As your startup grows, so do your risks. It is no secret that your startup requires capable executives and board members to succeed. The problem arises, however, when these executives make choices that may put them in danger of personal liability risk.
When such happens, Directors and Officers (D&O) Liability Claims can suddenly start appearing. D&O insurance comes into play to safeguard the startup and its management against such claims.
So, what exactly is D&O insurance? And what is the difference between general liability insurance and D&O insurance?
In this article, we've covered all you need to know about D&O insurance to help you understand it better.
So, let's jump into the realm of startup insurance policies.
What Is Directors and Officers Insurance?
Directors and Officers (D&O) insurance provides liability coverage for the company's board of directors and officers against claims that may result from decisions and acts exercising their authority and responsibility. D&O insurance claims are compensated to offset lawsuit-related losses, such as legal defense costs.
Today's increasingly complicated legal climate exposes corporations to a greater risk of liabilities and lawsuits frequently triggered by "adverse news events." Directors and officers have considerable authority within a company, yet they are constantly scrutinized for their decisions.
According to a survey conducted by Chubb, over 25 % of private companies received a claim during a three-year period, and those who did not get Directors and Officers insurance suffered a loss of roughly $400,000 on average.
If an officer or director conducts an action that leads to allegations of mismanagement, breach of fiduciary responsibility, contract breach, and other similar claims, that officer or director, and not the corporation, might be personally held liable for all the misconduct.
This is where D&O insurance enters the frame; it safeguards senior management from such lawsuits. Given the stakes, businesses without a strong D&O insurance policy are less likely to be able to entice the best and brightest management minds to join their ranks.
Understanding Directors and Officers Insurance
D&O insurance reimburses directors, officers, and personnel for misconduct-related defense costs. Also, D&O coverage includes monetary damages, settlements, and endorsements that result from such claims.
D&O insurance directly covers the costs of legal claims if the company can't cover them for its directors and officers. This keeps the director or officer's personal assets safe.
If the corporation indemnifies for these costs, the D&O insurance will reimburse the corporation for doing so. If the corporation itself is sued, the D&O insurance will also provide some coverage to the corporation.
Typically, such coverage extends to current, former, and future directors and officers of the company and its affiliates. D&O insurance safeguards the officers for activities committed or omitted while serving in that capacity.
This means that even if the individual is no longer a board member, they will still be covered by the policy in place when the claim is made.
It's important to mention that D&O insurance does not cover fraudulent or illegal acts committed intentionally.
Difference Between D&O Insurance and General Liability Insurance
General liability insurance protects a firm against its whole exposure to liability claims. This insurance will pay for bodily harm, property damage, personal injury, and marketing damage that the firm may face while conducting business.
D&O insurance, on the other hand, protects against lawsuits particularly directed at the company's directors and officers if they are sued for how they carry out their obligations and duties.
This safeguards the corporation’s directors and officers from being held personally responsible for the actions of the corporation in the event that a lawsuit is filed against them. This can help protect the personal assets of the executives.
To put it briefly, general liability insurance will protect you from lawsuits brought by disgruntled customers or the general public due to your business's operations or products. In the meanwhile, D&O liability insurance will cover how management manages the company's business.
Directors and Officers Insurance: Key Points
What Does It Cover?
D&O insurance generally covers:
Who Does It Cover?
Typical D&O insurance covers the following:
Common D&O Risks and Claims
The following situations may result in the filing of D&O-related lawsuits:
Who Can Claim?
The following entities can claim lawsuits:
What Does It Not Cover?
D&O insurance does not provide coverage in the following scenarios:
D&O Insurance: Coverage Types
A typical D&O liability insurance policy for large corporations and startups may contain three kinds of coverage. These are known as Side A, Side B, and Side C. Although this may appear confusing, the three insuring agreements are quite simple.
Side A (Direct Coverage)
Side A coverage protects individual directors and officers against claims for which the corporation refuses or cannot pay indemnity. This is especially common in bankruptcy situations.
This kind of coverage often provides individuals with defense costs, settlement payments, or judgments. Under Side A coverage, it is the individual employee whose personal assets are at risk.
Side B (Corporate Reimbursement)
Side B coverage covers the company itself when the company does grant indemnity to its directors and officers. This implies that when companies pay legal costs and settlements on behalf of a director or officer who has been sued, their D&O insurance coverage will indemnify the company and safeguard its assets.
Side B coverage is important for startups, as legal costs and settlements may be quite costly, even for large corporations. Therefore, if a corporation pays legal costs and makes settlements to a third party on behalf of its directors and officers, it can seek compensation under the side B coverage of its D&O insurance.
Side C (Entity Coverage)
Side C coverage protects corporations against claims filed directly against the corporation by covering defense costs and corporate assets. Side C coverage guarantees that the company is protected in the event that it is sued alongside its officers and directors.
Typically, side C coverage protects corporations against liabilities they face due to securities-related lawsuits.
