Cracking Your Cash Flow Potential with Litigation Funding
For organizations of all sizes and across jurisdictions, there is often an emphasis on reducing risk exposure and costs while also seeking opportunities to maximize market share, revenue and advance business objectives. When the prospect of litigation arises, companies typically have difficulty with issues like determining how to protect company valuation and interests while exploiting the best and most cost effective legal services. Such concern rises especially 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 translates to spending money, time, and resources that are too often in short supply. Given the circumstances of smaller organizations looking to vindicate rights against a larger, better-funded defendant, “David v. Goliath” scenarios often occur in this legal realm.
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. However, litigation funding can resolve the aforementioned issue. It would behoove finance professionals to cultivate their proficiency in this tenet of litigation, and how it can ultimately have a positive impact on cash flow.
To further illustrate its criticality; some legal scholars have referred to the emergence of litigation finance as “likely the most important development in civil justice of our time.” This blog will flesh out how you can leverage litigation finance in your efforts to maximize cash flow.
Defining Cash Flow
The term cash flow refers to the total amount of cash and cash equivalents being transferred in and out of an organization. Cash received represents inflows, while money spent represents outflows. A company’s capacity to create value for shareholders is primarily determined by its ability to produce positive cash flows.
Properly executing cash flow calculations requires the following: proficiency in Microsoft Excel and its specific capabilities in regards to cash flow, knowing cash flow planning techniques that addresses today’s volatility, and the adoption of high tech systems that offer powerful insights in this crucial financial planning process.
Cash flow is the amount of cash that comes in and goes out of an enterprise. Organizations take in money from sales as revenues and spend money on expenses. They can also receive income via investments, royalties, interest and licensing agreements and sell products on credit, expecting to receive the cash owed at a later date. Assessing the timing, amounts, and uncertainty of cash flows, along with where they originate and where they go, is among the most important objectives of financial reporting. It is critical for assessing a company’s flexibility, liquidity, and overall financial performance.
Positive cash flow indicates that an organization's liquid assets are increasing, enabling it to cover obligations, return money to shareholders, reinvest in its business, pay expenses, and provide a buffer against anticipated financial issues. Organizations with high financial flexibility can exploit profitable investments. They also fare better in downturns, by evading the costs of financial distress.
Defining Litigation Funding
Litigation funding (also called litigation finance or legal financing) is the practice where a third party unrelated to a given lawsuit provides capital to a plaintiff involved in litigation in return for a portion of any financial recovery from the lawsuit.
Litigation finance helps seize the potential value of legal claims by providing capital to plaintiffs before their cases are resolved. Such financing has been around for over 20 years in the United States and is increasingly a mainstream solution that equalizes access to the legal system. Fortune 500 companies, major universities and businesses of all sizes have benefited from litigation funding in recent years.
Tying Litigation Funding into Cash Flow Maximization
Keeping costs off the balance sheet is incredibly beneficial for organizations concentrating on valuation. This is particularly important, obviously, when increasing capital, acquiring another company, transitioning to public, or conducting some other strategic transaction. Every dollar not spent on legal costs translates to increased valuation.
Optionality enables enterprises to pursue litigation that they may defer or avoid on the basis of cost. However, a relatively new legal and financial strategy, litigation funding, offers an advantageous new approach to such considerations. Litigation finance is capital committed by outside investors that finances attorneys’ litigation costs and fees to bring litigation to a resolution.
Litigation funding is normally “nonrecourse” finance, 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 comes with crucial advantages.
Companies can show higher net income with litigation financing, lower their expenses, and advance important business strategies. A key tenet of a sound financial strategy is that options have value. Litigation funding empowers organizations 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 pursued if an organization has secured a favorable judgment or arbitral award before reaping their 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. Companies do not have to sacrifice potential recovery and do not need to precariously self-fund the risk of an uncertain outcome.
A number of organizations are already studying and cultivating policies to guide strategy and evaluation for affirmative litigation, which is also defined as “corporate recovery.” These policies are similar to related policies guiding how to evaluate options for incurring debt or investing idle cash. Finance leaders should spur discussion with internal legal staff members if potentially litigated matters were avoided or deferred and therefore are good candidates for financing. Discussion questions could include:
Which matters are eligible for financing?
Will the matter or matters require external law firms, or can they be litigated in house?
How many matters could be eligible to be financed?
The CFO should also review the organization’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.