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Private Equity and Venture Capital: Insurance Considerations
Private equity (PE) and venture capital (VC) are two terms often used synonymously to describe firms and the way they are operated. And although the two concepts are quite similar, there are some important distinctions between them.
This article contains all the information necessary to understand the nuances between private equity and venture capital firms. It also aims to help you learn about the risks associated with PEs and VCs and provides strategies for minimizing the risk.
What are Private Equity and Venture Capital Firms?
To better understand the complexities of private equity and venture capital, we first need to define the two terms separately and then outline the differences between them. Here is what sets a Private Equity apart from a Venture capital firm.
A private equity firm is a company that invests in other companies not publicly listed and traded. When firms obtain private equity in a company, (a portion of the company’s entire shares), they gain either part- or full ownership of the company.
Private equity requires substantial investment capital, so PE firms need to have a high net worth. PE firms buy shares in private and public companies on behalf of accredited or institutional investors. Usually, PE investors decide on a complete buyout, to take the companies they buy off the market.
In most cases, PE firms invest in companies that are struggling financially and need restructuring and debt consolidation. After the company takeover, the PE firm will implement an improvement plan to increase the company’s worth. And if the plan is executed successfully, the PE firm can sell the company for profit.
Venture capital is considered to be a form of private equity, although the choice of investments differs significantly. VC firms invest in startups and small businesses that have the potential to grow and generate profit in the long run. Unlike private equity, venture capital investments don’t have to be as substantial. But the risk involved is much greater since the investments rely on the expectation that the new company will be successful.
New companies depend on venture capital investments; they have short or no operating history, aren’t publicly traded on the stock market, and banks may be reluctant to give out loans. So, the only way to get funding is via venture capital. However, when in need of VC investments, companies need to submit a business plan, so the VC investor can decide whether the venture is worthwhile. Additionally, venture capital firms need to perform due diligence, including an investigation of the company’s products, business model, management, etc.
VC investments don’t always come in the form of money; firms can offer managerial or technical support to up-and-coming companies and receive a portion of company shares in return. Even though the investment is riskier, venture capital investments can see above-average returns, which is why they are so popular — in spite of the risk.
What are the main Differences between Private Equity and Venture Capital?
The table below illustrates the main differences between the two types of firms.
As you can see, even though PE and VC seem similar, there are several key aspects that are quite different. So, if you decide to enter the world of investments, be sure to choose the type of investment that aligns with your goals and can produce the effect you want.
What Are the Risks of PEs and VCs?
Risk is an inevitable factor in every investment, and PE and VC firms are not exempt from it. There are several risks you need to be aware of before you put down your money.
#1: Investments Falling Through
The number-one risk both PE and VC firms face is that the company they invest in might fail. With private equity investments, this risk is lower; PE firms put their money in companies that are already established, despite any current financial difficulties. The risk of such a company failing is very small, even non-existent. However, with the current state of the market, anything is possible, and PE firms invest significant sums, and losing such sums would be a difficult blow.
VC firms, on the other hand, expect some of their investments to fall through; investing in startups poses a significant risk, as most of them don’t succeed in the long run. Venture capital firms take a calculated risk and try to minimize it by investing smaller sums in different companies. Even if just one of these companies grows and becomes profitable, all the unsuccessful investments will pay off.
#2: Lawsuits & Liability Claims
Just like any other company, PE and VC firms face the risk of a lawsuit or a liability claim. These lawsuits/claims can be made by one of the investors or board members if they believe that the company operations stray from the agreed-upon terms. Claims can also be made by unsatisfied customers using the company’s products or services.
Because PE and VC firms have full or partial control over the company, they are responsible for resolving any legal issues and paying any settlement amounts. Any company is open to liability, and there’s not much anyone can do to prevent it, but investors can take measures to protect themselves against these actions.
#3: Property & Equipment Damage
When a PE or a VC acquires a company, they also acquire any property and equipment owned by the company. Owning such assets is always risky because they can be subject to damage and incur additional costs. Understandably, the PE or VC investor is responsible for covering all of the costs for repairing or replacing damaged assets.
There’s also the risk of theft. Although not as common as the risk of damage, theft of physical assets can occur even in the most highly-secured companies. It’s of utmost importance to have an insurance policy that covers both theft and damage, and investors should also look into asset cap insurance.
#4: Compromised or Lost Data
In this digital era, all data is virtually stored. And although this is a significantly more effective way to store information, it’s also risky. Investors should be aware of the danger cyber attacks pose, as well as of the consequences of having sensitive information stolen or compromised.
PE and VC firms will be responsible for any financial loss that occurs due to a data breach or leak. Not only will they need to retrieve the lost data, but they will also need to compensate any concerned parties for the damage. Currently, cybercrime is the most serious and most common threat companies face.
In order to operate properly, a company must have employees. Unfortunately, employees are also the company’s soft spot, one of the necessary risks an investor must take on.
Any employee injury (and the medical expenses resulting from it) is considered company responsibility. Lawsuits and claims by current and former employees are also a risk and the company must settle them in or outside of court. That’s why it’s essential for PE and VC investors to have a legal team that will be able to handle any hurdles in the operation process.
What insurance do Private Equity and Venture Capital need to consider?
Once you understand the risks associated with operating a PE or a VC firm, you know the importance of insurance. Whether you’re looking for private equity insurance or venture capital insurance, there are several insurance policies you need to consider before you invest in a company.
Business Owners Policy (BOP)
The Business Owners Policy combines three distinct policies into one — the General Liability and Product Liability, Commercial Property, and Business Interruption policy. This is a particularly good choice for small and medium-sized businesses, as they don’t have to pay separately for each policy.
