Founders soliciting venture funds quickly get comfortable revealing details about their operations, vision and finances. They may also need to be willing to step on a scale and get a blood draw. Investors try to ensure that the startups they’re funding are healthy, and, strange as it might seem, they like to know that critical founders are in good shape, too.
A physical is required to obtain key person insurance, which investors can require as a condition of granting Series A funding. Key person insurance is basically term life insurance on a company’s founder or founders, with the company as the beneficiary.
It’s not uncommon for VCs to insist that a startup take out a key person policy on the person or people whose expertise is critical to the company’s current operations and future success. The rationale for the request is that should a key person suddenly die, the business would either collapse or be so crippled that it would have to take a huge step back to reboot and rebuild.
VCs are always mindful of downside protection for their investments, and you really can’t blame them. If a founder whose very existence is essential to the company’s future meets an unexpected end, its investors and the company will be left to shoulder the debts because early-stage companies normally have little or no revenue or cash reserves to draw on.
Although a founder might initially view the demand for a policy on his life be a bit off-putting, he could also see it as a compliment.
That’s where the policy steps in. Its proceeds pay wind-down costs, including salaries, creditors and debts to vendors and the landlord. Whatever’s left will be distributed to stockholders, usually at pennies on the dollar. If the company opts to carry on without its key person, the insurance money can fuel the company’s operations.
Investors typically ask a company to purchase key person insurance coverage when a company is raising its first round of financing. VCs will request the insurance at the term sheet stage or as part of negotiating definitive investment documents.
Although a founder might initially view the demand for a policy on his life be a bit off-putting, he could also see it as a compliment: Investors consider his knowledge and skills so vital to the company’s wellbeing that they need a backup plan if anything should happen to him.
Of course, investors won’t request a key person policy on everyone at the company. If you’re not deemed a “key person,” treat that determination dispassionately as a business decision. Typically, the more founders or team members in a company, the less crucial any single player is.
Key person insurance costs around $500 to $1,000 a year per million dollars of coverage for a healthy individual, and most early-stage companies opt for between $1 million and $3 million in coverage. Businesses decide on coverage based on how much cash they’d need to weather the storm immediately after the loss of the key person or to wind down operations and satisfy their financial obligations.
Any big-name insurance company can underwrite one of these policies. Companies often group it with D&O (directors and officers) insurance and other business insurance, which can help save money.
Getting a policy is pretty straightforward. You’ll need a physical, and even if you’re not a Tough Mudder, you won’t be denied; your company will just pay a higher premium. Each year the board assesses whether to keep the policy in effect.
Though key person insurance can cost a startup several thousand dollars a year, it’s a short-term need. Your company can drop it at any time, but boards usually renew the policy until the company is mature enough that its success is no longer tied to the vision or genius of a single person. You won’t need a policy when the key founder’s “special sauce” has been transferred to a development team.
The most reassuring aspect of key person insurance is that, like most policies, you’ll never need it. It’s a hedge against the worst-case scenario and a reassurance for risk-taking VCs that when they bet on your company, they’re prepared for the worst so they can expect the best.Featured Image: Andrey Kozachenko/Shutterstock