Column: Diversity Riders Can Make the Investing Network Better in LA. Here's How Entrepreneurs Can Help.
Back in August of last year, L.A.-based Act One Ventures partner Alejandro (Alex) Guerrero launched the Diversity Rider, along with a number of other marquee venture capital firms, including First Round Capital, Maveron and Greycroft.
It's likely not a shock to anyone that barely 7% of VC investment partners nationally identify as African American or Latino, according to the National Venture Capital Association and less than 10% of VC-funded companies are led by women.
In L.A. County, where Black and Latino communities represent almost 60% of the population, the numbers aren't much better. Given the fact that distribution of investment dollars roughly reflects the composition of diversity among investment partners, money invested in Black and Brown founders in L.A. is vastly disproportionate. Put simply, VC partners and check writers in L.A. don't look anything like their customers or employees.
Introducing the rider in a recent dot.LA story, Act One's Alex Guerrero put it like this:
"You haven't gotten those chances, not because you don't work hard or you're not there, but because you don't come from those networks, you don't have that wealth, you don't have that privilege and that's what's hindering you and that's not your fault. Sometimes you just don't hit the birth lottery."
While COVID was raging across the country and America was exposed to the horrific killing of George Floyd, Guerrero was thinking about equitable access to opportunity in a new and creative way. Specifically, he was thinking about the opportunity to drive real wealth creation for communities that historically don't have access to the table. He was also thinking about how the venture capital-financed ecosystem needed another tool to drive diversity, equity and inclusion across the entire stack. In particular, the equity component needed real and material change.
How Diversity Riders Work
Guerrero is asking for VC firms leading a deal to add a provision to their term sheets requiring a certain amount of capital in a given financing round be allocated to diverse check writers.
To understand how that provision — called a Diversity Rider — works, you have to understand how venture capital deals work. (This is a simplification, so, finance experts, please bear with me.)
VCs tend to make investments in a given company as a group, but that group of investors is typically led by a single firm, which gets to set the "terms" of the deal in the form of a contract, called the "term sheet."
It is the term sheet that defines many of the critical requirements and conditions of a company's financing event. These documents include many of the most salient and substantive details of an investment deal, including liquidation preferences, voting rights, pro rata rights, board composition changes, right of first refusal and, most importantly (at least, for some), the valuation tied to the investment round.
Much like any contract, everything is subject to negotiation and a lot of creativity can be introduced. This is where riders come along.
Guerrero's initiative is somewhat revolutionary in its incremental nature in that it didn't call for an explicit percentage of a round to go to DCWs, but rather just that a rider should be included and the lead VC. It's sufficiently flexible to enable all sorts of implementation, meaning the Diversity Rider can over time be added to more and more term sheets until it becomes a norm. Ideally we quickly get to the point that the Diversity Rider is perfunctory to include, and noncontroversial — or even better, it's no longer needed at all as the industry has internalized its mission and it becomeis the norm. What a world!
What Is Founders' Role in Expanding the Diversity Rider?
Alex and his supporters have already partnered with at least 10 venture capital firms that are committed to using the rider in their term sheets.
I asked Alex what obligations or part to play he thought founders had in the Diversity Rider call to action.
"Not only are founders incredibly essential to the growth of the rider," he said, "in my opinion they will be the key driver determining how fast the entire industry moves towards normalizing the topic of having a diverse cap table. When you [the founder] see the rider language in a Term Sheet, you will instantly know by their actions that that [VC] cares about D&I where it matters most: at the equity level."
But there's more that can be done, specifically, by founders who want to see their profits, and the ecosystem, grow.
"No founder should be dependent on any VC firm to be the ones to proactively bring up the topic of having a diverse cap table," he said. "These are your companies, and it is your call as to who gets the ability to participate, whether the existing or new investors like it or not."
It is tantamount to success across many dimensions and across many stakeholders to drive a higher participation of diverse participants in cap tables, with allocation requirements baked into the term sheet.
"Hopefully your VC investors will be understanding and supportive," Guerrero added, "but if in today's world you bring this up and an investor balks at it, you might want to ask yourself if you want to be in business with that person or firm in general since you wouldn't be philosophically aligned on this crucial aspect of building your business. I know that this topic of conversation can be uncomfortable, but if we don't commit to having this conversation everywhere, for every round, all the time, nothing will truly change."
We, as founders and entrepreneurs, have the ability to influence terms and make possible the change we want to see. We have leverage as a class, so let's use it for doing good while doing well.
Fernish will be allocating a target of 10% of all future rounds to diverse check writers as our own implementation of the Rider. (Shout out to Finix for setting a great example here for the rest of us!)
We've also broadened our board of directors and kicked off an exploration of DEI training to raise our understanding of unconscious bias in the workplace. We also recently donated to the Fund for South LA Founders and my time as a mentor to the inaugural cohort of this fund.
Why the Rider Works for L.A. Investors, Founders and Communities
Whether you hold a traditional Milton Friedman view that a company's responsibility is solely to its shareholders or a more modern and thankfully broader interpretation of a company's role in society, it is indisputable that more diverse companies — across investors, board members, leadership teams, all the way down to line staff — will have better returns over time. An extensive McKinsey report proved this from multiple angles.
Additionally, VCs are looking for ways to de-risk any and all investments. The rider will drive predictably higher performance so it's inclusion is another edge on the path to venture success. All around, this means the Diversity Rider is a win-win for diverse investors and the rest of the cap table alike.
Even better, the common class stockholders—i.e. the founders and the rest of the employees—will also get to benefit from this better performance. That makes it a win-win-win!
Also important: diverse venture investors get the opportunity to create multi-fold returns, rather than incremental returns, on their investments. Assuming that the investor is comfortable with the risk of an earlier stage investment, and has the financial wherewithal to spread their capital across a decent mix of companies, a blended "Internal Rate of Return" (IRR) target would be 20-30%. Someone who invested in an S&P 500 index fund WHEN? has seen a "compound annual growth rate" of 7-10%. And assuming the investor "picks a winner", this can be multiple multiples on the initial investment.
Venture and private equity as an asset class — and the wide range of preferential tax treatments for investments in this category — is how generational wealth is created.
This is also how DCWs expand their financial footprint, creating a flywheel effect whereby they can invest further. That wealth can, in turn, be used to forward initiatives of various sorts in their "communities" — however that might be defined — that can lead to more opportunity, more founders, more investment.
Courtesy of Fernish