There is nothing venture capital funds like more than a clean exit in which they can take their money from sales of portfolio companies, distribute funds as necessary to investors, and then move on to new acquisitions with the money they earned from the sale.
But sometimes there’s an issue and a VC fund can be sued by a third party well after the sale of the portfolio companies… with the fund being on the hook for millions.
That’s not such a clean exit.
Here’s the scenario.
A VC fund has a portfolio of 10 tech companies. They were all promising startups. Some fared poorly. Some did okay. With such early stage companies, that’s just the cost of doing business. Nobody can tell for certain what startups will crash and burn.
But some of the portfolio companies did very well in growing quickly and seeing revenues soar, thanks to breakthrough tech products, not to mention guidance from the fund.
After a few years, the fund had plenty of potential Buyers come calling. The VC fund was happy to offload several of the portfolio companies, resulting in a tidy profit overall. The fund managers are happy. The investors are happy to see a return on their seed capital.
Unfortunately, that fund, a legal vehicle for having equity in those portfolio companies, is still liable for lawsuits from third parties. And the fund also retained an obligation to indemnify the Buyer for contingent liabilities they were unwilling to assume.
And because a good portion of the capital from the sale of the portfolio companies is still held in reserve for contingent and/or tax liabilities that might come up, that capital is at risk and they are unable to make a final distribution.
It’s like if you had a bank account for several vacation rental properties you owned. You’ve already sold the properties. But because you still have that bank account with the sale proceeds, you are still linked legally to the properties.
If this lawsuit from an outside party is successful, the proceeds will come – be “clawed back” – from your reserves held in escrow against potential liabilities.
But there is a way to speed-up the liquidation of the fund so that all the proceeds can be distributed to investors instead of being held in case of potential clawbacks.
Fund managers can make a final distribution to the fund’s partners or interest holders without fear.
With this “fund liquidation insurance” in place, VC funds are able to close the “liquidity gap” after the sale of their portfolio companies and get a clean exit while still meeting the reserve requirement, which is what they’re after, of course, and maximize their returns.
This coverage can also be expanded to cover heirs, assigns, estates, spouses, and domestic partners of fund managers. With this insurance in place, policyholders are covered for identified and unidentified contingent obligations that fund managers would otherwise prepare for with reserves or holdbacks.
Fund liquidation insurance unlocks the millions (in some cases tens of millions) of dollars VCs are forced to keep in escrow/reserve to cover the cost of these potential liabilities.
Some Private Equity and similar investment funds are also using fund liquidation insurance rather than holdbacks during windups to cover back-end risks and to enable the efficient distribution of a fund’s proceeds to investors.
Divestments, which can be multi-year liabilities, can be insured, with the risk of clawback transferred completely to an insurance company. This is not Representations and Warranty Insurance (R&W), although the two types of policies can work in tandem.
This policy will be set up during the final stages of the liquidation process.
Potential liabilities, which can include sell indemnity caps, escrows, and excesses, are added up to form the policy limit. Premiums for this insurance are 1.3% to 3% of that limit, with an additional premium of 3% to 5% for unknown risks. It’s a low cost, considering all the benefits.
Another benefit: this specialized type of insurance could also be a deductible expense. Consult with your tax professional.
For more information on fund liquidation insurance, contact me, Patrick Stroth, at email@example.com or 415-806-2356.