California Imposes Demographic Reporting Rule on Venture Capital Firms

California Gov. Gavin Newsom recently signed into law Senate Bill 54, which requires venture capital firms to collect and report demographic information about the founding team members of the businesses in which they invest.

The law potentially applies to a broad variety of private fund sponsors beyond the venture capital industry and even fund sponsors without a direct nexus to California. The ostensible purpose of the law is to help more women- and minority-owned startups access venture capital funding.

The law will become effective on March 1, 2025, after which the California Civil Rights Department (CRD) can enforce it through civil actions.

Covered entities must report information to the CRD about their funding activities, including demographic information for the founding teams of all the businesses in which the covered entity made a venture capital investment in the prior calendar year. The term venture capital investment means an acquisition of securities in a company as to which the investment adviser has management rights.

The information that must be reported includes gender, race, ethnicity, disability, veteran status, and LGBTQ+ identity. To comply, a covered entity must use a survey provided by the CRD to collect personal data on each founding team member of businesses that have received a venture capital investment.

Failure to comply with the law's requirements could expose a covered entity to civil enforcement actions and penalties. The size of any penalty will increase commensurate with the size of the covered entity, its assets under management, the nature of the covered entity's failure to comply with the law, the CRD's attorneys' fees, and any other relief that a court deems appropriate.

What is a Covered Entity?

A covered entity means a "venture capital company," as defined under the Private Fund Adviser Exemption, which meets two criteria. The definition of "venture capital company" under Senate Bill 54 cross references the Private Fund Adviser Exemption and is broader than the definition under the Investment Advisers Act of 1940.

While the term "venture capital company" picks up "venture capital funds" under the Advisers Act, it also captures any entity that invests at least 50 percent of its assets in venture capital investments or any entity that is a venture capital operating company, as defined under the Employee Retirement Income Security Act of 1974 (ERISA).

Real estate funds and private equity funds that have sought to qualify for the venture capital operating company exemption to avoid being deemed plan assets under ERISA could find themselves deemed "venture capital companies" for purposes of Senate Bill 54.

The specific criteria for a venture capital company to be deemed a covered entity are as follows:

• The venture capital company primarily engages in the business of investing in, or providing financing to, startup, early-stage, or emerging growth companies.
• The venture capital company manages assets on behalf of third-party investors, including investments made on behalf of a state or local retirement or pension system.
• The venture capital company is headquartered in California, has a significant presence or operational office in California, or makes venture capital investments in businesses that are located in or operating in California.
  

For example, if a venture capital company managed by an investment manager with no operations in California makes a venture capital investment in a business headquartered in New York that has a handful of employees in California, the venture capital company would arguably have to request diversity data from the founders of the New York business.

If a venture capital company has solicited capital from a single California resident, regardless of whether that California resident invested in the venture capital company and regardless of whether the venture capital company makes an investment in a business with a California nexus, the venture capital company would have to request data from the founders of all of the businesses in which it has made a venture capital investment.

Who is a Founding Team Member?

A founding team member includes the following:

• The person owned initial shares or similar ownership interests of the business.
• The person contributed to the concept of, research for, development of, or work performed by the business before initial shares were issued.
• The person was not a passive investor in the business.
• The person has been designated as the chief executive officer, president, chief financial officer, or manager of the business.
  

Covered entities may wonder if they have fully surveyed all founding team members if a founding team member might not be a shareholder. It may not be immediately obvious which employees have roles akin to senior management, but not within senior management.

While the law indicates that the CRD will provide the survey for covered entities to use, it will be incumbent on covered entities to report data to the CRD on an aggregate and anonymized basis. The CRD has not yet provided guidance on how to report data.

The law could be challenged in the courts, given the reasonable possibility that it will fail to fulfill its ostensible purposes, its sweeping coverage of fund sponsors beyond the venture capital industry, its dragooning of fund sponsors without a real nexus to California, and significant privacy concerns.

Robert Crea, Carol Schepp, Barbara Smith Tyson and Lauren Ford are attorneys with Bryan Cave Leighton Paisner. © 2023 Bryan Cave Leighton Paisner. All rights reserved. Reprinted with permission via Lexology.