Diversity aspects in Venture Capital and Tech M&A transactions

Status quo, hidden potential and key figures

Diversity is no longer just a trend; it is becoming increasingly important, especially in the VC sector and in M&A transactions. More and more investors are making their investment decisions dependent on ESG (Environmental, Social, and Governance) criteria, meaning that diversity and inclusion performance are playing an increasingly important role in investment decisions. These criteria are increasingly often used to assess the sustainability and ethical impact of an investment in a company.

Many studies today show that diverse teams work more efficiently, profitably, and innovatively. As a result, according to a study by McKinsey & Company, companies with a high level of gender diversity are 25 % more likely to be more profitable than average. According to the same study companies with a high level of ethnic diversity are even 36 % more likely to be more profitable than average. Some numbers are slightly improving: A study by the Investors4Diversity initiative found that in 2020 half of the 30 most influential institutional investors in Germany had made a gender-balanced composition of management bodies a requirement for investments in a company. This figure had increased to 73 % by 2022. This approach of investors becomes more and more visible as time passes. The approach would ideally cover all aspects of diversity and not just gender. According to the fourth edition of Deloitte’s VC Human Capital Survey in 2022, 38 % of firms said they requested DEI (Diversity, Equity and Inclusion) details from their portfolio companies. Many clients also increasingly see and value the importance of having a diverse team of legal advisors and some even have respective requirements.

Diversity in Venture Capital and M&A

Venture capital firms have historically been criticised for their lack of diversity. Recent data as shown in articles like this one reveals that the majority of venture capitalists are still predominantly white. Gender diversity also remains a critical issue. According to the fourth edition of Deloitte’s VC Human Capital Survey, women constitute just 26 % of investment professionals, with 20 % serving as investment committee members and a mere 17 % owning management companies. This gender disparity is particularly concerning given the growing body of evidence suggesting that diverse teams are more likely to outperform their less diverse counterparts.

The M&A sector faces similar challenges. The leadership teams involved in M&A transactions are often homogenous, which can limit the range of perspectives and ideas brought to the table. This lack of diversity can have tangible impacts on deal outcomes, as diverse teams are better equipped to identify and mitigate risks, as well as to capitalise on opportunities.

Challenges

Several barriers hinder the progress of diversity in VC and M&A. These include:

• Unconscious Bias: Decision-makers may unknowingly favour candidates who resemble themselves, perpetuating a cycle of homogeneity.
• Network Homophily: The tendency for individuals to associate with others who are similar to them can limit the diversity of professional networks.
• Lack of Role Models: The scarcity of diverse leaders in senior positions can discourage underrepresented groups from pursuing careers in these fields.

Strategies

To address these challenges, firms can implement several strategies:

• Inclusive Recruitment Practices: Actively seeking out diverse candidates and implementing blind recruitment processes can help reduce bias.
• Mentorship and Sponsorship Programs: Establishing programs that support the development of underrepresented groups can help build a pipeline of diverse talent.
• Diversity Metrics and Accountability: Setting clear diversity goals and regularly measuring progress can ensure that firms remain committed to improving diversity. External audits like the Pride Index in Germany measure such criteria.

Diversity rider approach in the US

An initiative in the US, has come up with a fresh approach to promote diversity. Among other things, the Diversity Rider provides a so-called diversity rider clause which can be used in term sheets in connection with a planned financing round. This clause requires start-ups and their investors to seek various co-investors in their business – including diverse investors. The aim is to drive diversity efforts and increase the representation of underrepresented minority groups at the cap tables.

The diversity rider clause reads:

“In order to advance diversity efforts in the venture capital industry, the Company and the lead investor, [Fund Name], will make commercial best efforts to offer and make every attempt to include as a co-investor in the financing at least one Black \[or other underrepresented group including, but not limited to Latin, women, LGBTQ+] check writer (DCWs), and to allocate a minimum of \[X]% or \[X] %’s of the total round for such co-investor.”

By including a diversity rider like this the start-up can profit not only from the financial up sides of the investment but from the possibility to acquire know-how from different sides. This know-how can then be used to further strengthen the financial basis of the company.

A pledge to use the diversity rider also gives companies and investors exposure to new networks. This may be of high importance for underrepresented co-investors from the Black, LatinX, female, LGBTQ+ and disabled communities as they would become more visible. Initiatives like this – giving more access to underrepresented groups – would potentially allow them to reach vastly new audiences.

Beyond the term sheet

This clause reflects the intention of those involved to promote diversity in a special context. It can be combined with further diversity clauses which indicate the direction in which the company should be heading towards. Intentions like this are not set in stone because of the non-binding character of the term sheet. They do, however, define the basic conditions of an investment as the term sheet also serves as the basis for the legally binding documents to come. The positive impact of having a diverse cap table can be further cemented by diverse clauses in the definitive documents. Binding agreements can be made in the form of diversity covenants. These are often included in shareholders’ agreements and can stipulate that ESG/DEI criteria must be implemented within a certain period of time after the financing round documentation has been signed. If covenants are not followed through, this may have a negative impact on the further financing of the company and on its reputation.

ESG also plays a role in VC and M&A transactions. ESG due diligences are becoming increasingly common, in which the typical ESG risks of the industry and geographical region in which the target company operates are analysed. ESG aspects can be considered in determining the share price. Guarantees can be given in relation to ESG criteria. Investor and shareholder agreements can include ESG target clauses from investors in some cases by defining milestones – making a portion of the promised funds depending on certain DEI & ESG targets. Even severe consequences like withdrawal rights in the event of serious breaches can be included in the contracts.

Outlook

Diversity in VC and M&A is not just a moral imperative but a business necessity. By fostering inclusive environments and actively working to overcome barriers, firms can unlock the full potential of diverse teams. As the industry in Germany continues to evolve, embracing diversity will be crucial for driving innovation, enhancing decision-making, and achieving sustained success.

Each of Osborne Clarke's practice groups deals with the topic of diversity and ESG. At Osborne Clarke, we also have employee resource groups where the different aspects of diversity are tackled.