On October 8, 2023, California’s Governor Gavin Newsom signed into law Senate Bill 54 (the “VC Diversity Law”) requiring “venture capital companies” with business ties to California to file annual reports detailing (1) specified demographic data for the founding teams of all portfolio companies invested in during the prior year and (2) the aggregate amounts of investments made by the venture capital company during the prior year and investments in specified categories of portfolio companies. Demographic data must be obtained through voluntary surveys sent to each founding team member of a portfolio company that receives funding from the venture capital company. The data, in anonymized form, will be publicly available – and searchable and downloadable – on the California Civil Rights Department’s website. The VC Diversity Law is stunning both in its scope and its plain objective to impose State-level requirements that go beyond Federal requirements. And this at a time when the Securities and Exchange Commission has exponentially increased those Federal requirements.
Unlike the previously proposed diversity reporting bill, which imposed reporting requirements on venture capital advisers, the VC Diversity Law instead applies the reporting requirements to venture capital funds. This is significant because the law therefore applies to entities that are not subject to State law reporting, such as SEC‑registered advisers and exempt reporting advisers under the Venture Capital Fund Adviser Exemption (Rule 203(l)-1) and Private Fund Adviser Exemption (Rule 203(m)-1) of the Investment Advisers Act of 1940 (the “Advisers Act”), as well as entities that are not subject to the most or all provisions of the Advisers Act, such as offshore advisers and excluded advisers like family offices and banks.
A “venture capital company” is defined by reference to the California exemptions from state investment adviser registration, and includes any entity that meets any of the following requirements:
- 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, valued at cost, are “venture capital investments” (generally securities conveying management rights in operating companies);
- is a “venture capital fund” as defined in Rule 203(1)-1 under the Advisers Act, which, among other requirements, is a private fund that (a) represents to investors and potential investors that it pursues a venture capital strategy and (b) holds at least 80% of its aggregate capital contributions and uncalled committed capital, valued at cost or fair value, in equity securities of qualifying portfolio companies (generally non-public companies), tested after the acquisition of each non-qualifying investment; or
- is a “venture capital operating company” as defined in the US Department of Labor rule 2510.3-101(d) (which has generally the same meaning as (1) above).
On its face, this definition is both broad and ambiguous. For example, “venture capital strategy” for purposes of prong (2) is not defined in the Advisers Act, and prongs (1) and (3) have no requirement that an entity invest in “venture capital” investments at all (merely operating companies that grant management rights), meaning ordinary private equity funds could be captured depending on their portfolios. Prongs (1) and (3) are not limited to private fund vehicles (i.e. vehicles that rely on the 3(c)(1) or 3(c)(7) exemptions from registration under the Investment Company Act of 1940) and there is no requirement that the applicable venture capital company be an advisory client of an adviser. Single investor co-invest vehicles and AIVs are therefore in scope, as are vehicles like business development companies and trusts that do not qualify as “private funds” under the Advisers Act. When applying the venture capital company designation, advisers will likely need to be consistent with the classification they have given an investment vehicle for purposes of reporting on Form ADV and, if applicable, Form PF.
Not all venture capital companies are subject to reporting. “Covered Entities” under the law are limited to venture capital companies that satisfy both an investment test and a presence test.
- Under the investment test, the venture capital company must either (x) primarily engage in the business of investing in or providing financing to startup, early‑stage, or emerging growth companies, or (y) manage assets of behalf of third party investors, including, but not limited to, investments made on behalf of a state or local retirement or pension system. Because of the broadness of this test, arguably entities that are not typically subject to SEC or State oversight, such as family office investment vehicles and internally managed vehicles, will be required to report.
- Under the presence test, a venture capital company must either (w) be headquartered in California, (x) have a significant presence or operations in California, (y) make venture capital 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.
Because prong (z) will be satisfied by marketing directed to a single California investor (either an entity or a natural person), in practice the presence test will likely only spare private funds that have specifically excluded all California residents from fundraising activities. California residents may of course be located in other jurisdictions at the time marketing is undertaken, so screening for such investors is likely to carry a significant compliance burden. In addition, “significant” is not defined regarding either presence or operations, and as such, will require advisers to make difficult and subjective judgements that are likely to be scrutinized by the Civil Rights Department.
