Financial Analysis of Litigation Funding

The emergence of litigation finance has enabled CFOs to better manage and finance a once dormant asset – potential litigations. Many of the companies that Lake Whillans finances are emerging businesses with promising new products that have the ability to transform an industry. Businesses such as these are often characterized by a high ROI (return on investment) and a constrained budget (often having recently raised capital from the venture community).  Imagine that the wrongful conduct of a third party has damaged such a business, and the company now faces the prospect of an expensive and lengthy litigation if it is to secure compensation.  Before litigation finance, the decision might well have been between bringing litigation or not – now the decision is between self-financing or third party financing.

In order to determine which option is preferable, the CFO would likely attempt to value the potential litigation. In an older post (which you can find here), we discussed the framework for valuing a litigation. For the sake of simplicity let us assume that the expected damages are $30 million, and the chances of losing the case are estimated to be 30% – therefore the estimated value is $21,000,000.

Next, the CFO would likely attempt to calculate the cost of monetizing the asset.  In order to estimate the true cost of allocating capital to the litigation, a CFO might undertake the following analysis:

Step 1: Determine the company’s current ROI; for the type of high growth companies that we are discussing, an ROI can be expected to be in the range of 30% – 50%.

Step 2: Estimate the budget for prosecuting the litigation. The budget should include all fees and expenses through trial, appeal, and collection. For purposes of our example, let’s assume that the total estimated budget is $5,000,000.

Step 3: Estimate the potential duration of the litigation. This will likely be a function of the complexity of the case as well as the jurisdiction. For this example, let’s assume a duration of three years, which is a common anticipated duration.

Step 4: Calculate the cost of bringing the litigation to the company. For the sake of simplicity, let’s assume that the company will have to reserve for the full amount of the litigation on day one. This would be common in an emerging company that has little cash flow, and raises money from outside investors with the prospect of monetizing the company once the business has been more fully developed.  Based on the assumptions outlined in steps 1 through 3, the cost of allocating resources to the litigation would be between $10,985,000 and $16,875,000. (You can see the math used to arrive at these numbers here). In other words, the business has two choices of how to invest the $5 million required for the litigation: (i) it can invest it in the operations of the business (i.e., marketing, Capex, etc…) or (ii) invest it in the litigation – due to capital constraints the business cannot invest in both. The expected value of the investment in the litigation in three years is $21,000,000. The expected value of the investment in the business in three years is between $10,985,000 and $16,875,000.

Step 5: Consider litigation finance. Can the company sell a portion of the litigation to a third party so that it can invest in the business and retain the upside of the litigation?  For purposes of this example, let’s assume that a litigation finance company might be willing to finance the entire litigation ($5 million) for return of capital, plus 1/3 of the remaining proceeds.  The chart below outlines the potential outcomes of the investment scenarios:

We have not yet considered, however, two critical issues: (i) the risk profile of the investment; and (ii) how the company’s valuation is affected by the different types of investment.  With respect to the risk profile, it is unlikely that the company has a portfolio of claims, so the 30% chance of loss means that the return on any litigation investment is going to be unhedged, and either generate a large return or result in a complete loss.

With respect to valuation, we must consider the different treatments that investors and the ‘market’ might accord to proceeds generated from the core business as opposed to those garnered from monetizing a litigation. As noted above, many of the businesses that we work with are in the growth phase of their lifecycle, and many of these companies are seeking to generate returns by rapidly increasing the company’s valuation. Businesses in the current economic environment are seeing valuations that are as high as 20X revenue (for an interesting discussion of revenue multiples, see here). Revenues from a litigation are considered non-operating revenues, which are reported on an income statement separate from operating revenues, and therefore are likely to be discounted by investors as a one-time gain – rather than recurring profit, which is used as the basis for valuation. This means that when considering the value of the company, any return generated from the litigation would receive no multiple. Let us revisit the chart above in consideration of this fact:

 In this situation, the use of litigation finance appears to be the best prospect for the company in that it allows the damaged company to fully allocate its resources to growing the business and maximizing its valuation while minimizing the risk of loss on the litigation and maintaining much of the upside of a successful litigation.

[1] (($30M-$5M)*2/3)+Return from amounts invested in Operations

[2] (($30M-$5M)*2/3)*.7+Return from amounts invested in Operations

[3] The lower bound is simply the 10X multiple of the return applied the lower ROI figure + $0 for the litigation

[4] The upper bound is the 10X multiple of the return applied to the higher ROI figure + the company’s stake in a successful litigation (~$16.6M)