D&O Insurance is one of the most important types of insurance for startups. You’ll undoubtedly see it on the term sheet of the vast majority of institutional investors because it’s a big risk exposure for both you (the founder) personally and your investors.
D&O lawsuits can be a bit of a different breed for startups compared to others (i.e. public or non-venture-backed private companies). Private “family-owned” companies typically have a handful of shareholders at most and can lack the level of sophistication to have a major D&O exposure (at least from shareholders). Public companies are clearly the complete opposite, and as such, they tend to ensure strict adherence to corporate procedure as outlined by both state and federal laws and the company’s own charter and bylaws. Slip-ups simply can’t be afforded at such a high level.
Venture-backed startups, on the other hand, have an interesting cap table and board composition compared to the others. First of all, your average seed round might be syndicated by upwards of 30 VCs and Angels, each with potentially varying viewpoints about how the company should be run (and ultimately sold or wound down). Second, the C-suite of most startups is much younger and inexperienced in the ways of corporate formalities and duties. Mix these two together and you have some potent grounds for “Side A” D&O claims, or claims from shareholders against directors.
That’s not to say that there are are plenty of exposures on the B and C sides of coverage (i.e. claims from “outsiders”)…
So here are 3 major flavors of startup D&O insurance lawsuits & claims:
1. Regulatory Proceedings
According to a study done by Advisen, capital regulatory proceedings took the title for the highest percentage of D&O claims in 2013 at 42 percent. Not sure what these are? Regulatory actions are those brought against companies (and their directors & officers) by the SEC and other bodies that regulate raising capital. This area is heating up because more and more of Dodd Frank, the massive regulatory overhaul passed after the financial crisis, is starting to take practical effect. While Dodd Frank tends to deal more with the big banks, don’t think it leaves VCs totally untouched. Let’s also remember that there are new laws specifically for startups, too.
2. Securities Lawsuits
By securities lawsuits, I’m more referring to securities fraud lawsuits. This overlaps with category #1 in that regulators are heavily involved, and may not seem intuitive as to how this can touch the startup community for D&O claims. While it probably isn’t a huge concern for right now, it could be in the near future.
The government has recently automated the fraud detection process. Right now, the automation is focused on scanning the filings of public companies for signs of fraud. However, there’s no reason to think that the use of automation won’t eventually expand, raising the chances that a private company filing even a Form D, for example, could be implicated in a securities claim and have to “deal with it.” D&O insurance generally covers the costs of these claims even if they’re ultimately nothing.
This one gets starred because it’s the most important for startups. Remember the funky cap table situation unique to VC-backed startups that I was describing above? This is one big area where that can come into play. And it also happens to be the most expensive area in the D&O insurance world right now. And claims are incredibly common! According to Advisen, “nearly all M&As in 2013 valued at over $100 million” resulted in some form of shareholder lawsuit. I’ve you’re trying to knock one out of the park with your company, expect a claim here.
Here’s how this happens. Generally there are rules that you have to follow whenever a merger/acquisition is on the table. This is true regardless of the size of the corporation and whether it is private or public. The directors have to vote at certain times, inform the shareholders at other times, and there’s a protocol to follow and fiduciary duties to uphold. Whether or not this is done flawlessly, shareholders may sue the directors and officers personally on behalf of the corporation through a derivative lawsuit if they don’t approve of the transaction or the manner in which it was handled.
This is why having multiple rounds of funding syndicated by multiple VCs can raise issues. A “grand slam” acquisition for one VC could be considered child’s play by another, setting up a dispute over the transaction and a subsequent D&O claim.
According to Advisen, derivative shareholder actions averaged around $13.5 million in 2013 compared to $4.8 million in the previous year. Given the study was somewhat more weighted towards larger companies, but it’s easy to see how paying a few thousand dollars for a $1-2M D&O policy can be a no-brainer (and huge life-saver) for startup companies and their investors.