How funding can help VCs and startups unlock their litigation assets
Litigation finance can help venture capital firms solve a critical problem: how to pursue meritorious and potentially lucrative claims without expending capital that could be dedicated to ensuring the growth of a portfolio company.
For many VCs, litigation is automatically rejected because of the potential costs, even in cases with a strong probability of success and with the opportunity for a sizeable recovery.
Unfortunately, this stance can dramatically undervalue litigation’s potential as an important business asset. Cash recovered from litigation can help a start-up fund its operations, assert its rights in the market, send a strong “hands-off” message to predatory competitors, and return money to investors. In fact, one might argue that VCs and their portfolio companies have a fiduciary responsibility to their investors to explore whether a case has merit and the potential to bring a substantial return.
By teaming with a litigation funder, venture-backed companies have the opportunity to develop and pursue a litigation strategy that can dramatically reduce costs. In the process, a funder can help them gain the insights they need to make informed—and potentially highly profitable—decisions about their litigation assets.
A funding discussion
Companies like Omni Bridgeway provide non-recourse dispute financing for cases that are strong on the merits and that have high potential for success. Non-recourse funding means that the funder invests capital to pursue the litigation in return for a percentage of the recovery. If the case is successful, the funder and the company benefit from the proceeds. If it is not, the funder receives nothing.
Recently, at a webinar hosted by the National Venture Capital Association, Omni Bridgeway’s Stephanie Southwick, an Omni Bridgeway investment manager and legal counsel who works closely with VCs and startups, chatted with two others in the VC industry: Aravinda Seshadri of Venturous Counsel, who provides outside general counsel guidance to diverse-led startup companies, and Eric Bahn, co-founder of Hustle Fund, a venture fund that invests in early-stage startups. They discussed the benefits that can accrue to VCs and startups that work with funders and the reasons venture capitalists should become more informed about funding.
Here are three key takeaways from the discussion:
- Funding Provides Non-Dilutive Capital. Litigation financing, as Sehadri noted, is “a source of assets and liquidity, and a real competitive benefit to a company.” Because the financing is non-recourse and because a funder like Omni does not take equity in the companies it funds, funding is non-dilutive. It is simply used to pay attorney’s fees and litigation costs, and in some situations, can be leveraged to provide working capital. From an EBITDA perspective, funding removes litigation costs from the balance sheet, injects capital into a company’s revenue stream (thus helping to boost growth), and allows the company to monetize strong legal claims long before a potential recovery in court or in an arbitration.
- Funders Can Help Provide an Opportunity-Cost Analysis. Declining to monetize a litigation asset should be an affirmative, informed decision—not a knee-jerk rejection. In evaluating potential claims, a company should examine the settlement and judgment value of a case, attorney’s fees and other litigation costs, and the availability of litigation funding. This data can assist companies in weighing the opportunity cost of forgoing litigation against the costs of pursuing litigation.
Omni Bridgeway regularly performs this kind of analysis as part of its typical process. Our team conducts extensive due diligence into the cases we fund to ensure that we are investing in strong cases. This analysis can occur in advance of hiring litigation counsel. And in fact, we routinely help companies identify the most appropriate and strongest litigation team for their cases. Because legal fees are covered by the funder, a financing arrangement allows companies to hire the best-possible counsel for their matters, which, in turn, helps improve the likelihood they will maximize their claims.
- Funding Is a Tool that VCs Should Know More About. Investors, founders, and directors need to educate themselves about litigation funding. Every venture capital fund is likely to have a portfolio company with a litigation asset that it can monetize. “As a VC, it is important to have a good sense of what tools are in your arsenal to serve founders,” said Bahn of Hustle Fund.
A funding scenario
Omni Bridgeway funds claims from companies at every stage of development and in a wide variety of commercial matters. For startups, typical claims might include cases against larger companies that have misappropriated (or stolen) intellectual property, or against competitors deploying unlawful, anti-competitive tactics, or against ex-customers that have breached commercial contracts.
Consider this hypothetical offered by Southwick during the webinar discussion:
- A startup company’s growth has been undermined by a larger competitor, and its counsel has advised that it has a strong theft of trade secrets case that could yield a recovery of $100 million. If it abandons its claim, the company faces ruin.
- The case is estimated to run for three years, with a budget of $8 million in attorneys’ fees, and an additional $500,000 to cover costs. The start-up is also seeking $1 million annually in working capital to operate its business during the course of the litigation.
- Outside counsel will not take the case on full contingency or front out-of-pocket costs, but it will accept a partial contingency where it is paid 50% of its fees with a 20 percent stake in the recovery.
- The company pursues non-recourse litigation funding with Omni Bridgeway. It seeks $7.5 million total, including: $4 million for the remaining 50% of the attorneys’ fees; $500,000 for costs; $3 million in working capital.
- In return for its investment, Omni Bridgeway will receive 25 percent of the recovery. This amount will cover its outlay, plus a return on its capital. (The company’s return depends of the case’s risk profile.) It receives nothing if the case is unsuccessful.
- In the end, the case succeeds. The company receives $103 million in gross revenue – which is the $100 million recovery plus the $3 million in working capital. It nets $58 million (recovery funds + working capital) and pays out $45 million to the funder and law firm.
Without funding, the company likely would have received nothing or would have been forced to settle early and for pennies on the dollar. Working capital, a unique feature of funding that may be available when a company’s legal claims are exceptionally strong and large, has given the company runway for operations.
Seshadri, of Venturous Counsel, recalled her experience prior to learning about funding. A client’s critical intellectual property was stolen by a larger competitor during acquisition discussions. The client didn’t have the money to pursue a claim, and its investors weren’t interested in funding a case.
“I would have felt much better if we had explored funding,” Seshadri said. “It’s a miscarriage of justice, where the big guy smashes the small guy, and it’s a situation where I could see bringing [the funder] in and at least doing the diligence. … At least we could have taken some affirmative action instead of saying, ‘we’re just the small guy, we have to sit here and take it.’”
To learn more about how litigation finance can help venture funds and portfolio companies, visit our Company Insights. While there, explore our recent podcasts, blog posts, and videos. Or contact us for a consultation to learn more about the ways we can help you pursue meritorious claims.