Venture capital companies must report several different types of data with respect to both their portfolio companies and their investment holdings writ large.
At the portfolio company level, a venture capital company must report, at an aggregate level, for each member of the “founding team” of a portfolio company that received an investment in the prior year: (1) gender identity (including nonbinary and gender-fluid identities), (2) race, (3) ethnicity, (4) disability status, (5) whether such member identifies as LGBTQ+, (6) whether such member is a veteran or a disabled veteran, and (7) whether such member is a resident of California. Notably, the venture capital company must also report (on an anonymized basis) if any member of the founding team declined to provide any of this information. The law does not specify whether team members must affirmatively decline, or whether a failure to respond by a specified deadline is sufficient.
“Founding team member” is defined as either (a) a person who has been designated as the chief executive officer, president, chief financial officer, or manager of a business, or who has been designated with a role of similar authority, or (b) a person who (i) owned initial shares or similar ownership of the business, (ii) contributed to the concept of, research for, development of, or work performed by the business before initial shares were issued, and (iii) was not a passive investor in the business. Whether an individual is a founding team member will be a facts and circumstances determination, and in many cases advisers may face challenges in both identifying all relevant founding team members and successfully soliciting survey responses.
At the aggregate portfolio level, a venture capital company must also report, for the prior calendar year:
- on an anonymized basis, the number of venture capital investments to businesses “primarily founded by diverse founding team members”, as a percentage of the total number of venture capital investments the venture capital company made, both in the aggregate and broken down into the diversity categories described above,
- the total dollar amount of venture capital investments to businesses primarily founded by diverse founding team members in the past year, on the same bases as category (1),
- the total dollar amount invested in each company that is a venture capital investment during the prior calendar year, and
- the principal place of business of each company in which the venture capital company made a venture capital investment during the prior calendar year.
Venture capital companies are required to obtain this information in a standardized voluntary survey provided to each founding team member of a business that has received money from the venture capital company. A business “primarily founded by diverse founding team members” means a founding team for which more than half of the founding team members responded to the 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.” This proscribed calculation means if founders don’t respond, a venture capital company’s reporting burden will be significantly reduced, and, conversely, an adviser will not be able to report successful diversity conscious investments if founding team members do not submit survey responses. Advisers should expect that the Civil Rights Department will review communications between advisers and founders for signs that an adviser is gaming the system, and the law specifically prohibits a venture capital company (or the Civil Rights Department) from encouraging, incentivizing or attempting to influence the decision of a founding team member to participate in the survey.
Notably, the “principal place of business” of a business is not defined, and the law does not provide for this information to be anonymized. Advisers who do not ordinarily make public their portfolio holdings may therefore struggle to keep such information confidential if public disclosure of address-level information (as opposed to city or state) is required.
If a venture capital company fails to submit a report to the Civil Rights Department by March 1 of a given year, the department will notify the entity that they must submit the report within 60 days. If the company fails to submit the report within 60 days, the Civil Rights Department is entitled to enforce the law by filing in court to both compel the respondent to comply with the law and submit the report, and to pay a penalty sufficient to deter the company from failing to comply with this section. In determining the appropriate penalty courts are directed to consider the size of the company, the number of assets under management by the company, and the nature of the company’s failure to comply. The court may also award reasonable attorneys fees and costs of the department in pursuing the actions, and any other relief that the court deems appropriate.
The VC Diversity Law is intended to increase transparency into the allocation of venture capital funding, and in doing so increase diversity in recipients. Proponents noted that funding to startups led by women, Black, or Latinx founders has never risen more than 5% in any given year. The law is also intended to increase awareness of existing funding discrepancies and highlight venture capital companies that are supporting diverse founders, allowing investors to make informed decisions about which venture capital companies, and which advisers, to support.
