This blog post first featured in the London Entrepreneurship Review on 2 March 2016.
Many growth companies must contemplate legal action due to the improper and/or illegal conduct of incumbent competitors keen to put the ‘new guys’ out of business. This is frequently the case for companies that are successfully disrupting large players in high growth sectors such as energy, healthcare and technology. Improper/illegal conduct by incumbents commonly takes one of three forms:
- Interference with intellectual property (IP) rights – attempting to prevent the growth company acquiring IP rights (for example, by lodging objections to patents, trademarks or domain name registrations) or deliberately infringing those rights.
- Anti-competitive behaviour – misusing a powerful market position by, for example, engaging in predatory pricing, discriminatory conduct, or interfering with contracts and customer relationships.
- Other forms of intimidation or harassment – for example, running negative media campaigns, bringing (or threatening) vexatious law suits, lodging regulatory complaints or other improper actions designed to put the company out of business.
Faced with this conduct, growth companies have traditionally had to choose between three responses.
First, they can divert resources to commence (or defend) legal action. This can be painful for growth companies who usually operate to tight budgets and have limited access to capital. For these companies, the opportunity cost of allocating capital to fund legal actions (which are generally expensive in the UK and take, on average, between 18-36 months to be resolved) is high.
Second, growth companies can devise a way for the business to continue to operate, and grow, despite their competitors’ attempts to thwart the business. This isn’t always possible, and even where possible, might require a deviation of strategy, or compromise of business objectives, which are not acceptable to the stakeholders in the company.
Third, a growth company can shut down. This is a painful decision for any manager, made worse in these circumstances because the forfeiture of the business was brought about by the deliberate and improper acts of competitors designed to bring about this result.
The developing market for litigation finance in the UK provides a fourth and often more attractive option for growth companies seeking to protect their rights, and their businesses, from the damaging conduct of competitors. This article explains how litigation funding works and the potential benefits of this type of finance for growth companies, drawing on lessons from a recent case in which we supported a growth-stage content aggregation business in the UK (let’s call it “ContAg”) in an IP dispute brought against it by a monolithic Silicon Valley social media company (let’s call it “BigTech”).
ContAg is a growth company that developed a popular app using proprietary technology to rank and disseminate web-based content to its subscriber base. Early in its development, ContAg made an application to register a trademark. BigTech filed an opposition to this application, which was rejected, and the mark was registered in ContAg’s name. Not willing to accept this decision, BigTech hired an international law firm to appeal the decision and sue ContAg, resulting in ContAg being involved in disputes in nine separate jurisdictions. BigTech, through its lawyers, told ContAg that if it was not willing to surrender its trademark then BigTech would fight all disputes in all jurisdictions through all levels of appeal and would contact each of ContAg’s investors to brief them on the dispute and BigTech’s intended strategy to wear ContAg down until it submitted. For good measure, BigTech personally smeared the founder and CEO of ContAg in an attempt to increase the pressure on him to settle the matter.
ContAg, therefore, found itself involved in disputes in multiple jurisdictions against a determined and better-resourced opponent. With legal fees rapidly mounting, ContAg approached us to support it with these claims. With legal fees rapidly mounting, ContAg approached us to support it with these claims.
Litigation finance involves a third party funding the costs associated with protecting a company’s rights through legal avenues, in exchange for a share of the value obtained by the company, if (and only if) the matter is resolved in the company’s favour. In its simplest form, litigation finance involves paying the legal fees (the costs of solicitors and barristers) and expenses (court fees, photocopying, expert evidence) of a claimant on a non-recourse basis in exchange for an agreed return – commonly a multiple of the amount committed to the case, or a percentage of any damages recovered – in the event of success.
Litigation finance is an expensive form of finance, reflecting the non-recourse nature of the funding and the inherent risks of commercial litigation. Like VC firms, litigation financiers depend on high returns from a small number of successful investments to cover the costs of other unsuccessful investments. As a rule of thumb, litigation financiers in the UK seek returns of between two and four times their investment, or 20-40% of the amount recovered. As an example, consider a strong claim brought in the UK with claimed damages/compensation of £15m and estimated costs to the conclusion of the case of £1m. A funder may commit to providing the £1m required to run the claim through to conclusion, on a non-recourse basis, in exchange for:
- the amount of committed capital drawn down at the time of settlement/adjudication; plus
- a return equal to the greater of 3x the committed amount or 30% of the claim proceeds recovered.
In this example, if the case settled for £12m 18 months after the funding agreement was executed, and at the time of recovery the funder had provided £0.6m of the £1m facility, the funder would receive £3.6m. This being £0.6m (capital actually spent) plus £3 million, being 3x the committed capital, leaving the claimant with £8.4m, or 70% of the total amount recovered.
Litigation financiers can support litigants in a variety of novel ways, including by purchasing their claim outright; providing a recourse loan secured by the proceeds of the claim; investing directly in the company involved in the litigation; or providing insurance for costs associated with litigation. This article focuses on the simplest form of litigation financing – funding the costs and expenses associated with bringing (or defending) a litigation claim on a non-recourse basis – and the benefits of this funding for growth companies such as ContAg.
