On October 8, 2023, California Governor Gavin Newsom signed into law Senate Bill (SB) 54, which requires venture capitalists to disclose the demographic information of the founding members of companies in which they invest. The new law, Fair Investment Practices by Investment Advisers, is intended to promote access to venture capital funding for women-led and minority-led startups. While the law does not mandate diversity, but instead requires disclosure, it is a groundbreaking law that may have long-lasting effects on the landscape of the venture capital ecosystem in California and in the US in general. This law can be seen as part of a broader trend in the California regulatory scheme that uses extensive disclosure requirements to promote environmental, social and governance (ESG) accountability, including two new climate-related reporting statutes.

Who is covered by the law?

As a threshold, the law applies to “venture capital companies” under the broad definition of the California Code of Regulations. This definition covers, among other things, any entity with, on at least one occasion during each annual period since its initial capitalization, assets at least 50 percent of which are venture capital investments, as well as any entity that is considered a venture capital fund under the Investment Advisers Act of 1940.

To be considered a “covered entity” pursuant to the law, a venture capital company must:

• Primarily engage in the business of investing in or providing financing to startup, early-stage or emerging growth companies, or manage assets on behalf of third-party investors; and
• Have a California nexus by (i) being headquartered in California, (ii) having a significant presence or operational office in California, (iii) making venture capital investments in businesses that are located in, or have significant operations in, California or (iv) soliciting or receiving investments from a person who is a resident of California. The term “significant presence or operational office in California” is not defined in the law, and, on its face, the expansive California nexus test might capture a significant percentage of the venture capital companies in the US.

It is important to note that SB 54 is broadly drafted and covers not only “classic” VCs, but also private equity firms and other asset managers, including family offices, that have 50 percent or more of their assets comprised of venture capital investments and have the specified California nexus.

What are the disclosure requirements?

A covered entity will be required to disclose, on an aggregated basis, the following information regarding the founding teams of the businesses in which it made venture capital investments in the prior calendar year:

• The gender identity of each member of the founding team, including nonbinary and gender-fluid identities
• The race of each member of the founding team
• The ethnicity of each member of the founding team
• The disability status of each member of the founding team
• Whether any member of the founding team identifies as LGBTQ+
• Whether any member of the founding team is a veteran or a disabled veteran
• Whether any member of the founding team is a resident of California
• Whether any member of the founding team declined to provide any of the information described above

In addition, a covered entity will be required to disclose the total number and dollar amount of venture capital investments that it made during the prior calendar year to businesses “primarily founded by diverse founding team members,” i.e., businesses for which more than half of the founding team members are diverse. This information must be provided as a percentage of the covered entity’s total investments, in the aggregate and for each of the categories described above. 

A covered entity will also be required to report the total amount of money in venture capital investments that it 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 venture capital investment during the prior calendar year. 

For purposes of these reporting requirements, a “founding team member” is:

• A person who (i) opened initial ownership interests in 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; or
• The chief executive officer, president, chief financial officer or manager of a business, or a person having a role with similar authority as any such position.

A founding team member is “diverse” if the founding team member self-identifies 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.   

It is important to emphasize that, as noted above, the law requires the disclosure “at an aggregated level” and states that the disclosure must not include the demographic information of specific persons. However, the law also mandates the disclosure of the total amount of money invested by the covered entity in “each business.” It is currently unclear whether covered entities will be required to disclose the specific names of the businesses in which they invest, or if this information can be anonymized. 

When does the law go into effect?

The first report pursuant to the law is due on March 1, 2025, and each of the “covered entities” will be required to disclose the demographic information regarding its investments in the 2024 calendar year to the California Civil Rights Department (CRD). Subsequent reports must be submitted annually after the initial 2025 report. Consequently, covered entities will need to gather the applicable information for the year of 2024. However, Governor Newsom noted in his signing message that while he supports the law, it “contains problematic provisions and unrealistic timelines” and that he plans to propose “cleanup language” as part of the 2024-25 Governor’s Budget. Therefore, the effective date of the law may be postponed.

Does the law apply to portfolio companies located outside of California?

Yes, the disclosure requirements apply to any covered entity, which, as described above, includes any venture capital company with the specified California nexus, regardless of whether the portfolio company itself is located in California.

How should the information be gathered by the VCs?

Covered entities must use a survey in the form specified by CRD to gather the founding members’ information. The form will allow each founding member to decline to respond to any question, and no adverse action may be taken against a founding member who chooses to decline. The form may only be provided after funding is received, which means that the form cannot be provided as part of the initial diligence process.  

How will CRD use this information?

CRD will publish reports containing the gathered information on its website, where they will be “readily accessible, easily searchable, and easily downloadable.” While this law is mainly seen as a “soft regulation” aiming to incentivize venture capital investment in women-led and minority-led companies using public disclosure, there is a possibility that CRD may also use the collected information in a civil action under any law, such as treating such demographic information as evidence of a VC’s violation of federal and/or state anti-discrimination laws.

What happens if a VC does not provide the required disclosure?

If a covered entity fails to report by March 1 of any given year, it will be given a 60-day extension. Following that, CRD may take legal action against the noncompliant company to compel compliance with the disclosure requirement and impose penalties as a deterrent for future noncompliance.

If you have any questions about the Fair Investment Practices by Investment Advisers law, how it may impact you or how you can ensure compliance, please contact any of the authors of this alert at the contact information above.