For instance, if a shareholder sues the firm for any reason relating to the shares traded on the stock market, Side C coverage will reimburse the corporation for the legal fees paid.
Although Side C coverage for publicly traded companies is often limited to securities claims, for privately held companies, Side C coverage can extend to a far broader variety of claims against the company arising from directors' and officers' failure to execute their duties.
Note: The coverage type that a company chooses generally relies on a number of factors. These factors may include the type of business, the company's financial picture, its business model, past legal claims, and the insurance company.
Why Do Startups Need a D&O Insurance?
If you are a startup founder wondering if you should get D&O insurance, the answer is probably yes (if you are just getting started, then no, but once past external investment, definitely).
One of the greatest myths regarding D&O insurance is that only large corporations require it. However, the reality is that startups also require it to secure their future development.
Startups and small private companies are more prone to legal claims in today's complex business environment. That's why D&O, employment practices liability (EPL), and other policies are commonly packaged to create a broader management liability insurance policy to cover startup executives and their assets against legal claims.
Let's have a look at some of the most compelling reasons why startups require D&O insurance.
Startups Are More Prone to Wrongdoings
By their very nature, startups are significantly more agile and less risk-tolerant than conventional large businesses. Decision-makers (directors and officers) frequently make decisions in a high-risk environment and might lack time to assess all potential exposure.
Consequently, the likelihood of a D&O claim is inherently high for startups.
D&O Helps Startups Attract Potential Investors
To grow and succeed, Startups require funding from venture capitalists. However, most investors and private equity firms will desire to monitor and safeguard their investments.
This often indicates that they will request a position on the board of directors. Investors will ask (as part of the term sheet) for reputable D&O insurance ensuring broad coverage to decrease their risk and possible legal exposure.
Startups May Fail and Face Liquidation
Even if bankruptcy offers some relief and protection from lawsuits to the corporation, its directors and officers may still be in danger. Certain stakeholders may blame the corporation's leadership and policies for the bankruptcy and ask that they personally reimburse the corporation's debts and liabilities.
In harsh failing statistics, having the proper D&O strategy in place is indeed important. An effective D&O policy will respond to this issue and give the directors and executives security.
D&O Provides Startups and Private Companies Legal Cost Coverage
Directors and officers have considerable authority and accountability. They make important decisions affecting operations, finances, employees, and more. This subjects them to an array of lawsuit risks.
Additionally, startups and private companies are subject to government regulations. Legal action against your startup or management by government or third-party regulatory authorities can be extremely expensive.
If the government or independent authorities discover that your startup has violated workplace regulations or lacked proper corporate structure, you may face regulatory actions and fines.
However, with proper D&O insurance in place, you can deal with such issues quickly and consistently. D&O coverage and trial defense expenses may also apply to criminal and regulatory investigations.
The insurance company will assist you in dealing with the claim, hiring the finest defense team, and covering the associated costs.
Startups Commonly Face Lawsuits by Employees
Undoubtedly, employment-related claims are one of the most prevalent forms of D&O claims. If the employees feel management won't address their issues, they may sue the corporation and its management.
Common employment practice claims against startup management include harassment, discrimination, contractual violation, inability to address security or health issues, wrongful termination, and inappropriate recruiting practices.
Employment practices liability (EPL) insurance covers employee claims, but a D&O policy is essential to safeguard management's personal assets in a lawsuit.
When Do Startups Need a D&O Insurance
It is a general misunderstanding that D&O claims are exclusive to large public corporations. In reality, a recent Towers Watson survey revealed that public, private, and non-profit organizations and startups all face D&O lawsuit risks.
The following situations illustrate when D&O insurance is necessary for a startup.
While Securing Venture Capital or Funding
We all know that capital investment is essential for a startup's success. D&O coverage is crucial for startups, especially when raising capital. To safeguard their investment, most investors will need you to have D&O insurance in place before providing you with venture capital or funding.
In fact, most startup funding agreements from institutional investors mandate that D&O coverage must be obtained within 90 days of closing the financing.
While Recruiting Competent Leadership
Startups constantly seek top leadership talent for expansion and growth. But there is a lot of competition in the market for quality management. Top-tier Directors and officers will not even consider joining a startup if their personal assets are at risk.
Most startups need D&O insurance when they are looking for competent management. D&O insurance enables management to concentrate on making the best decisions possible for the company rather than worrying about the risks connected with their position.
How Much Does D&O Insurance Cost?
Naturally, this question does not have a single correct answer. Today, several insurance companies provide coverage for startups beginning at $400 per year for nonprofit businesses and $3,000 per year for profit-seeking businesses.
For businesses with yearly revenues of less than $50 million, the annual average cost of $1 million worth of coverage falls between $5,000 and $10,000. According to estimates from the insurance industry, your startup will need to spend at least an extra $5,000 in yearly premiums for each additional $1 million in coverage.
