Monday, 4 June 2007

Keyman insurance in early-stage companies

Most entrepreneurial managers I know are deeply uninterested in anything like insurance- and it seems strange that in a company where the chance of serious success is pretty small that it could ever be very relevant.

What is keyman insurance

A particular example of insurance that's relevant to early stage companies is the so-called "key man insurance". This provides, usually the company, with a lump sum of cash in the event that death or serious disablement causes a nominated individual to become unable to work for the company. As such it seems to cost a little more than the standard domestic life insurance, but is very dependent upon the age and health of the individual concerned.

Why it is contentious

  • From the "keyman's" point-of-view the insurance doesn't benefit him/her- although arguably if it helps preserve the value in the company which could ultimately flow back to them or their dependents then maybe that's relevant.
  • If the individual was unavailable it'd be "game-over" for the company- therefore there'd be no benefit other than to the creditors.
  • "Investors' risk is spread across a portfolio of investments, so why should they insist the company is burdened with a premium

Tests for the use of keyman insurance

In my view part of the confusion here is that there are two distinct ways in which "keyman" insurance is being used:

  1. to protect investors capital against the loss of a pivotal individual who is deemed to be irreplaceable

    We've suffered one example of this in the life of the fund, where within 4 months of investment the technology lead on a project died quite unexpectedly. In this instance the individual concerned had developed the ideas and done the research behind the company's technology, and there was little prospect that we could go out and hire someone else to "fill those boots". In this instance, had it been in place by that date, keyman insurance to cover our investment would've been helpful- and given the unexpected nature of the death not too expensive either.

  2. To protect the company against the loss of a replaceable individual at a really bad time

    There are probably relatively few "completely irreplaceable" people in our portfolio companies, but there are lots of people who's departure would leave a huge void which would take some time to fill. In my opinion, it is in the interests of everyone concerned that the company is sufficiently insured that it could stand the time and the cost of recruiting a replacement even if the timing was pretty unfortunate. For example, if the company was about to complete a follow-on round and perhaps was rather low on cash, the loss of the individual could cause investors to hesitate. In this instance I'd suggest that everyone involved would like to see that the insurance was sufficient to allow the company to trade on for perhaps 3-4 months whilst a suitable individual was found.

My view

If you accept my view that there are these two types of keyman insurance, I think there's a logical position to be adopted:

Replaceable with time Irreplaceable
Cost to insure Low At least 6 months net burn Cover for cost of investment
High At least 3 months net burn Contentious- Cost of investment- but maybe worth succession planning as an alternative approach

Who should pay

Where keyman insurance is being provided to protect the investors capital, it seems reasonable that this cost might be borne by the investors directly. This can clearly be an emotive issue, but on closer inspection, certainly for our kind of investment, it doesn't make a great deal of difference. In practice the premium comes from investor capital in both cases, and so adding it into deal terms could reasonably be expected to result in the same net situation. However, in my experience VC funds do not retain earmarked funds against each investment, so the only practical solution is for the company to pay the premium- effectively part of their cost of raising money. There's also the consolation that we'd certainly try to keep the use of truly irreplaceable people to a minimum and then usually only for a transitional period.