October 16, 2023
If you’re a startup founder, directors and officers (D&O) coverage may not be on your radar yet. Many entrepreneurs opt for “bare minimum” insurance to mitigate overhead costs. You likely want to invest your funds in building out your product or service — and winning those important first customers.
Inadequate insurance, however, can place your early-stage venture at risk. Here’s how D&O coverage can protect your reputation, personal finances, and bottom line.
What is D&O insurance?
D&O coverage is like a safety net for company leaders. If someone sues you for a decision you made while managing the company, this insurance can help cover legal costs (defense costs, damages, awards, settlements) and other expenses. It’s a way to protect your executives and board members from personal financial loss.
Why startups need D&O coverage
As a startup founder, you wear multiple hats. You’re creating and launching a groundbreaking product or service, while also juggling operational details like banking and insurance. The sheer speed at which you work and make decisions brings both success and risks. Here are five reasons to explore D&O coverage:
1. You may have a tough time attracting seasoned executives and board members without it
You’re building a strong leadership team to help drive the business and grow. D&O insurance is a crucial selling point to get expert leaders and board members to sign on. The more experienced they are, the more likely they will demand D&O coverage as a condition of employment. They’ve been part of organizations that have had to deal with risk exposures. They know this coverage is critical to protect them individually as well as the company.
2. You’ve unwittingly conducted unlawful hiring and termination practices
Though workplace claims typically fall under employment practices liability insurance (EPLI), they have the potential to cross over into D&O. Here’s why: Startups often do not have expertise across all business functions. Due to budget constraints, you may not have funds to hire an experienced human resources (HR) employee. A court can hold directors and officers liable for the decisions they make regarding the handling or response to employment-related claims.
Before you tap an engineer to oversee HR — or hire an entry-level employee to manage job applications and employee benefits — consider the risks. If the person responsible for HR activities is not aware of hiring and firing pitfalls, you and your company can end up with claims that could result in costly fines or worse.
3. The trade-off decisions to launch a product or service quickly can have a bad ending
Startups often feel pressure to get a product or service to market. If they knowingly launch an incomplete product, investors will not be happy and can sue. Additionally, a customer class action lawsuit can result for any product or service that doesn’t deliver as promised.
4. Failure to launch despite promises of going public
Sometimes, the vision doesn’t work out for startups, as any serial entrepreneur knows. Instead of having a planned public launch, they close shop. They sell their assets. Even after the business closure and sale of assets, the startup’s officers are not free and clear from obligations. They still need to have coverage for any claims that happened prior to the entity’s closing. Tail coverage, an extension of the D&O insurance, serves this purpose. Without tail coverage, the defunct company’s officers’ personal assets are at risk.
5. You don’t have a risk manager to identify or prevent exposures
The CFO or COO often takes on risk management responsibilities. However, they are juggling multiple projects, so they likely have blind spots to different exposures across the company. That knowledge gap itself is a risk exposure. Eventually, a dedicated risk manager will be on your team. Until then, you’ll want a third-party risk advisor to help you identify risks and ways to mitigate them.
What D&O underwriters want to see from startups
You may now be on board with obtaining D&O insurance or expanding your existing coverage. Here’s what D&O underwriters are looking for when determining the extent and price of coverage:
- Strong financials and a solid business plan: Like venture capitalists, underwriters want to know if the business is financially viable. They request the latest financials and pay particular attention to income fluctuations. Underwriters look at the previous 12 months of results, along with your forecast for the next 12 to 36 months. However, they may settle for less if the business plan is solid with a strong team in place. You’ll want to demonstrate a clear and detailed path to achieve your revenue goals and remain viable.
- Solid reputation of the founders and senior executives: Underwriters are adept at turning over rocks we don’t even know exist in the cyber world. If there’s something negative or damaging about anyone on the board or leadership team, they’ll find it. Also, underwriters are looking for a positive track record from the senior team members. Knowing the financials will only go so far back, underwriters also review leaders’ past successes. They’ll want to know the leaders have strong business connections and a market presence.
- A good story: Maybe the financials aren’t quite there yet. Or the CEO doesn’t have startup experience. But CEOs or CFOs who tell a great story can overcome those obstacles. You can help an underwriter look beyond a misstep or missing information to catch your vision.
It’s important for startups to make sound, focused investment decisions. D&O insurance is one of those priority investments for early-stage companies. As with all insurance, you may never need it, but having it can make the difference for your bottom line and long-term viability.
Want to learn more?
Find Scott on LinkedIn, here.
Connect with the Risk Strategies Management Liability team at MLPG@risk-strategies.com.
About the author
With over 15 years of broking experience, Scott Taylor develops executive liability programs for startups, small businesses, and middle market companies. He specializes in D&O insurance, EPLI, fiduciary liability, cyber liability, professional liability, and crime coverage.
The contents of this article are for general informational purposes only and Risk Strategies Company makes no representation or warranty of any kind, express or implied, regarding the accuracy or completeness of any information contained herein. Any recommendations contained herein are intended to provide insight based on currently available information for consideration and should be vetted against applicable legal and business needs before application to a specific client.