Startup insurance: Everything founders should know about protecting their company

First-time entrepreneurs rarely give more than a passing thought to taking out insurance to protect their startup. But a dramatic shift takes place by the time entrepreneurs are on their second—or third or fourth—go around. Industry insiders say two of every three repeat startup founders make insurance an integral part of their early growth plans.

Why the change? In one word: experience.

Consider the strikingly similar stories of two entrepreneurs, who asked to remain anonymous because of the sensitivity of the topic. Both say their startups were hit with claims from early employees and third-party contractors alleging their work warranted higher equity compensation than what they were granted. In both cases, the claims were thrown out, but the process of defending and settling cost more than $50,000 each time. Insurance would likely have covered the costs.

These are hardly the only tales of extraneous risks startups often fail to consider. Young companies are frequent targets of everything from cybercrime to wire and email fraud. They face suits and claims from customers, competitors, and former employees that can target the companies, as well as their founders, investors and directors. Such actions are more common than you'd expect and will often leave founders scrambling or worse. Recently, an Ohio startup was forced to shut down after suffering a massive cyberattack, according to its founder and CEO.

"Companies should fail for the right reasons," Travis Hedge, cofounder of Vouch, a startup that specializes in insurance tailored to the needs of young tech companies. "Experienced entrepreneurs know they need insurance." Startup lawyers in Silicon Valley and elsewhere agree: "When you don't have insurance and you're paying everything in full, well, you learn quickly," says Andy Bradley, a partner at Gunderson Dettmer.

Easy to overlook; hard to get

There are plenty of reasons first-timers don't bother with insurance. For starters, it's boring, and with so much else to worry about, it's easy to overlook. To make matters worse, the reputation of the insurance industry isn't pretty. It's known for cumbersome applications, slow delivery of policies and murky pricing guidelines.

The experience of Justin Barad, founder and CEO of OssoVR, is all too typical. "I had a talk with an agent who told me we could get coverage in a couple of weeks"” says Barad, whose Northern California company makes a platform that allows medical professionals to train hands-on for surgeries and procedures. "Nine months later, like pulling teeth, we finally got policies. We couldn't understand them. They couldn't tell us how much it would cost. There were so many mandatory bundle-ins and things we didn't need. I can't emphasize how distressing and distracting this was."

Insurance options are improving

Not every legacy insurance company operates like that, but the tales of woe from disgruntled, disillusioned founders aren't hard to find. Why is buying a policy so difficult? In short, because most insurance companies don't understand startups.

Vouch—along with other InsureTech companies like Coalition, Zeguro, and NewFront—is among a crop of new digital insurance companies focused on the needs of startups. They use data about companies to streamline the process of buying insurance while slashing the price. They're making it easier, cheaper and faster than ever to get a policy custom-built for your needs now, and as you build.

Instead of lengthy questionnaires and interviews, these companies use data to evaluate clients. With underwriting based on proprietary algorithms, they are able to undercut traditional insurers.

Start with basic coverage

So what kind of insurance does your startup need? Start with the basics: business property and general liability insurance will cover things like stolen laptops or a slip and fall accident, respectively. In many cases, landlords will insist on seeing proof of general liability insurance before renting to a startup.

General liability coverage typically includes important protection called "advertising injury," which kicks in when another company challenges a startup's marketing claims to be faster, smarter or used by more people. Vouch has seen three such claims from competitors in recent years. "The suit gets tossed," says Hedge, "but it takes several months and thousands of dollars to resolve it."

Worse, sometimes large, deep-pocketed companies may bring such suits simply to undermine a startup. The claims could be without basis, says an attorney for an analytics startup that recently found itself on the receiving end of such a suit. "But does it really matter if your competitor hasn't been able to raise money, hasn't been able to hire new employees, has been distracted by having to fight a lawsuit instead of investing in a new product or growing new clientele?"

Investment triggers changing needs

An investment round—or the prospect of one—often acts as a forcing function that sends founders looking for insurance. That's because as part of closing conditions, investors will typically require that a startup get coverage to protect directors and officers. In a D&O case, a startup gets sued along with its top executives and directors, who are named personally. It's a common approach from litigants since investors are likely to have the deepest pockets.

Investments make insurance more necessary for other reasons. It's great news when a company closes a round of funding, say $5,000,000 to $10,000,000. But when a funding round is announced publicly, those assets can become a target for thieves. "That's when the cockroaches come out of the woodwork," says Hedge.

Attacks on a company's accounts may come in the form of spear phishing, cyber-attacks or a security problem—meaning embezzlement—in the new, untested back office. "The people committing email and wire fraud are evolving at a pace that is terrifying," says Bradley, who considers what the industry calls "crime coverage" to be essential.

What if your employees turn on you?

When a startup begins to hire, insurance needs to grow hand in hand with the risk of employment-related lawsuits. A company can handle an employee dismissal strictly by the books but still have things go wrong. Someone has been terminated, says Bradley, "and that person retains counsel and sends a shot across the startup's bow saying they're going to file suit for any amount of real or imaginary claims." What do we do now?

"My first question is, do you have EPLI?" Bradley says. "And they say, 'Andy, what's that?'" Bradley goes on to explain the ins and outs of what the industry calls Employment Liability Protection Insurance.

First-time founders often learn about EPLI the hard way. Hedge says that over five years nearly 40 percent of US companies end up with an employment-related lawsuit. One attorney who defended employment cases for years: "Unless you have insurance that covers that kind of thing you're on the hook."

Lawsuits are not only a distraction. They can prevent a company from raising funds, as investors are likely to be scared off by the potential liability.

What if your customers sue?

Finally, there's errors and omissions (E&O) coverage, which is basically product liability for software. Bugs in code or mistakes in the process can cause havoc for clients, who may decide they have no option but to sue. If you have E&O insurance your legal and other expenses will likely be paid. It also assures potential clients that, while yours may be a young company, there's a safety net if things go wrong in the code.

Indeed, if your startup is negotiating with well-heeled potential customers, you may find that it's the prospective client who insists on your being protected. "We had really no experience in insurance," says the attorney for the analytics startup. "One of the clients we landed said, 'Oh, you guys need to have good insurance.'" After a quick Google search by the CEO, the startup found coverage. "We could say yes, we've got it covered," the attorney says.

Follow the money

For now, the traditional agencies dwarf their digital kin. Even so, the interest they have spurred among their startup customers has attracted the attention of investors. Investors have poured more than $100 million into this new crop of digital insurers. It's the clearest sign that the slow-moving insurance industry is on the verge of experiencing its own digital transformation, and it's making it easier than ever for startups of all stripes to get insured.