The typical cost of D&O insurance a corporation pays mostly relies on the coverage provided. D&O insurance is not a commodity; hence there are considerable disparities based on pricing.
Factors That Influence D&O Insurance Cost
Let's discuss the most influential factors that might affect the cost of directors and officers insurance:
Due to fewer predictable revenue sources and shorter histories of established effective management, younger businesses pose greater risks for insurance companies. Insurers will also look at mergers and acquisitions, shareholding arrangements, and financial changes.
The corporation's size is the most prevalent variable that influences the cost of D&O insurance. Metrics such as yearly revenue, total financing, the number of fundraising rounds, and the number of paying customers are all useful for estimating a startup's size.
In higher revenue brackets, the cost of D&O insurance varies in part owing to industry-specific risks. As a result of the inherent risks connected with their operations, industries, including manufacturing, financial firms, and biotech, typically pay higher rates for greater liability coverage.
Startup's Financial Outlook
Your rates will go down if you are financially stable, expanding your income, and keeping your debt under control. It is also true that unstable cash flow is a red flag. A startup with excellent financials and functioning in an industry with a favorable economic outlook will have affordable coverage.
How willing you are to take risks can also affect the price of D&O insurance. Risk-averse startups might choose a lower retention rate (the amount that the insured must pay before the insurance policy kicks in).
This will result in a price hike. Alternatively, a startup with a greater appetite for risk may choose higher retention, so reducing its insurance cost.
Any previous claims will influence the underwriter's perception of your company. Typically, this does not apply to fresh startups since they lack a claims history. If you have had no D&O claims in the past and no litigation or regulatory action is pending, you can expect lower prices.
Important Terms/Provisions You Need to Understand
D&O insurance policies are quite flexible. As a startup founder, you must understand the legal provisions of D&O insurance coverage.
Here are some example provisions that every startup founder must comprehend.
The Insured vs. Insured Exclusion: Typically, D&O plans have an "insured vs. insured" exclusion. This exclusion prohibits claims filed by an insured or on their behalf against another insured. The goal of the exclusion is to prevent coverage of inter-corporate conflicts, including collusion.
The Order-Of-Payments Provision: The "order-of-payments" provision stipulates that the D&O policy restrictions shall apply to Side A losses first. Then, if any restrictions remain, the corporation will receive payments under Side B and/or Side C coverage.
These provisions aim to ensure that, in the case of bankruptcy, the policy funds will be available to the officers and directors, not the debtor.
The Cancellation Clause: The cancellation clause of D&O insurance specifies the conditions under which an insurer may terminate the coverage. Numerous D&O policies let the insurer cancel the insurance for any or no reason. Typically, D&O policies permit the insurer to cancel coverage if the insured corporation fails to pay its expenses.
The Application Severability Provision: A clause on application severability specifies that the knowledge of an insured who was aware of misrepresented facts in the application would not be imputed to any other insured to evaluate whether coverage is attainable under the policy.
A Debtor in Possession (DIP): When a corporation seeks bankruptcy protection under chapter 11 of the Bankruptcy Code, it becomes a "debtor-in-possession."
A debtor in possession (DIP) is an individual or company that has filed for bankruptcy protection under Chapter 11 but still has corporate or personal assets on which creditors have a legal claim based on a lien or other securities claims.
As such, it may not fit the policy's definition of "insured." This might severely compromise the company's D&O insurance coverage.
Still in Doubt?
Still wondering if you need D&O insurance or not. Here are some examples of actual lawsuits filed against the founders, directors, and officers of the companies.
SEC Sued Tesla's CEO Elon Musk
The Securities and Exchange Commission (SEC) once filed a lawsuit against Tesla CEO, Elon Musk, for advising investors "false and misleading" information.
According to SEC, Musk did not contact any top executives, workers, or outside consultants before sending tweets rounding up the Tesla go-private value to $420 per share because apparently he believed his girlfriend would find it amusing.
Loeb's Third Point Filed a Lawsuit Against Campbell Soup
Third Point, the activist hedge fund of American investor Daniel Loeb, filed a lawsuit against Campbell Soup and its board members. Loeb accused Campbell Soup of providing incorrect information to shareholders and concealing key information during a proxy battle between the two companies.
Source: Financial Times
Signet Jewelers Sued for Securities Fraud
Signet Jewelers Ltd. was alleged to have made misleading or false comments on the seriousness of sexual harassment allegations against executives.
The Irving Firemen's Relief & Retirement Fund, a Signet stockholder, is alleged to have suffered economic damages following the publication of a Washington Post article claiming pervasive sexual harassment at Signet Jewelers Ltd.
Source: Beacon Journal
Leading a startup involves making critical decisions one after the other. A lot of stress and responsibility come with being in that position. Even one small mistake might result in serious legal consequences.
Therefore, regardless of your industry, as a startup founder, you must shield yourself and your management from potential legal claims. And when it comes to protection, only D&O insurance can provide the sort of coverage you require.