The primary reason we receive inquiries about insurance is a funding event. Many founders typically don’t think too much about Directors & Officers (D&O) and Key Person Life Insurance until they get a term sheet. In this month’s blog, we share some insight on which insurance policies VCs require and why.
What/Why Do They Want It?
In short, VCs need to protect their investment and themselves personally since they will likely sit on your board. Two ways this can be accomplished is through D&O and Key Person Life.
Directors & Officers (D&O) – For most early stage companies, we see a minimum $1 or $2M limit requirement for D&O in the term sheet. This can change depending on the size of the round and the geography of VCs involved. D&O is designed to insure the decision and responsibilities of not just the VC but also for the executives of the company. Keep in mind this is designed to protect the founders as well, so it is not all about the VC here. Savvy or seasoned entrepreneurs will know this is one of the most important policies they purchase.
Key Person Life – Key Person Life on the CEO or technical co-founder is very common. Keep in mind this is term life insurance on the co-founder(s), but it is owned by the company. This is designed to help the company find a replacement in your absence. $1M – 2M face value with a 10 year or 15 year term is common. “Key Person Life: Your VC Wants Key Person Life Insurance on You and Why It’s Not ‘Weird’” discusses this in more detail.
Some VCs Get Granular Regarding D&O
Some of the larger or more sophisticated VCs will have very specific requirements. This may stem from being burned in the past, wise legal counsel, or an internal risk management team. Here are some of the more granular requests we have seen:
Additional Side A Coverage – I have seen some VCs ask for specific coverage, such as Additional Side-A Coverage. Side-A Coverage essentially comes into play during a bankruptcy scenario or when a director does something so egregious the company does not reimburse legal expenses to distance themselves. This coverage is designed specifically to cover the individual director or VC in the scenario, which is why a VC is interested in looking into this. $1M is a typical additional limit, but not all carriers will offer it. This is something a founder should have regardless of the requirement.
Specific Carriers – Most VCs are agnostic as to which carrier a company uses as long as they have good ratings. Some VCs might limit this to admitted carriers when possible meaning carriers that have jumped through a few more hoops on the regulatory front. Some may even have preferences for specific carriers based on past experiences (good or bad). In many cases startups are limited when it comes to carriers who will offer terms, so meeting these requirements might not be possible.
Pre-Determined Tail – The likely scenario for a startup is an acquisition. In a favorable acquisition, most acquiring companies of any size or sophistication will ask for a 6 year tail as part of the deal. As a result, some VCs would want pre-defined tail terms so there are no monetary surprises in an acquisition scenario. Most policies only have a 1 year term defined in the policy. Though not all carriers will offer it, it does not hurt to ask for 3 or up to 6 year terms to see if they will offer up front as opposed to asking when a sale is pending. See prior blog, “D&O Tail Coverage – Tips for the Acquisition”, for more tips on tail coverage.
Seasoned Entrepreneur Tips
Start Early/Don’t Wait Till the Last Minute – most of the time carriers who can move fast don’t have an appetite for tech startups. There may be underwriting guidelines, such as less than 3 years in business or not enough runway for a carrier to offer terms. You do not want to hold up funding or start off the relationship with your VC on a bad foot.
Use Post Funding Financials If Possible– Terms are often limited by the financial health of the startup. Shorter runways, little ARR and no clear plan for sustaining operations are reasons why an underwriter would decide not to offer favorable terms or terms at all. In some cases, the carrier might only offer a $1M limit or have some wording on the policy that limits coverage. This is common until the startup can show improvement on their financial health in the form of funding, revenue and profitability.
A Recommendation Is Not a Requirement– Private equity money is notorious for cleaning out the C-Suite the same way a college head football coach would bring in all their coordinators and staff. On the contrary most founder friendly VCs we have worked with are there to provide resources and guidance in addition to capital. When it comes to D&O, keep in mind most VCs are primarily concerned with you getting coverage in place and less concerned with who you use to get it. If they get prescriptive, you might have the wrong VC.