The Top 2 Dangers of Portfolio Company Lawsuits
In our previous piece on Venture Capital Insurance, lawsuits from your employees and Employment Practices Liability Insurance (EPLI) took the spotlight. This article focuses on the risks posed by portfolio companies. For more info on how to protect your VC, take a look at our intro post, as well as our summaries of SEC investigations and lawsuits from investors.
There are 2 forms of portfolio company lawsuits. First, legal action initiated by a third party against your portfolio company and, second, legal action initiated by your portfolio company against you. For a VC investor, portfolio company lawsuits present the unique risk of a two-pronged assault on your fund’s returns: the cost of your own legal expenses as well as the legal expenses of the company in which you invested. Both forms of portfolio company lawsuit present unique challenges that have the potential to derail even the most carefully planned operation.
As part of your investment in a portfolio company, chances are you have taken a sizable equity position in that company. Maybe you even have a seat or two on the board of directors. The benefits of this are clear: you grow with the team in which you have invested, you are able to pass on your knowledge to maximize the company’s shot at success, and you have the power to encourage a discussion if you see an opportunity or problem that requires attention. But alongside those benefits is the knowledge that you have now accepted a new liability: when one of your portfolio companies is the subject of litigation, you, your employees, and your firm could be all named alongside the company because you are stakeholders.
Think for a second about the legal risks facing your average manufacturer. Customers, investors, employees, business partners, vendors, lenders, and regulators all have the ability to initiate legal action against the manufacturer and its owners for a countless number of perceived offenses. Imagine that you are one of those owners. Now imagine you also own twelve other manufacturers, each with the same number of risks. Now imagine trying to get a good night’s sleep with all of this on your plate. This mental exercise is a fact of life with any VC and it exemplifies why Directors & Officers and Errors & Omissions (“D&O” and “E&O”) insurance are wise investments. It protects your firm, your returns, and your personal wealth from the exponentially growing risk that shadows your exponentially growing successes.
The next question may be: since my portfolio company agreed to indemnify me and my firm, wouldn’t their insurance cover these claims? Yes, if they buy D&O and E&O insurance, then the portfolio company’s insurance should pick up the claim first. Another question may be: since my policy’s retention (aka “deductible,” or the amount you have to pay before the insurance company starts paying) is $75,000, wouldn’t I have to pay the initial legal costs required to reach a dismissal anyway? Another yes, you would have to cough up that first $75,000 regardless of whether or not you are insured and there is every possibility it will take less than $75,000 to put the issue to bed.
But both of these ‘yes’s are based on two tenuous assumptions. The first assumption is that your portfolio company is carrying enough insurance to prevent the matter from reaching you. If they are not, then the company has to lean on their balance sheet to pay for the costs of mounting a legal defense. If you work in venture capital, you can probably recall one or more of your investments that did not have the financial strength to indemnify you in the event that their insurance policy was exhausted.
The second assumption is that you and your firm will actually be dismissed from the suit and that the matter will be closed in a timely manner. Time equals money, and this is never more true than when you are talking about lawyers’ bills. The problem for the venture capitalist is that the amount of time until settlement or dismissal is dependent on the severity of the claim, the discoverable evidence, the venue of the trial, the tactics of the plaintiff, and the whim of the presiding judge or arbiter — all unpredictable qualitative factors. If it turns out at the end that, not only were your motions to dismiss denied, but you were also liable for the judgments and damages awarded by the judge, you could be dealing with a potentially devastating expense.
The ultimate goals of all forms of investing is to generate returns. This is obvious. But being a Venture Capitalist comes with the additional reward of the knowledge that you are achieving this goal by helping small, young, potentially world-changing companies find success by guiding them through scalable growth. It’s not to say that VC investors are altruists, but they are certainly strong contenders for the role of ‘good guy’ among the world of financial institutions.
In practice, however, people have disparate motivations, goals, abilities, beliefs, and plans. What happens when you have a great investment on paper but the company’s management is not following the plan? It is an unfortunate truth for any private equity investor that sometimes tough changes need to be made for the benefit of your company’s health as well as the health of the company in which you are investing. At that time, who the ‘good guy’ is and who the ‘bad guy’ is suddenly becomes dangerously subjective.
Sometimes the decision may not even be in your hands. One real-world example of this involves a firm that was run by a particularly colorful and sometimes unpredictable CEO. The VC that invested seed money in the company had no problem with this guy. He was a bit unusual and the VC had to adjust its typical style work effectively with him, but there was no reason to remove him from his position.
The problem arose during a later round of funding. The company was being courted by a large and prestigious firm that could provide a lot of benefits if they were to invest — and this firm hated the CEO. It happens. But in this case, the firm demanded the CEO be removed before any deal could be inked. The company complied and the CEO sued the company and each member of board of directors (including the representative from our VC seed investor) for every offense imaginable. Some of the claims were patently ridiculous, some seemed to carry merit, and all cost every party dearly in legal expenses.
Another situation could be a dispute about fees. Perhaps the VC charges a monitoring fee to its portfolio companies that the VC feels places an undue burden on the company. Or it could be a disagreement about the VC’s involvement in the company’s operations, where the company feels the VC is getting in the way of the goal with which the founders had originally set out. There are any number of other possibilities, all of which should be considered when making the decision to buy insurance.
The primary reason a Venture Capital Insurance policy exists is to pay for legal defense costs and the amounts demanded in a judgment or settlement following the initiation of a lawsuit. When you consider both your firm’s legal expenses and the legal expenses borne by your portfolio company together, the potential damage to your returns grows substantially. Even if the portfolio company is the plaintiff and you aren’t actually paying for their lawyer, you will eventually pay when the company is valued with the massive legal bill taken into account. In this regard, even a victory is bittersweet. This is why seasoned VC investors do not give a second thought to speaking to an insurance professional (like us!) about this policy. More than any other type of insurance, this can truly be an investment to hedge against the tremendous risk you assume as a venture capitalist and maximize the potential for your firm’s success.
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