Use litigation funding to protect cash flow

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For businesses of all sizes and in all jurisdictions, the focus is on reducing risk exposure and costs while seeking opportunities to maximize revenue, market share and advance business goals. When the prospect of litigation arises, companies can wrestle with issues such as how to protect the company’s interests and valuation and obtain the best possible legal services at the lowest cost.

Grant Farrar

This is especially true when a company is considering taking legal action as a plaintiff to seek monetary recovery and assert company positions (commonly defined as “affirmative litigation”). Access to the courts requires time, money and resources that are often scarce. In the case of a small business seeking to enforce its rights against a larger, better-funded defendant, this “David versus Goliath” scenario often presents itself.

According to generally accepted accounting principles. (GAAP), litigation costs are expensed in the income statement for the period in which they are incurred. Yet potential future recoveries cannot be treated as an asset on the organization’s balance sheet, however certain they may be.

To compound this problem, when a collection occurs, it is usually one-time revenue and does not count towards a claimant’s recurring revenue. As a result, analysts, investors, and potential buyers may assign an inaccurately low enterprise value to a company that self-funds its litigation.

Keeping costs off the balance sheet is hugely beneficial for valuation-focused businesses. This is especially important, of course, when raising capital, acquiring another company, going public, or completing another strategic transaction. Every dollar not subtracted as legal fees means an increase in appraisal dollars.

Optionality allows businesses to pursue litigation that they can defer or avoid based on cost.

However, a relatively new legal and financial strategy, litigation funding, may offer a creative new approach to these considerations. Litigation funding is capital committed by outside investors that funds attorney fees and court costs to settle the litigation.

This type of financing is generally “non-recourse”, which means that if litigation fails, the entity that advanced the funds loses its invested capital without return. This is similar to the more commonly understood contingency fee litigation model, but with significant advantages.

Litigation funding allows companies to show higher net income, reduce expenses and advance important business strategies. A fundamental tenet of sound financial strategy is that options have value. Litigation funding allows businesses to find and fund the best possible law firms to represent them, not just the firm that can potentially take on litigation or has otherwise limited budget. This option allows businesses to pursue litigation that they can defer or avoid based on cost. And companies may reject unfavorable settlements due to considerations of length of litigation or increased legal expenses.

Financing can even be committed if a company has obtained a favorable judgment or an arbitration award before receiving the proceeds. Financing could fund further proceedings to immediately collect and monetize a judgment, thereby covering the risk of loss and immediately bringing significant dollars to the balance sheet. In short, companies don’t have to forgo a potential recovery and don’t need to self-finance the risk of an uncertain outcome.

Some companies are already researching and developing policies to guide valuation and affirmative litigation strategy, which is also identified as “corporate takeover”. These policies are similar to related policies guiding how to evaluate options for incurring debt or investing idle cash. CFOs should discuss with their in-house legal staff whether potentially contentious matters have been deferred or avoided and are therefore good candidates for funding. Questions to discuss include:

  • How many files could be eligible for funding?

  • Will the case or cases require outside law firms, or can they be litigated in-house?

The CFO should also review the company’s litigation history. The potential cost of litigation may have created an internal bias against litigation. Legal funding opens up new options, so it might be a good idea to revisit past rulings on affirmative litigation. Litigation that previously seemed too costly may now be feasible.

Finally, a litigation funding agreement should stipulate that the company and its legal counsel retain sole control of litigation strategy and settlement decisions.

Funding arrangements are tailor-made and, when properly designed, can benefit all parties involved. They reduce the risk of an early takeover free of charge. With litigation funding, litigation strategies can now be fully integrated into a company’s value and service delivery mechanisms.

Grant Farrar is an experienced litigator and litigation finance expert who assists private and public sector entities with litigation.

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