How Would You Like to Pay for That?

Today, it’s standard practice to obtain a litigation budget at the outset of a claim. This wasn’t always the case.

Not long ago, a client asking for a litigation budget might have been met with a senior partner’s dismissive response: “It’s impossible to predict the cost.” But clients persisted, prompting a shift in how litigation expenses are planned and managed. As obvious as the question sounds, asking “How much will this cost?” was an innovation in litigation management.

Now, it’s time to ask an inward looking, directed at the buyers of litigation services rather than law firms. Like the budgeting question before it, this one has the potential to transform how litigation claims are handled.

The question is: “How are we going to pay for this claim?”

Why the question matters

Asking “How will we cover the cost of this litigation?” invites deeper considerations:

• What options does a business have for financing litigation?
• How does this decision affect the company’s risk and potential upside?
• Does the opportunity of the claim justify its cost?

Historically, the answer to the question was viewed as obvious — legal expenses are paid from available cash, either cash flow or reserves. But is paying cash always the best choice?

Businesses leaders have to justify the business’ expenses, in particular those that are large, somewhat uncertain and not part of growing a business’ core capabilities. When a company assumes that cash is its only option to pay for legal expenses, that assumption will constrain its decision-making. In reality, litigation expenses, as with other operating costs, can be financed in several ways, each with distinct implications.

Paying for litigation: What are the options?

A narrow, often misleading, way to frame the question is: “Do we have budget available for this claim?” While this can indicate whether management considers the claim a priority, it presents a false binary; either cash is available, or a potentially valuable claim is abandoned.

Instead, businesses should consider its scope of funding options:

1. Cash reserves (the traditional approach)

Using cash on hand is the default option, and for a cash rich business this may be correct. This approach provides clear financial discipline. If you have cash, litigation is an option available to you. If you don’t, it’s not. It is an economic counterweight to what can sometimes be emotionally driven impulses to take legal action.

However, the cash-only approach brings with it opportunity costs. Every dollar spent by a company on legal fees is a dollar not invested in growing the core business. This means missed opportunities in R&D, acquisitions, or scaling up operations. By the same token, if cash is invested in the business at the expense of valuable litigation, that asset goes unrealized.

Less understood by litigators is how spending cash on legal budgets invites unwelcome accounting consequences, which creates an unflattering financial picture for a company. This is discussed further below.

2. Debt financing

Debt — whether short or long-term — is a common way to fund operational expenses, including litigation costs. Debt strategies offer a variety of structures offering a business predictability or flexibility. There can be positive tax implications from debt financing a business. When interest rates are favourable and a company can manage its debt load, this approach can work well.

Upon successful resolution of a claim, the proceeds from the case can be used to pay down the debt. Presuming a successful outcome, a tremendous opportunity for financial leverage exists.

In practice however, litigation can be unpredictable, both in duration and outcome. It’s hard for a CFO to know when litigation proceeds will arrive to repay debt. Moreover, when a debt financed claim fails, the debt remains an obligation of the company, adding financial insult to the injury of losing a case.

3. Investor capital

Another option for litigants is to seek additional investment from shareholders or external investors. This strategy is common with joint ventures, small and mid-sized businesses, and companies where a litigation claim represents the key asset of the business.

Existing investors may be well-positioned to assess the value of a company’s claim, making them a logical source for support. Unlike debt financing, investor funding benefits from a clear and direct alignment between a company and its investors.  However, investors have their limits, and a heavily committed investor may be reluctant to put more capital into a venture. Some will look upon requests to fund litigation as throwing good money after bad.

4. Litigation funding

Litigation funding provides capital for legal expenses in exchange for a portion of the case’s proceeds, like counsel acting on contingency. Unlike debt, litigation funding is non-recourse. This means that if the claim is unsuccessful, the company owes nothing. Given this, litigation funding is only available for claims that are assessed by a funder as being particularly strong.

For cash-constrained businesses, litigation funding can mean the difference between advancing a valuable claim or abandoning it. But even well-capitalized companies can benefit from litigation funding, particularly from an accounting perspective.

What do the accountants think?

Paying legal fees with a company’s cash creates an immediate drag on profit-and-loss (P&L) statements. Worse, litigation claims — no matter how valuable — aren’t typically recognized as assets in financial reporting. As a result, when analysts look at the company’s balance-sheet they see no value in a litigation asset as it progresses.

Even if a claim succeeds, the proceeds from litigation are often not reflected as operating profit but rather as a one-time event “below the line”. So legal costs paid with cash weigh on the P&L, while a successful outcome gets recorded as non-operating revenue. This makes for unhappy CFOs.

By shifting legal expenses to a litigation funder, companies can manage litigation like any other business expense, addressing balance sheet issues and preserving cash flow and financial flexibility.

Shifting the risk and managing the reward

Ultimately, assessing how to fund a claim will help a business weigh risk and reward more strategically. For business leaders, the principle is well established: if someone else is willing to fund an expense on terms that make sense, it’s often the smartest choice to let them.

If a company has capital available, is it better spent on litigation or on growing the business? If the company doesn’t have cash on hand, does this mean a litigation asset should be sidelined or should another funding strategy be explored?

Asking “How will we pay for this?” doesn’t just change how claims are financed. It can change which claims are pursued, how costs are evaluated, even the overall litigation strategy. For any trusted legal advisor to a business, the question is essential.

This article was originally published by Law360 Canada, part of LexisNexis Canada Inc.