California’s New Law to Increase Transparency of Founder Diversity in Investments by Venture Capital Companies

On October 8, 2023, California Governor Gavin Newsom signed into law a bill intended to provide transparency with respect to venture capital investments. The new law, titled Fair Investment Practices by Investment Advisers (“SB 54”), is the first transparency measure of its kind in the U.S., and, according to its proponents, is an attempt to address the lack of diversity and equitable distribution of funding for venture capital (“VC”)-backed companies, particularly startups owned by women and minorities. By its terms, the law covers much more than traditional venture capital funds and could implicate traditional private equity and other investment vehicles as well. Noting Governor Newsom’s signing message that the law “contains problematic provisions and unrealistic timelines” that he will propose to address as part of the 2024-2025 Governor’s Budget, this alert seeks to answer some of the key questions regarding SB 54 as enacted that we believe will be of particular interest to our clients.

Effective Date

• When does SB 54 go into effect? Commencing March 1, 2025, and annually thereafter, SB 54 requires a “covered entity” (see below) to report to the California Civil Rights Department (“CRD”) specified information about the founding teams of all businesses in which the covered entity made a VC investment in the prior calendar year and certain other investment information, subject to requirements discussed below. Accordingly, covered entities must attempt to collect the required information with respect to in-scope companies in which they make investments from January 1, 2024.

Covered Parties

• What is a “covered entity”? The law applies to (a) “venture capital companies” (“VCCs”) that (b) meet two criteria. As a threshold matter, a VCC means one or more of (i) an entity that has, on at least one occasion during the annual period commencing with the date of its initial capitalization, and on at least one occasion during each annual period thereafter, at least 50% of its assets comprising VC investments (the “50% Threshold”), (ii) a “venture capital fund” as defined under the Investment Advisers Act of 1940 or (iii) a “venture capital operating company” as defined under the Employee Retirement Income Security Act of 1974.

  To fall under the law, a VCC must meet two criteria. First, the VCC must (i) primarily engage in the business of investing in, or providing financing to, startup, early-stage, or emerging growth companies or (ii) manage assets on behalf of third-party investors. Second, the VCC must meet any of the following criteria: (w) be headquartered in California, (x) have a significant presence or operational office in California,¹ (y) make VC investments in businesses that are located in, or have significant operations in, California or (z) solicit or receive investments from a person who is a resident of California.

• What is a “VC investment”? A “VC investment” for purposes of SB 54 means an acquisition of securities in an operating company as to which the investment adviser, the entity advised by the investment adviser or its affiliates obtain “management rights,” or the right, either individually or as part of a group, to substantially participate in, to substantially influence the conduct of, or to provide (or to offer to provide) significant guidance and counsel concerning, the management, operations or business objectives of the operating company in which the venture capital investment is made. As discussed below, references to “investment adviser” in SB 54, and those (as here) pulled in by reference to existing California code, are somewhat awkward, but will likely be read by CRD in this context to mean the covered entity and its related management company. 

• Covered entities can be more than traditional “venture capital funds” Due to the breadth of its drafting, SB 54 captures more than traditional “venture capital funds” as covered entities. For example, given the breadth of the VC investment definition set forth above – a definition that picks up more than traditional “venture capital” investments – it appears that private equity funds and other investment vehicles that manage assets on behalf of third-party investors would be “covered entities” if they meet the 50% Threshold and have the requisite California nexus, regardless of whether they hold any traditional venture capital investments in their portfolios. This result goes far beyond the stated intent of the SB 54 authors and is of potential relevance to non-traditional venture capital funds. More broadly, SB 54 could also capture private equity funds in scope for other reasons, as well as other entities such as business development companies, family offices and trusts.  

• Generally captures “funds” not “advisers” Although SB 54 was initially drafted to capture investment advisers to VCCs, it was revised over the course of the legislative process to apply to VCCs themselves. In this way, the focus shifted to a fund-by-fund analysis, such that it is possible for an adviser to manage one VC fund that falls under the law, but not another, depending on whether the applicable VC fund meets the required criteria or not.

