You Are Being Sued Because Your Startup Didn’t Meet Expectations.

A startup closes a $10 million funding round. Six months later, however, revenue is well short of the projections in its pitch deck. One investor, which put in $3 million, claims the deck overstated customer growth and left out a cash flow problem. It sues the company, its CEO, and its CFO for fraud and negligent misrepresentation and asks for its money back.

The company carries a private company D&O policy. The insurer responds with a reservation of rights letter listing several exclusions. Whether the policy actually pays for the defense and any settlement depends on details most founders never read when they bought it.

Private Company D&O Insurance Covers More Than Founders Expect

Many founders assume D&O insurance matters only after a company goes public. Public company policies usually limit the company’s own coverage to securities claims. By contrast, private company D&O policies cover directors and officers for claims arising from their management decisions, including alleged misstatements to investors. They also typically cover the company itself for a wide range of claims.

Depending on the policy, covered loss can include defense costs, settlements, and judgments. But many private company policies don’t require the insurer to take over the defense. Instead, the company hires counsel and the insurer reimburses reasonable defense costs, often subject to its consent on counsel and rates. That affects who controls the case.

Early Decisions That Affect Coverage Later

D&O policies are usually written on a claims-made basis, so the claim generally has to be reported during the policy period and within the policy’s notice requirements. Late notice can forfeit coverage that would otherwise exist. Most policies also prohibit admitting liability or settling without the insurer’s consent, and a quick settlement made to end the distraction can backfire. When a lawsuit includes both covered and uncovered claims, the policy’s allocation provision will shape how costs are split, and that split is often negotiable.

An Accusation of Fraud Doesn’t End Coverage

Investor complaints routinely allege that founders knowingly inflated their numbers. D&O policies generally exclude deliberate fraud and dishonest conduct. But many policies apply that exclusion only after a final adjudication in the underlying case establishes the misconduct. Until then, the allegation is only an allegation, and the insurer may have to keep funding the defense.

The Seventh Circuit applied that kind of wording in USA Gymnastics v. Liberty Insurance Underwriters, Inc., 27 F.4th 499 (7th Cir. 2022). Applying Indiana law, the court limited the policy’s conduct exclusion to claims involving conduct for which there had been a criminal conviction, not claims resting on allegations alone. The facts had nothing to do with investors, but the lesson carries over: when a fraud exclusion applies depends on its exact trigger language, and policies vary.

The Securities Exclusion

Another common insurer defense arises from the securities exclusion when the claim involves statements made to sell shares. Some securities exclusions bar claims tied to public offerings but restore coverage for private fundraising, sometimes only if the round stayed under a dollar threshold or met other conditions. Others are broader and may reach private rounds. What matters is what the specific exclusion says and whether this round fits within its exceptions.

Other Exclusions Investors Can Trigger

Venture investors often hold large stakes and board seats, and both can create coverage problems. Many private company D&O policies contain a major shareholder exclusion, which removes coverage for claims brought by a shareholder that owns more than a set percentage of the company, often around 10%. Many also contain an insured versus insured exclusion. If the investor’s representative sits on the board, the insurer may argue that the lawsuit is effectively one insured suing another. Both exclusions usually have exceptions, but they deserve attention as soon as a claim arrives.

Refunding the Investment May Not Be Covered Loss

The investor wants its $3 million back. Insurers often argue that returning money a company received isn’t an insurable loss at all. The Seventh Circuit adopted that view in Level 3 Communications, Inc. v. Federal Insurance Co., 272 F.3d 908 (7th Cir. 2001), holding that loss under an insurance policy doesn’t include returning an ill-gotten gain.

However, that argument has limits: courts in some other jurisdictions have rejected or narrowed it, and it fits poorly against officers who personally received none of the money, or against an investor seeking damages beyond a refund. How a settlement is structured and described can affect whether the insurer has to fund it.

A Disappointing Investment Isn’t Automatically an Uninsured Lawsuit

A startup’s failure to meet its financial projections does not necessarily establish fraud. Nor does an investor’s allegation of fraud automatically eliminate insurance coverage. The company’s actual disclosures, the investor’s allegations, and the D&O policy must be evaluated separately.

If your startup or executives face an investor lawsuit and your D&O insurer disputes coverage, we can evaluate the policy, challenge unsupported exclusions, and pursue available defense and indemnification benefits. Contact us to discuss your matter.

This article provides general information and does not constitute legal advice. For guidance concerning a specific matter, see our commercial litigation services. The available remedies and next steps depend on the governing agreements, facts, and applicable law. To discuss potential representation, request a consultation. Submitting an inquiry does not establish an attorney-client relationship.