The BOP offers protection from damage to office equipment and customer injuries, as well as monthly income insurance in the case that your business fails to produce an income. However, the best thing about this policy is that it’s highly customizable; you can ask for specific coverage depending on the company’s operations and requirements.
Errors and Omissions (E&O)
Often, VC and members of their firm provide professional services for the portfolio companies. They will sit on boards, play management roles, and operate as executives that provide advice or consulting services. If a member of their team makes a mistake, the entire VC or PE firm can be at risk.
Errors & Omissions insurance for a VC and PE protects the firm from claims against negligence that derive from the services they provide.
Commercial Crime Insurance
To protect your business from fraudulent activities either internal or from third parties, you’ll need to get a commercial crime insurance policy. This policy will cover monetary losses, but also the loss of assets incurred by property theft. With this policy, you can also get coverage for embezzlement, misrepresentation, burglary, and theft of cash funds.
The first-party coverage of this policy insures the company against direct losses, i.e. fraudulent acts that directly affect the business operations. The third-party coverage protects the business from allegations by other businesses that fraudulent acts have been committed. This policy is essential for businesses that conduct large transactions or own expensive assets.
Directors & Officers (D&O)
As an investor, you don’t want to risk any of your privately-owned assets. That’s where the Directors & Officers policy comes in. The D&O policy was designed to protect the personal assets of business owners, investors, shareholders, and board members in case of a lawsuit against them.
When executives make decisions that prove to be detrimental to the business, they risk being sued and their personal assets are on the line. The D&O policy protects both the company and the executive’s assets (home, finances, etc.), and even though bad decisions could result in financial losses for the company, an individual’s assets are fully protected.
Workers Compensation Insurance
Any business that has employees needs to get a Workers Compensation (WC) policy. The main purpose of this policy is to protect the business when a worker gets injured on the job. This policy should cover all workers- full-time, part-time, freelancers, volunteers, subcontractors, etc.
If an employee is injured, the WC policy will cover all the medical bills, lost wages, rehabilitation expenses, and death benefits. This policy simultaneously protects the business and its employees. They can rest assured that in the case of an accident, all expenses will be covered.
Cyber Liability & Data Breach
In this day and age, cyber-attacks are a threat to any business; often, they are the most serious threat businesses face. The cyber liability & data breach insurance policy protects a business from financial losses that occur due to various cyber crimes. This policy also covers the costs for lawsuits and liability claims by clients who have been directly by the cyber crimes committed against your business.
In addition to protecting company funds, the policy will cover the damages incurred by the loss of sensitive information in a data breach. It will also cover the costs for recovering such information. And in case such a case reaches court, the policy will cover not only the legal fees but also any settlement amounts that need to be paid to third parties.
Other notable coverages: Employment Practices Liability, Fiduciary Liability, Commercial Automobile, Foreign Liability, and Commercial Property.
Why Do PEs and VCs Need Insurance?
Choosing one or two of the recommended policies is a good idea, but the best course of action for you and your business would be to get all of the recommended policies to ensure that your new venture is protected in any situation.
But you may wonder why private equity and venture capital firms need insurance if all they do is invest in other businesses. Well, the answer is quite simple. Whenever a PE or VC firm purchase the entirety or a portion of a company’s shares, it becomes a full or part-owner of the company in question. That, in turn, means that the PE/VC is responsible for the company’s actions from both a legal and a financial standpoint.
To protect themselves from legal risks and financial losses, PE and VC firms need to get insurance to cover both them as an investor and the company they’ve invested in.
What does PE and VC Insurance cost?
At this point, you’re aware that PE and VC insurance are a must if you want to wade into the world of investments. However, what may concern you is the cost of the insurance policy.
But before we look into the separate costs of each policy, you need to keep in mind that the cost of each policy will vary depending on numerous factors.
The cost of the policy can depend on several factors:
- Company Size — small and medium-sized companies pay lower policy premiums; large corporations pay significantly more for insurance.
- Number of Employees — the higher the number of employees, the higher the premium.
- Revenue — the policy cost can be determined based on how profitable the company is.
- Industry — some industries are riskier, so their insurance policies are higher, too.
- History of claims — if a company has a history of claims or lawsuits, the insurance premium will be higher.
- Coverage limit — if you want a policy with a higher coverage limit, you’ll have to pay a higher premium.
Cost Per Policy
Now that you know what are the things that can influence the cost of a policy, let’s take a look at the price range for each of the recommended policies.
- Business Owners Policy — small businesses pay between $500 and $1,500 for yearly coverage; bigger companies can expect to pay more.
- Crime Insurance Policy— the price can range from $500 and $5,000 per year.
- Directors & Officers Policy — the average policy will cost between $5,000 and $10,000 per year. Businesses in highly regulated industries will need to pay more.
- Workers Compensation Policy — companies with more employees and risky operations will pay higher rates — approximately 2% per year. Safer occupations will yield lower rates. For example, the rate for office workers is approximately .0004%.
- Cyber Liability & Data Breach Policy — newer and smaller businesses pay a yearly premium between $500 to $2,500, while large companies can pay anything from $5,000 to $100,000 per year.
Based on these numbers, you can expect to pay a policy premium that can range from a few thousand dollars to hundreds of thousands of dollars per year. The exact cost will depend on numerous factors, so it’s best to consult with an advisor and figure out what the insurance cost will be before you invest in private equity or venture capital.
Private equity and venture capital are attractive opportunities for investing and seeing a return on the investment. But much like all business ventures, they come with a set of risks. This is where private equity insurance and venture capital insurance come into play. Although you can never enter a risk-free investment, getting insurance is an excellent way to protect the money you’ve invested.
It’s a no-brainer — get insurance policies for each of the risks you may be facing and you can resume your operations care-free!