Litigation finance has several potential benefits for growth companies:
An outside source of capital. Litigation finance allows growth companies to fight commercial claims without using their own resources. By accessing the capital of third party financiers, growth companies can use their own limited capital to support their operations and growth and thereby maximise return on this capital. ContAg had already spent several hundred thousand pounds fighting BigTech by the time it approached Balance Legal Capital for support. These claims were months, if not years, from final resolution. The monthly drain on the company’s resources was affecting its other projects and causing the management team to question how long they could maintain the fight. Accessing our capital would ease the pressure on ContAg’s capital.
Shifting/sharing the financial risk of litigation. Litigation finance can shift the often significant financial risk of litigation from a growth company to a third party financier, who will usually be better-equipped to bear that risk. In the UK, the financial risk of litigation includes both the month-to-month costs of litigation and the risk of being ordered to pay the other side’s costs if you lose (so-called “adverse costs” – which is the default position in the UK for a losing party). Dedicated litigation financiers have litigation expertise, and diversified portfolios of case investments, that make them better able to bear the financial risk of litigation than companies pursing a single claim. As a team of experienced litigators with a dedicated litigation fund, Balance Legal Capital was better equipped than ContAg to assess and bear the financial risk of ContAg’s multi-jurisdictional litigation against BigTech.
Levelling the playing field against better-resourced opponents. Litigation financiers can level the playing field between growth companies and better-resourced opponents by enabling them to retain better lawyers and pursue a superior (and often more expensive) case strategy. The involvement of a litigation financier itself can provide a catalyst for the swift resolution of a legal claim by signalling to a defendant that the claimant has funding, and that a strategy designed to prolong the litigation and “bleed-out” a smaller opponent will not succeed. Following our agreement to provide financial support to ContAg, BigTech’s legal team dropped its strategy of attempting to bully ContAg and engaged meaningfully in settlement discussions.
Unlocking the value of the claim prior to final adjudication. Growth companies with valuable claims can use litigation finance to unlock the value of those claims prior to final adjudication. Litigation finance is a form of non-recourse borrowing secured by the contingent value of a claim. In certain cases, in addition to financing a legal claim, litigation financiers will agree to advance sums to support a company’s operations whilst the legal claim is on foot. Access to this form of borrowing can be particularly valuable to growth companies with high borrowing costs and limited access to capital markets. We assessed ContAg’s claims as strong and predicted that ContAg would ultimately get a large payment from BigTech. The contingent value of this payment was what enabled us to agree to front the costs and expenses that ContAg would incur in fighting BigTech through to settlement or adjudication, allowing ContAg to unlock some of the value of its claims early and use the cash it would have spent on the dispute to support its operations and growth instead.
Improve recorded earnings. The costs of litigation are subject to unfavourable accounting treatment under the International Financial Reporting Standards and Generally Accepted Accounting Principles. A litigation claim is effectively an action taken to recover money that a company is owed (i.e. a “receivable”). However, unlike other receivables, pending litigation claims are not recorded as an asset on the balance sheet and money spent to realise these assets (legal fees and expenses) is not capitalised on the balance sheet. Rather, the costs of pending litigation are expensed as incurred through a company’s profit and loss statement, reducing its operating earnings. Perversely, if the company ultimately makes a recovery on its claim, it is penalised again by its accountants who treat this income as “below the line”, non-operating income because it was not generated by the company’s core business. The uneven accounting treatment of litigation cash flows usually has a larger impact on growth companies who commonly report little or even negative earnings, and rely on their financial statements to support their borrowing and fundraising activities and company valuations. Litigation finance enables a company to avoid the prejudicial effects of litigation on financial statements by completely removing the future expected costs of litigation from its statements.
Case strategy, resourcing and fee-structuring support. Litigation financiers are commonly former lawyers who have experience assessing and running cases as well as having knowledge of, and relationships within, the legal services market. A financier’s fresh assessment of a case’s prospects of success, the legal strategy, resourcing and budget can be of significant value to litigants, particularly those that don’t have an in-house legal function, or well-established relationships with law firms. Litigation financiers and litigants have a common interest in ensuring that the appropriate team, fee structure (including contingent fee arrangements where the lawyers share some of the client’s risk by agreeing that a portion of their fees will be subject to a successful outcome) and legal strategy is in place and that the matter is running to budget. Before agreeing to finance ContAg’s case, we assessed ContAg’s legal team and rigorously tested their case strategy and advice on key issues (we were satisfied with both). ContAg and its legal team benefited from our independent stress-testing of the case and strategy.
The relatively high cost of litigation finance means that it is not appropriate for every company and for every dispute. The full range of benefits that litigation finance can provide are summarised above, but on a pure corporate finance analysis, whether a company should seek litigation funding or self-fund a case can be determined by reference to:
- the company’s financial position: access to capital markets; cost of capital; projected annual free cash flows and return on current and future investments;
- the dispute itself: the amount in dispute; the chances of success; the time the dispute will take to resolve and the costs involved; and
- terms of finance available: the return that a third party financier will require in exchange for the risk of non-recourse finance.
Litigation finance was a valuable tool for ContAg because it had relatively limited access to capital markets, a high cost of capital, high projected ROIs and low projected free cash flow for several years. For ContAg, continuing to self-fund the litigation would have required obtaining a fresh injection of capital from its VC backers who were not in the position to evaluate the likelihood of success in the litigation and whether this investment was one they should make. With litigation finance, ContAg could continue to fight BigTech whilst funding its development and operations and pursue the claim, without raising fresh capital. Happily for ContAg, shortly after it secured litigation finance it agreed to a global settlement of all action with BigTech.