. Let’s go change the world.
👩🏻💻 My name is Marianne Österlund. I am an Investment Manager at Wave Ventures. I wrote a blog post about what we as millennial investors are doing to increase the venture capital allocated to female founders.