Stewart Elliott came up lame in his bid to ride Smarty Jones to a Triple Crown, but it’s a long shot that VCs will give up on the chestnut that you should always “back the jockey, not the horse.”
That’s why key-man insurance policies are still in vogue. “There’s been more interest in key-man insurance policies lately,” says Christopher Veber, a director at insurance brokerage Equity Risk Partners. “By and large it’s focused on the CEOs, but in certain cases, we’ll see venture firms take out protection against chief technology officers or other primary roles.”
Numbers regarding the purchase of key-man insurance are tough to find, but the frequency of its application has clearly grown, as evidenced by the NVCA’s new “Model Term Sheet,” which now includes a provision for key-person policies.
“We’re often critically dependent on one or two key individuals, particularly for early stage companies,” says Steve Foster, a general partner with Palo Alto, Calif.-based TPG Ventures. “Often times we’ll back executives with a certain level of skill and knowledge, and a vision that can’t easily be replaced. If, for whatever reason, we were to lose one of those key individuals, it would be very hard to achieve what we had hoped [in the investment].”
The incipiency of most venture-backed businesses only makes coping with the loss of a key executive that much more difficult. Management teams are thinner and the intellectual capital, vital relationships, and overall personality of the company are typically tied to one or two jockeys.
Easing a Transition
The loss of a primary executive will usually leave the business and its investors scrambling, and while nobody would say a key-man insurance policy completely makes up for the passing of a company’s leader, most agree that it does make the transition much easier.
If investors are not interested in sticking around for the conversion to a new management team, key-executive insurance provides a window out in some cases. Proceeds from key-man policies, which are tax free, can be used to recoup an investor’s interest in a business, cover the liabilities the company owes to the deceased, purchase the executive’s interest in the business, cover financial losses resulting from the death and pay for hiring and training a replacement.
Most key-man policies cover between $2 million and $5 million, says David Richter, a partner with San Francisco’s San Francisco Financial Partners. However, he notes, “The number of requests we’ve had for policies of $10 million or more has grown significantly.”
To determine the coverage, most insurers will use a system based on the salary of the key person, generally capping off at about 10 times the executive’s annual compensation. “We usually won’t issue coverage that exceeds more than ten times a person’s [yearly] compensation, but you have to look at what the particular executive brings to the company,” says Rus Hauswirth, a senior vice president of executive benefits at Chicago-based Aon Consulting. “If the individual contributes an unusually high percentage of the company’s profits or is compensated in a way that allows them to accumulate more stock rather than take on a high annual salary in the immediate term, then we will account for that. It typically just goes back to using a gut feeling.”
Perhaps the biggest appeal to key-man policies is that the cost of the coverage is cheap, at least compared to other forms of insurance VCs pay for. “It’s dependent on three factors,” Richter says. “Just like standard life insurance-the cost depends on how much coverage a company is looking for, the age of the person and their health.”
On average, the cost for key-man insurance is generally about $1,000 to $2,000 [a year] for every $1 million worth of coverage, says Fred Wilson, founder and managing director of Union Square Ventures in New York City. “Considering how critical a founder [or key person] can be, it is really not that expensive to have the protection in place.”
The marketplace for key-man insurance is crowded, with just about every firm that offers life insurance branching out to include key-man policies. St. Paul Travelers, Pacific Life Insurance Co., MetLife, ING Group and William Penn Life Insurance are just a few of the companies identified by VCs as among those offering the insurance.
While the competition keeps the cost at a minimum, the struggles of reinsurers could lead to some pricing pressure in the years ahead. “The cost of key man policies is pennies on the dollar, or even less than that, but because reinsurers are renegotiating their treaties right now, the cost of key-man insurance could grow,” explains Hauswirth of Aon Consulting. If the reinsurers get their way, key-man issuers could hand off anywhere from a 10% to 15% increase to the policyholders in the next couple years, he warns.
