This is the first of a series of articles we will be posting about the world of venture capital insurance.
Successful firms often invest in a blended venture capital insurance policy that offers protection from three main exposures: Management Liability (aka Directors & Officers or D&O), Professional Liability (aka Errors & Omissions or E&O), and Employment Practices Liability (EPL). These policies aim to cover a wide range of situations with the goal of hedging against one of the scariest expenses that can blindside a company: legal defense costs.
A Few Illustrations
Situation #1: One of your investors sues you for breaching your fiduciary duty following an investment decision. (See Smith v. Van Gorkom)
Situation #2: One of your employees sues you for gender discrimination. (See Pao v. Kleiner Perkins)
Situation #3: Your firm is sued by the former management of one of your portfolio companies. (See Carsanaro, et al. v. Bloodhound Tech., Inc. et al.)
Situation #4: One of your portfolio companies goes bankrupt and the board member you put in place is named as a defendant in a lawsuit from the trust. (See the Just For Feet bankruptcy case — thanks to industry veteran Kevin LaCroix who runs the indispensable D&O Diary blog)
(Another extremely common situation is an investigation or inquiry opened by your regulator, but we’ll go into detail about this in a later post).
The one thing all of these examples have in common is the costly legal defense required to protect your company’s interests (and your own interests if your company is unable to indemnify you). That is where venture capital insurance comes in.
The Price of a Suit
How costly are these legal defenses? A number of factors play a role in deciding the final cost of a lawsuit. These include the nature of the allegations, the rates charged by each law firm, the amount of work that went into litigating the case, the venue of the trial, and the final settlement or judgment. Between the costs of defense and settlement, litigation could run you anywhere from a couple thousand dollars (less likely) to several hundred thousand dollars (more likely).
When you factor these expenses into your IRR, one of these lawsuits can mean the difference between an automatic re-up by your LP’s and the painful process of explaining away your performance to a new set of investors or an unhappy group of existing LP’s.
Keep in mind, right now we’re just talking about immediate dollars and cents…the damage to your reputation is a separate issue and one that can cost you dearly in the long term. Naturally, your venture capital insurance policy cannot directly affect public perception down the road. What it can do lessen the toll that a trial would take on your firm’s resources, both financial and otherwise.
The bottom line is that, regardless of the verdict, a long and costly trial has the potential to threaten your current operations as well as the financial strength and performance history you can point to during your next offering. By paying defense and settlement costs for a covered claim, your venture capital insurance carrier can actually turn out to be a valuable business partner.
The Price of a Shield
The common follow-up question is: “how much venture capital insurance should I buy and how much will it cost me?” The admittedly unsatisfying answer is: “it depends.”
The decision of how much venture capital insurance to buy will be based on your firm’s size, history, and the nature of its operations, to name a few factors. Industry benchmarking will also be used to assist your broker in making his or her recommendation, so rest assured that this will be more than just an educated guess.
Now, the amount you should pay and the amount venture capital insurance underwriters want to charge you are two very different issues. The underwriter will look at factors such as your total assets under management, the nature of your investments, the composition of your limited partners, your claims history, and even the CPA that conducts your annual audits. Your broker will collect quotes from several of these underwriters, negotiate them to whatever degree they can, and present you with the best options for your particular needs. If he or she feels you are overpaying, it is your broker’s job to let you know and to find you a better quote.
We can use $12,000 to $15,000 for every million dollars of liability coverage as a baseline. The problem is that this rate relies so heavily on the total amount you decide to purchase, the insurance company, the state of the overall insurance market, and of course the unique risk profile presented by your company, that the only way to really gauge the cost is to get in touch with an expert who can see how the market values the risk.
To Sum Up
Venture capital insurance is a versatile risk management tool for firms of any size. It will allow you to focus more on the reasons you got into the venture capital business and worry less about the financial impacts of events that are sometime out of your control.
Next week we’ll talk Regulatory Investigations, another event that can cripple a company without the right venture capital insurance policy in place.