A tail insurance policy is one of the most important risk mitigation tools for a startup approaching an exit.
The mission for every founder is pretty much the same: get some traction, get funded, scale rapidly, and hit an exit opportunity. While the occasional unicorn might be fortunate enough to IPO, most startups go the acquisition route.
The acquisition will feel like the end of the [crazy] road, but it’s actually far from it. Even though your company is absorbed into the corporate shield of the parent company, problems from pre-acquisition can sometimes come back to bite you. That’s where tail insurance coverage comes in.
In short, getting acquired doesn’t erase previous errors the company may have [allegedly] made. The time in which a plaintiff can bring a claim in court after an alleged wrongdoing occurred – the “statute of limitations” – can be up to 6 years…and often is in tech hubs like California and New York. The average inception-to-acquisition timeline is about 5 years for venture-backed startups, and we’ve had plenty of clients that have blown this timeline out of the water. With an acquisition timeline well within the statute of limitations, it’s easy to see how an early decision can come back to bite post-exit.
To add to this issue, most E&O and D&O policies (arguably the most important insurance policies for startups) are written on “claims made” forms. This means that coverage is provided when the claim is both a) made and b) reported within the policy period. It’s impossible to meet these requirements when the company is sold and the policy is no longer in force.
Tail insurance is an extension of your existing insurance policy that allows you to report claims post-acquisition for alleged wrongdoings that occurred before you sold the company. It’s commonly referred to as an “extended reporting period” because that’s exactly what it does: gives the insured an extended period of time to report a claim that occurred during the actual policy period, meeting the requirements to get coverage under a claims-made policy form.
Tail coverage is incredibly important for startups, who generally have a roller coaster ride that includes a booming workforce, rapidly evolving customer acquisition model, and a noisy cap table. Some claims that could show up late include:
- Shareholder claims for Director Mismanagement – failure to disclose material facts around the acquisition or some previous funding round (Directors & Officers Insurance Claim)
- Regulatory claims against Directors for reporting errors around the acquisition (Directors & Officers Insurance Claim)
- Contractual disputes for failure to abide by the terms of your customer contracts (Errors & Omissions Insurance Claim)
Without tail coverage, these claims wouldn’t be covered post-exit and the directors & officers can be on the hook. A 3 to 6 year tail insurance policy will generally cost about 150-200% of the policy’s annual premium to put in place, and it’s well worth it compare to a huge out-of-pocket expense to deal with a lawsuit personally.
Time to be a bit of a downer…
The first half of this post focused on the upside of startup life, but tail insurance can be just as applicable to opposite result. Bankruptcy and winding down doesn’t erase the potential for latent claims either! It’s worth having the discussion with your insurance broker if liquidation is looming on the horizon as well.
Overall, tail insurance coverage is a huge asset for startups nearing the end of their life cycle and should be put in place to avoid any future headaches. It’s a crucial piece to the risk mitigation side of an exit, and shouldn’t be overlooked. Talk to us if you have questions!