SB 54 increases transparency in California’s venture capital industry – Venture Capital

by MMC
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California Governor Gavin Newsom signed Senate Bill 54 (SB 54) entered into force on October 8, 2023, to take effect on March 1, 2025, for all investments made during calendar year 2024. The law will require “covered entities” to report demographic information “founding team members” of all. companies in which the covered entity has invested. SB 54 aims to address the lack of venture capital funding aimed at diverse founders and is the first of its kind.1 Supporters of the law claim that “funding for startups led by women, Black founders, or Latinx founders has never increased by more than 5% in any given year.”2

To remember

Venture capitalists and other investors should work now with attorneys to determine whether they are “covered entities” under SB 54 and ensure they are prepared to comply with the SB’s reporting requirements 54, which will cover calendar year 2024. Compliance procedures and information collection processes should be in place for all covered entities beginning January 1, 2024.

Who does SB 54 apply to?

“Covered Entities” under SB 54 are venture capital firms, as defined in Section 260.204.9 of Title 10 of the California Code of Regulators, that meet at least one of the following criteria:

“(A) on at least one occasion during the annual period beginning on the date of its initial capitalization, and on at least one occasion during each annual period thereafter, at least fifty percent (50%) of its assets (other than short-term securities or term investments awaiting long-term commitment or distribution to investors), valued at cost, are venture capital investments… or derivative investments;

(B) the entity is a “venture capital fund” as defined in Rule 203(l)-1 adopted by the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended (17 CFR 275.203(l)-(1)); Or

(C) the entity is a “venture capital operating company” as defined in Rule 2510.3-101(d) adopted by the United States Department of Labor under the Income Security Act Employee Retirement Act of 1974 (29 CFR § 2510.3-101(d))”.3

The criteria for a venture capital firm to be a covered entity include two parts: the first concerns the activities of the venture capital firm and the second concerns whether those activities sufficiently affect California.

For the first prong, the requirement is met if (1) the entity “engages primarily in the activity of investing in or financing start-up, early-stage or emerging growth companies”; or (2) “manages assets on behalf of third-party investors, including, but not limited to, investments made on behalf of a state or local pension or retirement system.” »4

To meet the second prong, the venture capital firm must be headquartered in California, have “a significant presence or operational office in California,” or invest in “businesses located or with significant operations in California.”5

In particular, covered entities are defined such that they cannot, on their face, cover companies affiliated with venture capital firms, including entities under common control. As such, this reporting requirement can only cover the general partner or investment advisor. With respect to corporate venture capital funds, SB 54 can be interpreted to cover every entity that engages in venture capital activities. Thus, if corporate venture capital has more than one entity engaged in venture capital activities, SB 54 may cover both entities and, if so, each of those entities would be subject to the requirements of SB 54.

What information must be reported?

Covered entities must provide annual information on the founding teams of all companies in which they have invested in venture capital during the preceding year. A “founding team member” is defined as any person who falls into one of the following two categories: (1) a person who (a) owned the original shares of the company, (b) contributed to the company before the initial issuance of the shares, and (c) was not merely a passive investor; and (2) the “chief executive officer, president, chief financial officer, or director of a company, or who has been designated with a role with a level of authority similar to one of these positions.”6

Covered entities must provide aggregate demographic information about the founding teams regarding race, ethnicity, gender, sexuality, veteran status, and California residency, and indicate whether any of the members of the founding team The founding team declined to provide this information. Additionally, covered entities must provide information on the number of investments and investment amounts in portfolio companies comprised primarily of “various members of the founding team.” A diverse founding member is defined as a founding team member who identifies as female, non-binary, Black, African American, Hispanic, Latinx, Asian, Pacific Islander, Native American, Hawaiian, Native American. Alaska, disabled, veteran. or disabled veteran, lesbian, gay, bisexual, transgender or queer. They must also provide the total amount of all venture capital investments during the previous year, as well as the principal locations of all portfolio companies that received these investments. The covered entity must anonymize this data.

What is the procedure to follow to comply with reporting obligations?

Under SB 54, required demographic information will be collected via a survey that will be provided to founding team members once the investment agreement has been signed by the covered entity and the first transfer of funds has been made. been carried out. Such survey will contain a written statement indicating that the disclosure of demographic information is voluntary, that the founder will not be subject to any adverse action for non-participation in the survey, and that the data collected will be aggregated for each category and reported to the California Department of Civil Rights.

All covered entities must maintain records relating to these reporting obligations and retain such records for four years after providing the information to the California Department of Civil Rights. Fees will be collected by the Department of Civil Rights from covered entities for administrative costs.

What happens if you fail to comply with reporting obligations?

All reports must be submitted no later than March 1 of each year. If a report is not timely filed, the Department of Civil Rights will notify and the report must then be filed within 60 days of notification. If a covered entity does not file the report within this window, the California Department of Civil Rights may file a complaint. ex parte petition to a superior court seeking compliance, payment of a fine, attorney’s fees, and other relief as determined by the court.

If the court finds that the petition sets out good reasons for relief, it will make an order. The Department of Civil Rights will then serve the petition and order on the covered entity, which must file a response. Either party may file a request for a hearing. If the court grants the request, the court order will specify the time limit and methods for compliance.

Possible obstacles and lasting implications

Since SB 54 was signed by Governor Newsom, it will take effect on March 1, 2025. However, in his signing statement, Governor Newsom clearly stated that his administration would propose revisions to correct “problematic provisions and unrealistic deadlines that could present obstacles to successful implementation and enforcement.7 Governor Newsom further cited his belief that the Department of Civil Rights “is unable to perform this work” and that “establishing this expertise, as well as any work resulting from the administration of the law , creates significant and continuing pressures on General Fund costs.”8This means the law could be subject to substantial revisions before it takes effect, and state enforcement efforts may go unfunded.

Additionally, even if signed into law, SB 54 could still be challenged based on various doctrines, including the Equal Protection Clause or the Civil Rights Act. For example, Senate Bill 826 and Assembly Bill 979 aimed at increasing diversity on corporate boards were ruled unconstitutional. Regardless, these bills’ attempts to increase diversity could have lasting effects even if they were overturned, and simply introducing SB 54 into law could create a legacy in the landscape of risk financing in the future.

Footnotes

1. Dominic-Madori Davis, “California Passes Law Requiring Venture Capital Firms to Disclose Investment Diversity Information,”
TechCrunch (October 9, 2023, 9:01 a.m.). (explaining that “this is the first piece of legislation in the United States to increase diversity within the venture capital landscape.”)

2. Identifier.

3. Cal. Code regulations. tit. 10, § 260.204.9.

4. SB 54, 2023 S., Reg. Sess. (Cal. 2023).

5. SB 54, 2023 S., Reg. Sess. (Cal. 2023).

6. SB 54, 2023 S., Reg. Sess. (Cal. 2023).

7.”Governor Gavin Newsom’s Signing Statement on Senate Bill 54 to Members of the California State Senate» (October 8, 2023).

8. Identifier.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your specific situation.

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