Disclosure Requirements

• What information does SB 54 capture? SB 54 requires reporting about “founding team members” of all the businesses in which the covered entity made a VC investment in the prior calendar year to the extent the information was provided pursuant to a prescribed survey. A “founding team member” covers anyone who (i) owned initial ownership interests in the business, contributed (conceptually/developmentally) to the business before such initial shares were issued and was not a passive investor in the business, or (ii) is an officer, manager or person of similar authority in the business.

• What are the reporting requirements? SB 54 requires a covered entity to report, at an aggregated level, for each member of the founding team, such person’s (i) gender identity; (ii) race; (iii) ethnicity and (iv) disability status. Covered entities must also report whether any member of the founding team (w) identifies as LGBTQ+, (x) is a veteran or a disabled veteran, (y) is a resident of California or (z) declined to provide any of the preceding information.

  SB 54 also requires disclosure of the total number and dollar amount (each, as a percentage of total VC investments made) of VC investments to businesses primarily founded by diverse founding team members, aggregated and broken down by each of the above categories (other than (y) and (z)), during the prior calendar year. “Primarily founded by diverse founding team members” means more than half of the founding team members responded to the annual survey, and at least half of the founding team members self-identify as a woman, nonbinary, Black, African American, Hispanic, Latino-Latina, Asian, Pacific Islander, Native American, Native Hawaiian, Alaskan Native, disabled, veteran or disabled veteran, lesbian, gay, bisexual, transgender, or queer.

  Finally, SB 54 requires the covered entity to disclose the total amount of money in VC investments the covered entity invested in each business during the prior calendar year and the principal place of business of each company in which the covered entity made a VC investment during the prior calendar year.

• Does SB 54 set diversity mandates? No. Unlike other California laws, such as a 2018 law mandating female directors on all boards of the state’s publicly held corporations, and a 2020 bill requiring publicly traded firms based in California to include women, racial minorities and members of the LGBTQ community on their boards, both of which were struck down as unconstitutional, SB 54 does not set any particular target for diversity startup funding.

• Does SB 54 only apply to investments made in California? By its terms, SB 54 does not limit the businesses with respect to which information is to be collected solely to companies formed or operating in California. Consequently, a VCC to whom SB 54 applies will also be required to gather the same information listed above from non-California portfolio companies, regardless of their jurisdiction of formation or principal place of business. This will increase the compliance costs of covered entities.

Information Gathering

• Do covered entities have to report the names of businesses in which they invest? The law requires the disclosure of the total amount of money in venture capital investments a covered entity invested in “each business” during the prior calendar year. Covered entities might argue that naming a particular business generically (e.g., “Company A”) should be adequate so long as the business-level information is disclosed. However, it is not clear CRD will agree with this position, and even if it does, the provision of this information, together with the required disclosure of the company’s principal place of business may, if such information is made public, allow third parties to identify the business in question, an outcome that many VC firms will find troubling.

• Is there a prescribed form to gather information? Yes, covered entities must use a standardized survey form provided by CRD to collect information. The covered entity must provide each founding team member of a business that has “received funding from a VCC to which the covered entity has acted as an investment adviser” with an opportunity to participate in the survey. This awkward drafting, which arose from changes during the legislative process to focus the bill on funds rather than investment managers, if read plainly, suggests that the survey must only be provided by VCCs to which the covered entity VCC acts as an investment adviser. It would be very rare for one fund to advise another fund, and a strict reading would render this provision meaningless in practice. Accordingly, it is likely that CRD will read out the problematic reference in favor of the intent of the law, which is to require the covered entity to obtain information from each founding team member of a business that the covered entity has funded. The survey includes a “decline to state” option for each question on the survey.

• When can the information be gathered? Covered entities can only collect survey information after the covered entity has executed an investment agreement with the business and made the first transfer of funds. Therefore, covered entities looking to increase efficiency by, for example, asking survey questions as part of their pre-investment diligence programs, will be disappointed in being unable to use this approach.

• How must information be collected and reported? Survey results must be collected and reported in a manner that disassociates the responses from individual founding team members. Also, back-up data for reports must be preserved for at least four years after the report is delivered.

