How legal finance providers add value as equity investors

Litigation finance as an asset class is hailed as “uncorrelated” with traditional debt or equities. This characteristic attracts investors seeking to outperform traditional markets. But sometimes this characterization overlooks an extraordinary opportunity—an accretive equity investment from a litigation finance provider. 

Suppose, for instance, that a start-up technology company’s chief engineer leaves his company, steals some of its intellectual property, and starts a competing business. Foregoing legal action against him could doom the company; on the other hand, pursuing litigation would drain precious resources with perhaps equally fatal opportunity costs.

Conventional solution

Traditional legal finance offers a simple solution to this problem: Cover the expenses of the company’s litigation against the former employee in exchange for a portion of proceeds from any favorable result. For the finance provider, there are basically three possible outcomes:

• A multi-million-dollar loss
• A share of a settlement (likely at a discount to the total value of the claim)
• A share of winnings at trial, priced to return about 4x to 6x the provider’s invested capital after a 4- to-5-year timeline to trial

This investment style is expected to generate significant risk-adjusted returns (with an IRR target of 20 to 30 percent), regardless of the underlying performance of the company.

This approach is what makes “uncorrelated” legal finance so attractive. The litigation investor can expect returns at the level of high-performance venture capital or private equity even as it is largely indifferent to the value of the company.

Missed opportunity

That said, litigation quite frequently does influence a company’s enterprise value. What if this is a missed opportunity? For instance, what if winning the lawsuit not only generates cash, but also shuts out the competitor and thereby doubles the company’s market share?

Value-add solution

With that in mind, suppose instead that the investor not only covers the litigation expenses but also purchases shares of the start-up’s equity, e.g., in a traditional venture capital round. The interaction between the two investment components creates value for both the investor and the start-up.

On one hand, litigation success (the competing business shuts down) leads to greater market share, increasing shareholder value and thereby generating incremental upside for the investor. Litigation failure (the competing business survives) should leave shareholders with at least some value, if less than desired. Hence, the equity provides the investor some enhanced returns in the event of a win and some protection in the event of a loss, as compared to the traditional “non-recourse,” fees-and-expenses-only financing approach described above.

On the other hand, the legal claim is largely immune to fluctuations in equity value; whatever happens to the company while the litigation is pending, a significant portion of the legal claim value should survive. If anything, they may be anticorrelated: certain legal remedies like “lost profits” can increase precisely when equity value begins to suffer.

Herein lies the opportunity. The asymmetric, predominantly one-way relationship between litigation and equity value gives the litigation investor an edge. And because of this edge, the investor can offer more attractive capital on a holistic basis than the company might find in the combination of siloed options from traditional litigation finance and venture capital.

Quantitatively, the advantage to the company is straightforward: Holistic valuation of assets almost always equates to more competitive pricing of capital. For instance, a holistic investor with a meaningful share of equity might be satisfied with less than 4 to 6x returns at trial on the litigation capital, given the downside protection the equity provides. And likewise, the liquidity from the litigation can temper the holistic investor’s need for highly dilutive equity. (More pointedly: A venture investor generating up to 2 to 3x returns from a litigation outcome prior to company exit might not press as hard for things like high-multiple participating preferred shares.) Contrast this with a pure equity investor, whose higher uncertainty about the litigation might push him to discount heavily the positive litigation outcomes and instead lean harder on liquidation preferences, redemption rights and the like.

Qualitatively, too, a litigation-savvy equity investor can be an extraordinary value-add to the right company. Who as a director could better advise a company facing the predicament described above? Such an investor by definition understands the risks of litigation and has the stamina to bear them through the arduous path litigation often takes. Along the way, as an adviser, such an investor can help the company prevent, identify and handle similar problems as they inevitably arise.

It’s no accident we chose this particular hypothetical scenario to illustrate the point. Intellectual property theft is a common and often recurring problem in highly competitive markets. And sadly, this scenario is even harder to navigate today than it was ten years ago. The present US legal regime, while resulting from many well intended policy changes, has made intellectual property enforcement far more challenging, not just for so-called “trolls” (non-practicing entities) but also for legitimate operating companies.

An investor with litigation expertise (and just as importantly, risk tolerance) levels this playing field. Competitors of the financed operating company will have to succeed or fail on their merits rather than by skirting laws that can be prohibitively expensive to enforce. Litigation-savvy investment thus could pay substantial dividends in company value over time. Indeed, the company’s survival may depend on it.