Nearly everyone has seen the life insurance commercials on Lifetime or A&E designed to scare viewers into taking out their own policies. The ads usually portray a conversation between two or three older women discussing the plight of a recently widowed friend that can’t pay the bills. If those same commercials portrayed the loss of a key executive, more likely there would be a roundtable of VCs and lawyers going back and forth on just how to recoup their investment, or at the very least how not to lose their shirts.
What’s at Stake
As a managing partner at Flatiron Partners in 2000, Union Square’s Wilson endured such a situation when the firm’s new investment in Urban Box Office was seemingly torpedoed after its 42-year-old founder and CEO, George Jackson, died of a stroke.
Flatiron was the lead investor in a group that included Allen & Co., an affiliate of Chase Capital Partners, and the New York City Investment Fund, among others. Together the investors put $16 million into a second-round private equity financing. As was customary for Flatiron, the firm required that the company take out a key-person insurance policy for Jackson, which was to total $5 million of coverage. However, before the policy had been finalized-less than one month after Flatiron and others made the investment-Jackson died.
“George’s passing really had a major impact on the company,” Wilson says. “Maybe we would have looked to get our money back from the investment or possibly it would have smoothed over the transition to the new management team, but we certainly would have been better off if we had the insurance policy in place.”
Since Jackson’s death Urban Box Office has been through a difficult run. The company has spent some time in bankruptcy protection, and, like most dot-coms, it has had to scale back its operations. While the business would have had trouble keeping up its bubble-era aspirations even with its leader, the founder’s death certainly made things more trying. “UBO’s struggles were not completely the result of George’s death, but that certainly had a lot to do with it,” Wilson says.
(UBO is still operating and has shown improvement following its emergence from bankruptcy protection, according to Wilson. It remains a part of Flatiron’s portfolio.)
Today, Wilson insists that a key-man insurance policy is issued as a condition of closing in all of his firm’s investments. “In most cases, these executives are truly key people,” he says. “It’s absolutely critical that they are involved in the company, and if they’re not around, in a worst case scenario, the company could be completely and utterly damaged.”
All businesses, no matter what their size, can be affected by the loss of a leader. This is reflected in the bumps and dips of a company’s stock whenever a personnel announcement is released, and those fluctuations can be pretty steep as evidenced in Motorola’s hiring of Ed Zander in December or the resignation of Viacom President and COO Mel Karmazin in June.
In venture capital investments, though, the importance of a key person is magnified because there typically isn’t the managerial infrastructure to buttress the company in the event of a shakeup. Plus, recruitment can also be more time consuming, as the inchoate companies that make up a VC’s portfolio generally do not attract the line of potential replacements that a Fortune 500 business would.
Also, a good chunk of VC firms target the technology and biotech spaces, two sectors that are dominated by companies whose products are in development or redevelopment. Whether the company is creating a new software design or preparing for the clinical trial of a cancer drug, the success of an investment will come down to whether the company can be the first to reach the marketplace.
“No insurance policy can fully cover for the loss of an individual, but at least it helps a company keep moving on its product road map,” says TPG’s Foster. “If you lose a key executive, you are basically losing time, and that translates into money. In the venture business, it’s about getting a product to market faster than the competition, and being first is usually what matters the most.”
Dissention regarding the use of key-man policies will, at its most pitched, take the form of ambivalence. “It’s not something we really think about until the very end,” says one private-equity pro. “The salespeople won’t leave you alone, but in our business you always know you can get insurance. You don’t always know you can get a deal.”
However, Philip Ferneau, a co-founder and managing director at Hanover, N.H.-based Borealis Ventures, warns that key man policies should not be overlooked. “It’s devastating enough to lose the CEO in one of your companies, but no investor wants to compound his or her problems in that situation by also having to worry about a resulting hit to short-term cash-flow,” Ferneau says. “Compared to most other risks that venture investors face, the costs of losing a CEO unexpectedly can be mitigated, at least in part, fairly easily and inexpensively with a key-person policy.”