• Can affiliated VCCs consolidate their reporting? A covered entity may satisfy the reporting requirements by providing a report prepared by a business that controls each VCC to which the covered entity acted as an investment adviser at any time during the prior calendar year if the report contains all of the required information. Again, this phrasing, which originates from when the draft bill applied to investment managers, is difficult to apply in practice, since funds do not act as investment advisers of other funds. However, the intent of the law would likely allow a manager to consolidate the reporting of each relevant fund it manages in one report, provided it contains the required information.

Public Disclosure of Information and Use of Information

• What happens to the information reported to CRD? CRD must make the information collected from covered entities readily accessible, easily searchable and easily downloadable on CRD’s website. CRD may publish aggregated data from the survey results submitted to it.

• What will CRD do with the information? While the disclosure of information and the benefits that flow from shining the light on VC funding practices is the intended use of the information, CRD may also use the information in a civil action under any law.

Enforcement And Revisions to Law

• How will SB 54 be enforced? SB 54 allows CRD to take companies that do not comply with the reporting requirements to court to compel compliance or charge a penalty sufficient to deter failure to comply. In making the latter determination, CRD must consider all relevant factors, including, but not limited to, (i) the size of the covered entity, (ii) assets under management of the covered entity, and (iii) the nature of the failure to comply with the law.

• Will the law be revised? SB 54 puts CRD in the position of having to determine and monitor which VC investors are covered entities, which, as Governor Newsom noted in his signing message, will require CRD to “undertake significant and ongoing investigations… and the department is not suited to perform this work.” Likewise, SB 54 creates “significant, ongoing … cost pressures,” which Governor Newsom will propose to address in the 2024-2025 Governor’s Budget. While it is hopeful that the Governor’s review clarifies some drafting, it is not likely to significantly change the scope of SB 54 for covered entities.

Privacy Considerations

• How does SB 54 work with privacy laws in California and elsewhere? SB 54 presents some issues that businesses should address under “comprehensive” privacy laws like the California Consumer Privacy Act (CCPA) in California and similar laws in Colorado, Connecticut, and Virginia. These laws contain restrictions around the use of so-called “sensitive” personal information, which includes race and ethnicity data relating to an identifiable individual. Businesses are required to make disclosures about their collection and use of “sensitive” personal information and in some cases obtain consent prior to its collection and use. Consistent with these requirements, SB 54 already makes disclosure of race and ethnicity data voluntary, and businesses are required to clearly disclose that fact in an accompanying notice. Additionally, each of these laws contain exemptions for cases where the obligations would restrict the business’s ability to comply with other laws, and so although businesses should take steps like supplying appropriate notices (which can be part of a generally applicable employee privacy notice or a notice tailored to directors and officers), businesses can collect and aggregate the required information regardless of whether consent is obtained. To ensure compliance with applicable privacy laws, or as best practices, businesses should consider adding additional disclosures to existing privacy notices around the collection and use of the information collected in the surveys and conducting privacy impact assessments. They may also consider obtaining a consent as part of the survey process, although, exceptions to that requirement may apply. Many businesses have successfully navigated similar restrictions under the European Union’s General Data Protection Regulation, which also includes restrictions around the collection and use of “special category” data, including race and ethnicity data.

Possible Legal Challenges

• Can SB 54 be challenged? It is not uncommon for industry trade groups and others to assert legal challenges to potentially burdensome new state regulatory requirements like SB 54. When the requirements have been adopted via statute, such challenges are frequently grounded in federal constitutional law. As a general matter, federal doctrine is fairly deferential to a state’s regulation of commercial activity within its borders, even where the regulation also has impacts in other states and/or imposes requirements that are more burdensome than federal law. That said, there are certain principles that courts will on occasion invoke to strike down state regulation of commercial activity, and it would not be surprising to see a challenge asserted to SB 54 on one more of the following bases: (i) that the statute imposes an improper burden on interstate commerce in violation of the Commerce Clause; (ii) that it is preempted by the federal securities laws; and/or (iii) that it improperly compels speech in violation of the First Amendment.