Higher Cost for D&O Insurance Stings VCs –

A venture capitalist recently settled a suit by a former employee of a defunct portfolio company who claimed he got a raw deal. This particular suit ended up being nothing more than a nuisance, but these suits typically come down the pike naming anybody and everybody, including the company, VC firms and individual partners who acted as directors, putting their personal assets in jeopardy.

The rise of suits by jaded shareholders, in tandem with the big hit insurance companies took from 9-11 and the failure of Enron, is dramatically driving up the cost of directors and officers (D&O) insurance. Premiums on D&O policies are increasing 20% to 40% for blue chip public companies, while some companies face premiums that are doubling or even tripling, insurance experts say.

If you think this is only a problem for public companies, think again. VCs are feeling it in the pocket book, since they are increasingly asking their portfolio companies to carry D&O coverage. That cost, on the order of tens of thousands of dollars per company, adds up to a hefty sum for a portfolio of a few dozen companies, but many VCs consider it a standard cost of doing business.

“As part of all our investments, we require that they have D&O insurance,” says Tom Simpson, managing partner of Northwest Venture Associates (NWVA). “We keep a schedule of all our portfolio companies with their carrier, how much coverage they have and its expiration date, and our CFO stays on top of it.”

NWVA isn’t unique. “Some VCs mandate that their portfolio companies carry a certain level of coverage, and it’s a good idea to have it on the evaluation list,” notes Carolynn Burns, vice president of Corporate Risk Solutions LLC.

If the claims being paid by insurers are any indicator, this will continue to be a hot topic. Insurance companies paid $3 billion in 2001 in claims for SEC-type litigation, and they’ve already shelled out another $1.2 billion in the first quarter of 2002, says Mike Wiebe, senior vice-president of Marsh Inc., a global risk and insurance services company.

While these shareholder class action suits go after public companies, that doesn’t exempt venture capitalists. In fact, 301 companies that went public were sued last year by plaintiffs alleging an IPO misconduct called “laddering,” where investment bankers cut deals with traders to inflate stock prices.

And public investors aren’t the only unhappy folks looking for a scapegoat. As in the case of the VC who recently settled his lawsuit, failed portfolio companies expose VCs to suits from unsatisfied creditors and disgruntled employees and founders. (See table below for a list of common complaints.)

“On the portfolio company side, the frequency and severity of lawsuits are up,” says Marc McCabe, a senior vice-president at the Nasdaq Insurance Agency. Because of the increased number of suits, VCs and their portfolio companies will likely continue to see their insurance costs rise through 2003, industry experts say.

Faced with indirectly spending firm money on these policies, Doug Chertok, a managing director of Hudson Ventures, is looking into buying an umbrella policy for the firm’s business activities and covering the personal liability of its partners serving as directors of its portfolio companies, rather than insisting that each company carry a policy.

Signaling the growing need for D&O insurance among VC firms, the Chubb Group of Insurance Cos. offers a special policy for VCs that wraps traditional personal D&O coverage with blanket outside directorship coverage and professional liabilities protection for the firm and funds.

Chubb, one of the largest insurance carriers for D&O insurance, has 260 customers globally for this special VC insurance, up from three customers in 1998, says John Burkhart, worldwide venture capital product manager for Chubb. Incidentally, he says Chubb pays more for claims involving the special firm and fund coverage than for traditional D&O personal liability claims.

Most VCs probably have some form of D&O policy, but there’s no telling how many private companies carry this type of insurance. Both groups are relatively new and reluctant subscribers to this type of insurance.

“To guys like us [VCs], it’s just a business decision and a nuisance,” Chertok says. “It’s a cost.”

While this particular cost of doing business is almost guaranteed to increase for VCs and their portfolio companies, some executives keep prices in line by negotiating lower limits on the total coverage or higher deductible. (See the table above for other negotiable features of the policies.) The changes may be less painful for the VCs and company executives who have budgeted for the rate increases and prepared for negotiations.

“We would highly suggest, particularly in this environment, that VC firms get together with their broker several months in advance of the policy expiring and discuss changes so the broker can massage the policies,” says Jim Knox, a vice president with Nasdaq Insurance.

Massage. Massage? Bet the VCs who are getting hit with increases don’t feel like they got a relaxing backrub.

Watch Out!

Sources of Complaints That May Involve VCs

    * Employee lawsuits and allegations of sexual harassment and wrongful termination in both the firm and portfolio companies.

* Bankruptcy issues when a VC winds down a company causing it to default its creditors.

* A forced management change in the portfolio company that causes a founder to miss out on the financial benefits of the company’s success.

* Breach of contract claims from a customer when the portfolio company’s product doesn’t work.

* Intellectual property, trademarks and technology infringements.

* Merger and acquisition activity allegedly initiated to fraudulently learn trade secrets.

* Employees of the portfolio company who are accused of violating non-compete agreements.

* Involvement with a public company that restates its earnings.

* Limited partners that are unhappy with a fund’s performance.

Feature Attraction
Negotiable D&O Policy Features

    * The maximum coverage limit.

* The “retention” or deductible before coverage kicks in.

* Run-off coverage protecting directors after they leave company boards.

* Coverage extends to suits filed overseas.

Negotiable Features of D&O Policies for VCs

    * Mandatory minimum coverage limits on portfolio companies’ D&O policies.

* Investment advisory coverage for interaction with its LPs.

* Outside director coverage includes board seats on public companies.

* New funds raised mid-term are automatically covered.

* Coverage extends beyond the individual officers of the firm to the firm and fund as entities.

Features VCs and Executives May Not Want To Negotiate

    * The rating of the insurance carrier.

* The policy is not cancelable by the carrier.

* Coverage may be extended for a short period after the policy expires.

* The policy is written on admitted paper, meaning that state government-sponsored guarantees kick in if the carrier can’t pay claims.

Contact Charles Fellers at