There are many reasons that it makes sense for companies, law firms and other entities with valuable IP assets to utilize legal finance. Most are well understood: The cost of litigation is rising, the IP landscape continues to be ever more fraught with risk, and fewer firms are willing to take IP matters on contingency. As the co-chair of Intellectual Property at an AmLaw 100 firm commented in the 2017 Litigation Finance Survey, “In my field of intellectual property, there’s an increasing degree of uncertainty… [and] an increasingly high-risk, high-reward dynamic that’s well-suited for litigation finance.”
Shifting costs from litigants and law firms to finance providers whose core business is managing and monetizing legal risk is no doubt a reason why IP litigation is the most commonly requested type of financing by practice area in our experience (based on the last 12-month period for which data is available).
However, there’s another, less understood but quite compelling reason for IP litigants to use legal finance: Its positive impact on accounting outcomes.
The accounting and financial reporting impact of litigation is clearly a pain point: The 2017 Litigation Finance Survey shows that a noteworthy 76% of in-house respondents identify as a business challenge that “ongoing legal expenses depress financial results.” However, neither clients nor their counsel currently appreciate how legal finance can help address this issue: Fewer than one in three respondents (29%) say that improving accounting and other reporting outcomes would be a trigger for them to use legal finance.
The account impact of legal spend applies across all areas of commercial litigation and arbitration, but it’s especially relevant in IP. Clients with strong IP assets—whether they be corporations, startups or private equity backed entities—are also focused on optimizing their financial results. IP assets represent a major investment—in the R&D required to obtain them and the ongoing costs to maintain them. However, companies then face the dilemma of not being able to generate value from those IP assets without enforcement. That means it’s essential for them—and the law firms they work with—to understand the key role that legal finance can play in solving for the otherwise negative accounting and reporting impact of litigation spend.
Litigation spend and the bottom line
Due to accounting rules, spending on litigation actually harms corporate financial performance. This means that—whether the litigant is a claimant or a defendant—pursuing litigation can be punitive. By addressing this pernicious but little understood problem, legal finance helps IP litigants benefit the bottom line.
In essence, the costs of a litigation claim are not handled the same way other financial claims are. When pursuing a financial claim to recover damages from a failed joint venture, for example, a company’s balance sheet is unaffected: The costs are recognized as an asset that the company expects to realize. In addition, any resources spent pursuing that claim–whether in the form of legal expenses, fees and disbursements–will generate as a receivable on the company’s book, as they are capitalized rather than expensed through the company’s profit and loss statement. This makes sense for receivables and for the money spent to capitalize them, as it is money the company is owed. Many other assets work similarly.
However, litigation does not follow these accounting rules. When a company pursues a litigation claim, the money it spends is expensed through the P&L instead of being capitalized. This immediately reduces the operating profits of the company, and despite the pending litigation claim having the legal status of an asset, it is nowhere to be found on financial statements or even in the notes. Effectively, the money has disappeared.
What’s even more astounding is even when a litigation claim is successful, the revenue isn’t then returned to the P&L as operating income. Instead it is put “below the line” as a one-off occurrence because litigating claims isn’t considered core to the company’s business. This creates a “no win” situation for companies with valid legal claims: The costs will negatively impact the P&L in the short term, and when they are recovered after a successful suit, they will remain off the statement as non-operating income.
For companies that are publicly listed, this has a negative impact on valuation if they trade on a P/E or an EV/EBITDA multiple. If the company instead trades on book value they will be negatively impacted by a reduction in book assets, as the money is spent pursuing the claim without creating a corresponding asset.
This serves as a major disincentive for companies to pursue viable IP litigation. No matter the ultimate value of that IP litigation to the company, the immediate hit to profits and earnings can be significant. Obviously, companies want to maximize their profits and minimize their expenses. Being hit with expenses as a litigation matter goes forward and then not later recognizing the income from the win is a bad outcome. The situation is even worse for publicly traded companies with significant IP litigation. When investors and stock market analysts look at the balance sheet and don’t see an asset, they don’t credit it; and when they see the kind of expenses associated with high value IP litigation, they may take an overly negative view of the company’s risk factors and value. This can be extremely harmful for young companies balancing the need to assert IP rights and the reality of investor pressure to generate profits as quickly as possible.
How legal finance solves the accounting problem
Legal finance moves the cost and risk of pursuing litigation off corporate balance sheets—and therefore removes the accounting problem.
It’s simple: When legal fees and expenses are financed, they move from the company’s books to the finance provider’s. Costs do not travel out of the company’s P&L margin, and therefore the company’s profitability is preserved in the wake of legal action. In fact, the first time a financial statement is impacted is when the company wins a claim and receives the cash income from a successful outcome—or, if it’s desirable and the economics support it, a financing agreement may also provide working capital that can be recognized as income whenever the company chooses.
A typical legal finance arrangement provides the financing for the fees and expenses that are needed to pursue a claim on a non-recourse basis. This means companies can pursue worthwhile claims with value to the business without worrying about the accounting impact because there is no cash flow implication. Legal finance instead leaves the balance sheet completely untouched and transfers the risk over to the legal finance provider. In return, the legal provider is compensated by an agreed share of the proceeds of claims that otherwise may have been dismissed. This remuneration occurs if, and only if, the legal claim is successful.
Implications for IP litigation
In the world of IP, legal finance is growing based on demand for risk sharing that reflects an ever-changing and challenging reality. Patent litigation has been referred to as “the sport of kings” due to its higher relative cost. In the wake of the America Invents Act, patent owners are now virtually guaranteed to be required to dual-track PTAB proceedings alongside litigation, further increasing costs and risk. Fewer law firms are willing to take IP matters on full contingency, and even those with an appetite for risk must balance their client needs within a larger portfolio. As the co-chair of Intellectual Property at an AmLaw 100 firm commented, “In IP, there is more and more uncertainty, and that is going to cause litigation finance firms to grow, because they’re better equipped to handle that risk and because they’re better suited to assess and price it.”
Legal finance already represents a compelling solution for IP owners, providing needed capital so that they might obtain value from their IP. The accounting benefits expand the appeal to IP owners which have historically self-funded—or foregone—protection of their IP rights. Now savvy companies, and their GCs, CFOs, CEOs and their investors, can shift litigation costs to a funder’s balance sheet and put their former legal spend to work for the company in more profitable ways. Law firms that can help clients understand and appreciate all that legal finance can do for them—including addressing these poorly understood accounting impacts—will surely reap the benefits.