US court decision casts shadow on diversity venture capital funding

By Krystal Hu

(Reuters) - Just weeks after a U.S. appeals court blocked a Black-owned venture capitalist from funding women-of-color-led businesses, the ruling has had a chilling effect across the small industry of diversity-focused venture capital funds, according to founders, investors and lawyers who spoke to Reuters.

The Atlanta-based 11th U.S. Circuit Court of Appeals in early June found an anti-affirmative action group's lawsuit that accused Fearless Fund of discrimination would likely succeed, reversing a judge's decision to allow the firm to continue making grants while the case proceeded.

The Fearless Fund, established in 2019 to bridge the gap in venture capital funding for women of color, is facing a lawsuit by the American Alliance for Equal Rights, run by conservative activist Edward Blum, who led the successful U.S. Supreme Court challenge to the consideration of race as a factor in college admissions.

While the 11th Circuit ruling against the fund affects only Georgia, Alabama and Florida, investors and corporations running diversity investment programs elsewhere in the country are paying close attention to how this could expose them to similar lawsuits.

“We are already seeing the interim effect, where people say, ‘We are either going to restructure the descriptions or documents we use, or we’re not going to say things out loud but will engage in the same practices,’” said Ed Zimmerman, a lawyer at Lowenstein Sandler who advises venture capital clients.

The backlash against diversity, equity and inclusion (DEI) initiatives has expanded from Wall Street to Silicon Valley in the past year after the Supreme Court's decision in Students for Fair Admissions v. Harvard, which ended affirmative action in college admissions. Companies that championed diversity initiatives are now re-evaluating strategies to avoid legal entanglements.

This shift in sentiment has led to increased scrutiny of programs specifically designed to support underrepresented groups, from hiring practices to funding initiatives. Major U.S. companies, including JPMorgan Chase, have modified policies meant to boost racial and ethnic representation after conservative groups threatened to sue, a Reuters analysis shows.

Diversity-focused funds were created to level the playing field for communities who were historically excluded from services, employment and funding opportunities before the Civil Rights Act of 1964, which ended segregation. Corporations stepped up their funding initiatives after widespread protests over the death of a Black man, George Floyd, at the hands of Minneapolis police in 2020.

The outcome of the Fearless Fund lawsuit could affect over $200 billion committed in similar programs and roll back the scant benefits these funds have so far given to Black founders, who received less than 0.5% of the $140.4 billion of venture capital funding of U.S. startups last year, according to data firm Crunchbase. Venture financing of Black founders, which surged in 2021 after corporations pledged more diversity spending, has plunged since then, Crunchbase data shows.

“The ruling is a significant concern to us. It contradicts civil rights law and ignores the reality for entrepreneurs of colors,” said Ying McGuire, CEO of the National Minority Supplier Development Council, a nonprofit focusing on promoting opportunities for minority businesses.

Some founders are already feeling the impact. Sheena Allen, founder of digital bank startup Capway and a recipient of a Fearless Fund investment, took down her company’s website after funding dried up this year. The current climate has made it difficult for fintech startups to seek funding, especially for a Black female founder, she said.

Fearless Fund, which has invested $26.5 million into 40 startups led by women of color, said some of its committed limited partners have pulled out, citing the litigation. One of its cofounders, Ayana Parsons, stepped down as general partner and chief operating officer last week.

"People have the right to fund marginalized communities if and when racial disparities exist, and that is something needs to be protected," Arian Simone, CEO of Fearless Fund, told Reuters. "People who are serious about this work will find creative ways to do it regardless, but they shouldn't have to find a creative way to do it."

Other venture capital funds are exploring ways to mitigate the risks of running diversity-focused programs, investors say.

After consulting her lawyer and limited partners, Shila Nieves Burney, a general partner at Zane Venture Fund, another Atlanta-based venture capital fund, decided to hold her ground and leave intact her fund’s website description of supporting diverse and inclusive founders.

Burney, an outspoken voice in the community of Black female investors, organized a petition to start a campaign to rally support for the Fearless Fund last year.

She and co-organizers gathered dozens of VC investors, most of them Black women, to strategize on how to help fight back on the legal challenge by conservative activist Blum.

But the efforts stalled last year due to a lack of funding, she said. While her own fund continues to back diverse teams, Burney fears there will be fewer capital available for Black founders and that corporate backers will shy away due to reputational risks.

“If Fearless Fund is not able to raise their next fund, that creates a huge gap in the ecosystem. When there's an attack on Black VCs, who's going to fill that gap?” said Burney.

That is the question that now confronts Allen of Capway.

Allen, who has been an entrepreneur since college, was able to self-fund and grow build her previous company. However, a fintech startup like Capway required significant funding to scale. She is contemplating either pivoting the company’s direction or shutting down and starting a new venture.

“I know it’s hard for everybody, but as Black women, we've already had it a million times harder anyway,” she said.

(Reporting by Krystal Hu in New York, additional reporting by Nate Raymond in Boston; Editing by Kenneth Li and Matthew Lewis)