In practice however, the VC Diversity Law may be unwieldly and burdensome for advisers (and not only venture capital advisers) to implement, and is being adopted at a time when all private fund advisers are grappling with expanded reporting and other requirements under the new Private Fund Rules. Key compliance issues include:
- The VC Diversity Law applies to covered venture capital funds advised by all categories of investment advisers, many of whom who have no place of business in California and/or do not have reporting or other obligations under the Advisers Act. It also applies to investment entities with no “adviser” at all, such as family offices investment vehicles, internally managed vehicles, and charitable investment vehicles. These advisers and entities may not have the compliance infrastructure in place to implement such far reaching data collection and reporting requirements of the VC Diversity Law – and may not even realize it captures them.
- Reports must be submitted by March 1 of each year, with financial penalties accruing for delinquent reports. Practically speaking, this tight timeframe means that advisers should consider completing the survey process on a rolling basis as investments in portfolio companies are made, instead of completing the survey process and generating reports at the end of the calendar year. This timing requirement is much shorter than under the controversial new quarterly statement reporting rule adopted by the SEC. These reports also must be submitted in advance of Form ADV filing (March 31) and Form PF filing (April 30), as well as a fund’s receipt of its annual financial statements. This means that reported information may differ across reports and raises questions about updating requirements (which were not addressed in the law).
- Gathering, storage and management of survey responses regarding sensitive demographic data implicate significant compliance requirements under applicable State, Federal or international privacy laws. For example, California imposes expansive limits on the use of sensitive personal information under the California Consumer Privacy Act, and several categories of data reported under the VC Diversity Law are considered special categories of personal data under the EU’s General Data Protection Regulation (or GDPR), which applies strict controls on the collection, processing, and storage of sensitive categories of personal data. Advisers who manage funds subject to the VC Diversity Law should review both their privacy policies and their data security policies before collecting founder information. The law does not specify the procedure to be followed for anonymization, and we expect this to be an area of focus for compliance departments, particularly for advisers with multi-jurisdictional businesses.
- Beyond the obvious risk of review and potential enforcement by California regulators, SEC-registered and other Federally regulated advisers should expect the SEC Staff to review these reports in examinations and investigations. The SEC has adopted a number of expanded reporting requirements under Chair Gensler and have several more in the pipeline, all of which are intended to provide information for their examination and enforcement activities.
- Compliance costs related to establishing adequate data management and reporting systems, as well as producing reports on an ongoing basis, could be significant. SEC-registered advisers should consider whether these are compliance costs that can be passed on to investors in the affected venture capital companies. With respect to private funds, we anticipate that advisers may be able to treat compliance costs related to preparation of the required reports as fund compliance costs that may be charged to the fund. However, these charges would then be subject to the new Private Fund Rule disclosure requirements.
- The Legislative Counsel’s Digest for the VC Diversity Law notes that “Existing law generally prohibits discrimination in the provision of privileges and services on the basis of sex, race, color, religion, ancestry, national origin, disability, medical condition, genetic information, marital status, sexual orientation, citizenship, primary language, and immigration status. Existing law provides a cause of action against any person who denies, aids or incites a denial, or makes any discrimination or distinction on the bases listed.” This suggests that disparities in the availability of venture capital funding to diverse founding team members may constitute actionable discrimination under California law. In contrast, in other jurisdictions, litigation against diversity conscious programs has grown since the Supreme Court’s affirmative action decision in Students For Fair Admissions, Inc. v. President And Fellows Of Harvard College. Most notably, in American Alliance for Equal Rights v. Fearless Fund, the 11th Circuit Court of Appeals has ordered the venture capital firm Fearless Fund to temporarily pause grant applications supporting Black female founders while parties litigate whether the grant program is racially exclusionary. Advisers who market or invest across various state jurisdictions may struggle to reconcile the disparate legal standing for diversity conscious impact investing.
The VC Diversity Law will go into effect on March 1, 2025. However, Governor Newsom noted in his signing letter that the law’s language will be “clean[ed] up” to address “problematic provisions and unrealistic timelines that could present barriers to successful implementation and enforcement.” This update is expected to be released as part of the 2024‑2025 Governor’s budget in summer 2024. As drafted, the law provides for no grandfathering, so once any amendments are adopted and effective, advisers will likely face a considerable compliance challenge to gather necessary reporting data for legacy funds by the expected effective date.