Choosing D&O Insurance Limits at Private Companies: 5 Key Questions

Private companies purchase D&O insurance for many reasons, which we’ve laid out in Woodruff Sawyer’s Guide to Private Company D&O Insurance. Once a private company has determined that it needs D&O insurance, the next question is often: How much D&O insurance should we buy?

Good question, particularly given the rising cost of D&O insurance premiums for private companies. The following are five questions you can ask to determine an appropriate D&O insurance limit for your private company.

1. How Much D&O Insurance is Available for a Company at My Stage?

Early stage companies (think Series A) very often cannot obtain more than $1 million to $3 million of D&O insurance. Sometimes, however, younger companies want more than this in D&O insurance, for example, because a high-net-worth individual on the board insists.

Often times, however, more limits may not be available. This is because D&O insurance carriers want to limit their exposure to bankruptcy risk, something that is more likely for younger companies than more mature companies with a strong operational track record.

By contrast, a late-stage private company with a large valuation and a lot of assets, funds raised or revenue is a candidate for buying more insurance. Absent special circumstances I will outline below, however, later stage companies typically still only buy $5 million to $10 million in D&O insurance limits.

2. Who Are the Likely Plaintiffs in Potential D&O Litigation?

Concerns about shareholders suing the directors and officers of a private company might be a reason to pursue D&O insurance.

Remember, however, that a D&O insurance policy written on a typical private company policy form will not respond if insiders sue one another. This is due to the “insured vs. insured” exclusion, which is specifically designed to remove from coverage suits that arise when individual insured parties sue each other.

For example, it is not uncommon for a founder who is also an officer and board member to have a falling out with the company and, upon being dismissed, turn around and sue the company and its directors. These suits are excluded from coverage, as are suits when one director sues another director.

For some private companies, the members of the board of directors represent almost all of the shareholders. This is common for venture-backed companies where venture capital investors also take board seats. If that is the case, it may not be worthwhile to purchase much—if any—D&O insurance.

By contrast, if you have a lot of shareholders who are not either members of management or represented on the board, D&O insurance can be very useful if those shareholders decide to sue the company and its directors and officers.

It can be useful to work through other common private company litigation scenarios. This might include government suits, private suits, bankruptcy, and employee suits. Then, consult with your outside counsel to understand the expected costs associated with them.

Unfortunately, there is not a robust data set for private company litigation (unlike its public company counterpart). However, in the past three years, private companies experienced losses above $1 million in lawsuits with allegations such as:

• Breach of fiduciary duty
• Failing to disclose material aspects of business operations to investors
• Infringement of competition law by using wide most favored nation clauses in contracts
• Anti-trust business practices
• Repeated failures to follow client investment instructions
• Price fixing of bonds and futures contracts
• Improper conduct with respect to engagements with SEC registrant issuers
• Improperly obtaining and using confidential information to improve results from internal audits
• False Claims Act violations
• Stark Law violations
• Illegal sales practices

3. Are We in a Regulated Industry?

Companies that are not in a particularly regulated industry still, of course, have to adhere to securities laws. As I have written in elsewhere, private companies are subject to the anti-fraud rules.

When a company works good outside counsel, the likelihood of securities regulators knocking at the door goes down—but not to zero. The government is not particularly good at only pursuing bad actors; sometimes innocent parties find themselves needing to mount a defense. Companies raising money may want to consider purchasing $5 million or $10 million of D&O insurance limits in case they find themselves needing to respond to securities regulators.

In addition, some companies have a business model that challenges the regulatory environment. An example would be some disruptive fintech companies. This is the type of company that may want to buy more D&O insurance to defend itself from litigation.

Another example of a company that may want to buy more D&O insurance is one that does business with the government or takes government loans. (Which, today, could be any company—see my recent article on the False Claims Act and COVID relief loans). These companies may want to consider buying more coverage because of the enhanced chance of governmental scrutiny.

A classic example of this is Solyndra, a company that manufactured cylindrical panels. The company received a $535 million government-backed loan from the US Department of Energy under the American Recovery and Reinvestment Act of 2009.

The company was later accused of having misled the government in order to obtain the loan. Investigations (including a Congressional investigation) and lawsuits ensued and the company went bankrupt.

No director or officer wants to live through a situation like this, and if you must face it you’d at least hope you have a robust D&O insurance policy to support you.

4. Are We Just Really Big?

As a company becomes more valuable, there is more to protect. It’s also axiomatic that a larger company is a more lucrative litigation target than a smaller company. This can be a reason to purchase more D&O insurance.

Some might argue that if a company has a strong balance sheet then there is no need purchase D&O insurance. On the other hand, consider the following two points:

First, a valuable company with a large balance sheet might use a D&O insurance program to encourage plaintiffs to limit their demands to the D&O insurance program limit.

For this strategy to be effective a company needs to buy an appropriately sized amount of D&O insurance—think limits closer to the level of what a similarly valued public company might purchase. Such a limit of insurance is typically still far less than what is on the balance sheet of some highly valued public companies.

Second, no matter how large the balance sheet, most public and private companies cannot use the corporate balance sheet to settle breach of fiduciary duty suits brought derivatively. This is certainly the case for Delaware corporations.

Difficult derivative suits with large settlements are a trend, making the purchase of at least substantial amounts of Side A D&O insurance an important purchase for large private companies. For more on this phenomenon, see my article on Five Types of Derivative Suits with Massive Settlements.

Finally, larger private companies are typically also companies that have (or are trying to recruit) independent directors, which is to say directors who have no financial sponsors like a private equity of venture capital firm.

Directors placed on boards to represent the interests of a PE or VC investor typically enjoy indemnification from that financial sponsor and can also receive insurance coverage through the financial sponsor’s insurance programs. The fact that independent directors do not have these backstops tends to drive an upgrade in a company’s own D&O insurance program, resulting in limits of at least $10 million to $20 million.

Remember too that if a company is acquired, the D&O insurance limits that were in place before the acquisition are usually the limits of the D&O tail policy. Once a company is acquired, the departing directors and officers will typically be glad to have a solid limit of insurance to protect them if they are sued after the deal closes for pre-closing activities.

5. Are We Going Public?

It can be the case that the process of getting ready to go public uncovers sources of litigation. For example, a long-departed employee might suddenly decide to bring some kind of suit just because the employee has heard that the company is going public. D&O insurance can be very helpful in this type of scenario.

Purchasing at least $5 million or $10 million of D&O insurance while you are still a private company can also be a strategic move in case you are sued shortly after going public. This is because you typically do not have to provide a warranty statement to levels of limit you purchased in the past.

A warranty statement in this context is the assertion made by an insured party that the insured knows of nothing that is likely to give rise to a claim.

When you go public, your private company D&O insurance program will cease to exist, but the ability to avoid warranting limits you purchased as a private company will persist. Thus, the level of limits purchased as a private company are less vulnerable to being challenged by insurance carriers should a claim arise. The process of securing D&O insurance for a private company becoming a public company is a complex transaction with its own timeline and process.

Warranty statements are just one of many technical issues that will arise. The process is slightly different depending on whether you are going public through an IPO, direct listing, or de-SPAC transaction.

For more on this, see:

• Guide to Going Public for IPOs and Direct Listings
• Guide to D&O Insurance for De-SPAC Transactions

So how much D&O insurance does a private company need? In the end, the amount is a business decision. Answering the five questions listed in this article will help you take a systematic approach to determine what amount of insurance is appropriate for your company.