Legal

How Litigation Funding Can Protect a Small Company’s Cash Flow

Litigation financing helps companies obtain the best possible legal representation and avoid a drain on working capital.
Grant FarrarApril 19, 2022
How Litigation Funding Can Protect a Small Company’s Cash Flow
Photo: Getty Images

For companies of all sizes and in all jurisdictions, a common emphasis is on reducing risk exposure and costs while still looking for opportunities to maximize revenues, market share, and advance business objectives. When the prospect of litigation arises, companies can struggle with issues such as determining how to protect company interests and valuation and obtaining the best possible legal services for the lowest cost. 

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  Grant Farrar

That is particularly true when a company considers filing a lawsuit as a plaintiff to obtain a monetary recovery and vindicate company positions (commonly defined as “affirmative litigation”). Access to courts requires time, money, and resources that are often in short supply. In the case of a smaller company seeking to vindicate rights against a larger, better-funded defendant, this “David v. Goliath” scenario often presents itself.

Under generally accepted accounting principles. (GAAP), litigation costs are booked as an expense on the income statement in the period they are incurred. Yet potential future recoveries cannot be treated as an asset on the organization’s balance sheet, no matter how certain.

Compounding this problem, when a recovery occurs, it is usually one-off revenue and does not factor into a plaintiff’s recurring revenue. As a result, analysts, investors, and potential purchasers may assign an inaccurately low enterprise value to a company that is self-funding its litigation.

Keeping costs off the balance sheet is incredibly beneficial for companies focused on valuation. This is especially important, obviously, while raising capital, acquiring another company, going public, or conducting some other strategic transaction. Every dollar not subtracted as legal costs means increased dollars in valuation.

Optionality permits companies to pursue litigation that they may defer or avoid on the basis of cost.

However, a relatively new legal and financial strategy, litigation finance, may offer a creative new approach to these considerations. Litigation finance is capital committed by outside investors that finances attorneys’ fees and litigation costs to bring litigation to a resolution.

This kind of financing is typically “nonrecourse,” which means that if the litigation is unsuccessful, the entity that advanced the funds loses its invested capital with no return. This is similar to the more commonly understood contingent fee litigation model but with significant advantages.

Litigation financing allows companies to show higher net income, lower their expenses, and advance important business strategies. A core tenet of savvy financial strategy is that options have value. Litigation financing permits companies to find and fund the best possible law firms to represent them, not just the firm that can take the litigation on a contingent basis or that is otherwise budget constrained. This optionality permits companies to pursue litigation that they may defer or avoid on the basis of cost. And companies can reject unfavorable settlements due to litigation duration considerations or increased legal spending. 

Financing can even be committed if a company has secured a favorable judgment or arbitral award before collecting proceeds. Financing could fund further proceedings to collect and immediately monetize a judgment, thereby hedging the risk of loss and immediately bringing significant dollars onto the balance sheet. In short, companies do not have to give up on a potential recovery and do not need to self-fund the risk of an uncertain outcome.

Some companies are already studying and developing policies to guide evaluation and strategy for affirmative litigation, which is also identified as “corporate recovery.” These policies are similar to related policies guiding how to evaluate options for incurring debt or investing idle cash. Chief financial officers should discuss with their internal legal staff if potentially litigated matters were deferred or avoided and therefore are good candidates for financing. Questions to discuss include: 

  • How many matters could be eligible to be financed? 

  • Will the matter or matters require external law firms, or can they be litigated in house? 

The CFO should also review the company’s litigation history. The potential cost of pursuing legal action may have created an internal bias against litigation. Legal financing opens up new options, so it might be wise to revisit prior decisions about affirmative litigation. Litigation that seemed too costly before may now be feasible.

Lastly, a litigation funding arrangement should stipulate that the company and its legal counsel retain exclusive control over litigation strategy and settlement decisions.

Funding arrangements are bespoke and, when properly constructed, can benefit all involved. They de-risk an anticipated recovery without cost. With litigation financing, litigation strategies can now fully integrate into the value- and service-delivery mechanisms of a company.

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