Commercial Venture Insurance: An Ounce of Prevention or a Pound of Splurge?
The venture capital industry is known for its bold approach to the balance of risk in the face of reward. What isn’t always so obvious is the critical role that commercial insurance plays in creating that balance. The well-timed purchase of venture insurance can be a fundamental first step in minimizing unnecessary risk, as we explored in a recent webinar presented by Aumni and co-host Vouch, an insurance provider for the investment and startup community. Adequate insurance coverage protects the firm and its investments during a fundraise, as well as during the course of managing a growing portfolio.
Protection for directors and officers is paramount
The foremost insurance policy for any new firm to explore is Directors and Officers (D&O) insurance coverage. This is the contractual covenant found in the Investors' Rights Agreement. Within that agreement, there is a standard provision that details the company requirements on limits, policy size, and what coverage is required of directors, officers, and other key stakeholders. Most often written as a contractual covenant between the company and the investors, this provision is one of many provisions in venture financing agreements that address risk and risk allocation. Yet, D&O insurance is rarely negotiated in the context of investment deals. Even more critically, it is routinely overlooked by investors who are preparing to join a corporate board of directors.
According to our panel of experts, having insurance coverage is consequential across all stages of a company’s growth. Companies get sued, startups in particular. Having D&O insurance in place from the beginning will enable businesses to continue operating, without spending recently raised capital on unnecessary legal fees. "The cost of litigation is often underestimated," shared Kathleen Utecht, Managing Partner, Core Innovation Capital. “I remind CEOs how high the price is if they're sued. Paying $100,000 per year [in insurance costs,] is a lot better than having to pay $2M in legal fees that year." Having a solid D&O policy will ensure firms can cover all those litigation costs, and avoid the immense time and energy required for managing a lawsuit. D&O insurance is a must-have even in seed-stage startups -- Utecht stated that her firm wouldn't sit on a board without it.
There are instances where firms may elect to forego the insurance. We see this when investors are not joining the board, or when the company is not within a regulated industry. Panelist Travis Hedge, a co-founder of Vouch, explained that if a firm is in a regulated category such as FinTech, healthcare, education, or housing, he recommends that companies secure coverage at the seed stage, even around company formation. Founders are also considered directors and officers in the business, making them appropriate candidates for D&O coverage. If a company is in a regulated category or has any regulatory exposure, it is particularly critical from the company level to have coverage in place. Hedge shared that more than 40% of D&O-related claims are tied to regulatory action and 3% of startups get derailed by legal issues; furthermore, two out of five companies will experience employment-related litigation matters over the course of their history. With experience comes knowledge, and the more exposure investors have to these risks the more likely they are to require the coverage at the portfolio level.
Pivotal considerations on timing and coverage
A lawsuit can be filed against a company or its leaders by any number of parties: partners, employees, portfolio companies, vendors, and regulators. Lawsuits may claim failures in management or the provision of investment advisory services. Venture Capital Asset Protection Insurance (VCAP), which is a blend of Directors & Officers and Errors & Omissions insurance often covers defense fees and indemnification. However, VCAP policies were originally constructed for the private equity industry, which operates very differently from venture capital.
In the PE setting, firms are more prone to taking control positions, possibly with majority ownership. The PE firm will often put beneficial policies in place on behalf of portfolio companies. Venture is very different. VC firms are not taking board seats in every company and are investing across a number of different categories. In these settings, it is useful to consider what is being underwritten and which asset classes are included. Depending on the asset class in play, the firm can weigh the level of risk involved. VC firms are wise to evaluate assets under management (AUM) and the background and the track record of the GPs running the firm when considering the risk profile. Many LPs have modeled outcomes around various levels of loss. Because first-time LPs might have different expectations around loss, understanding their experience with the venture asset class is vital, as inexperience can yield a higher risk of litigation.
In light of these concerns, companies may be wondering how to optimize timing in order to avoid frivolous spending. Jim Marshall, Head of the Emerging Manager Practice at Silicon Valley Bank, advises an early start. He notes that there are a wide variety of technology tools available to help emerging managers build their firms: "It has never been easier to build institutional-grade hygiene from day one." A solid foundation comprised of both relevant venture insurance and strategic risk preparation creates good hygiene from the beginning, helping put emerging managers on a path to becoming institutional investor-ready in the areas of technology infrastructure, risk mitigation, and portfolio management perspective.
Thomas Muscarella, CFO & Venture Funds Practice Leader at Kranz reminded us that while coverage is important to have in the beginning, firms also need to consider having coverage as the fund ages. If the investor has deployed most of the capital that has been committed, funds are more vulnerable to the financial impact of uninsured risk. A lack of dry powder can be managed with additional coverage, ensuring the stability of the portfolio as exits are forthcoming.
Insurance provisions are also recommended in scenarios such as for venture lines of credit, or debt. When firms are lending money to a company, having adequate insurance policies will provide stability and protect relationships that are central to a firm’s longevity and health. The bottom line is this: no matter the size nor age of the firm, our experts agreed that the best course of action for venture firms is to require coverage of their portfolio companies. Systems that monitor policy status and coverage for each investment will provide visibility and serve as a last line of defense.
How to evaluate levels of portfolio company risk
When determining what guidance to give portfolio companies, there are several key considerations for firms. Here is a recap of takeaways and tips from our panelists:
- Verify that insurance coverage is in place at each portfolio company.
- Review insurance information at the board level and at board meetings.
- Err on the side of caution; insurance protection is central in times of crisis.
- Consider hypothetical claim scenarios, review regulatory action, and factor in the company’s industry and region.
- Talk to emerging managers who may not have venture experience about joining a board of directors and the associated fiduciary duties.
- Consider the less commonly addressed risks when it comes to commercial insurance: crime coverage, cyber coverage, and IP insurance (which is especially important for startups who will be subject to fluctuations in employee retention).
- Find a great regulatory attorney early on.
Insurance coverage may not receive the attention it deserves from founders and the C-suite, which is why it is especially beneficial for VCs to recommend insurance to portfolio companies. Our subject matter experts agreed that first-time founders are less likely to have insurance; the most experienced investors are decisive about this requirement and review coverage as part of initial due diligence and yearly financial reviews.