Funding through to Milestones: Accelerated and Supplemental Investments

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As previously discussed, the nature of legal claims as assets is such that plaintiffs can be deeply destabilized if funding runs out between milestones. In addition, litigation costs can be very uncertain, and it is hard to accurately estimate in advance how much funding would be needed to reach a milestone. That is, when a plaintiff is selling Litigation Proceed Rights at the outset, need it sell a million dollars’ worth to finance the claim’s conduct through to the completion of discovery, or two million? If a plaintiff sells much more than it needs to finance the claim, the plaintiff is giving up too much. If the plaintiff sells too little, the plaintiff runs out at a dangerous time.

The concepts of Accelerated and Supplemental Investments, coupled with the Funder’s ability to exit without cause, address this issue.

At the outset of the litigation financing the funder indicates how much capital it is willing to commit to financing the claim, and how much of that amount it is willing to make available at the initial investment and how much is contingent on the successful completion of future milestones. That much is analogous to staged funding in the VC context. However, under the model contract, if the money invested initially drops below a certain, negotiated level, and the litigation counsel reasonably believes that remaining balance is insufficient to reach the next milestone, the litigation counsel can so certify and the funder will be required to accelerate the investment of some of the capital committed for investment at the next milestone. This infusion of pre-committed cash is called an accelerated investment.

A supplemental investment occurs if all the capital committed has been invested, the claim is not yet concluded/the next milestone not reached, and the litigation counsel certifies that the balance in the litigation account has fallen below a negotiated level and that it reasonably believes the remaining funds will be insufficient to conclude the claim/reach the next milestone. A supplemental investment is a more drastic commitment than an accelerated one because it changes the amount the funder had intended at the outset to invest. However, the funder is receiving value for its additional investment in the form of additional litigation proceed rights.

The funder is given three additional ways to compensate for the increased exposure. First,  the funder can exit at any time without penalty, as long as the funder lines up acceptable qualified replacement funders who commit at least as much capital as the exiting funder is withdrawing by exiting. Second, the funder can exit at any milestone without lining up replacement funding. However in that scenario, the funder “pays” for exiting by losing the right to have the value of its Litigation Proceed Rights adjusted upward if the claim proves substantially less valuable than initially estimated. The repricing provisions will be discussed in a later post. Last, the funder can exit at anytime by simply surrendering its Litigation Proceed Rights. While the third option mean the funder takes a total loss, it would enable the funder to avoid accelerated or supplemental investments without having to line up replacement funding. The total loss is appropriate because the destabilization of the claim from exit other than at milestones is extreme, more so than in venture capital. Of course, the parties could negotiate some other price for thus destabilizing the claim, such as the surrender of 90% of the funder’s litigation proceed rights.

The relevant contract terms and definitions have been added to the Contract and Defined Terms at left.

Update: A point the original post failed to highlight is simply that the contract anticipates funders will want a premium if forced to make a Supplemental Investment, and suggests that one way the premium could be paid is by discounting the purchase price.

4 thoughts on “Funding through to Milestones: Accelerated and Supplemental Investments

  1. It is true that currently the “market place” of litigation funders is fairly narrow. The expectation is, however, that as awareness and acceptance of the asset class grows, more funders will enter the market and transaction terms and processes will become more standardized and transparent. As that happens the options for claimants will be enhanced.

    As to your question of timing to secure financing in the market – I believe that litigation funding is quite similar to venture funding. Both early stage companies and litigation claims require substantial due diligence before a funder will commit. Accordingly, the claimant and its attorney have to pay careful attention to their expense budget – burn rate in VC parlance – and the remaining committed funding so that they can commence the fund raising process well in advance of the time when fund run out.

    It is quite common for VC funded companies to seek bridge funding from their existing investors when funding runs out prior to achieving their next milestones. Despite the apparent leverage in favor of the funder, in practice the parties are generally sucessful in negotiating a commercial deal that is acceptable to both parties. The reality is that both the funder and the company/claimant are mutually dependent upon one another for the ultimate sucess of the transaction so both sides endeavor to protect the working relationship. In this context communication and planning are essential – if the claimant advises the funder of the liklihood of, and the reason for, a funding shortfall well in advance, the parties have the benefit of time and information as they work out the terms of the bridge.

    • Thank you for the additional information. I’d like your reaction to another part of the logic underlying the accelerated/supplemental approach in the model, which I describe in a moment. First I just want to note that Maya update the post above to point out that the model assumes the funder will want a premium if forced to make a Supplemental Investment, and proposes a discounted price as one way it could be paid.

      The other part of the rationale behind accelerated investments, in particular, is as follows:

      Unlike start up companies, the value of a commercial claim is unlikely to change by an order of magnitude. Further the value is always highly uncertain and imagining it can be estimated with tremendous precision is an illusion, particularly if the progress of the litigation has not reached a point where a material amount of the claim’s value has been realized. As a result, re-pricing the rights in between milestones seems much less necessary with litigation than with VC; the price paid at the preceding milestone is likely still appropriate. As a result, the only advantage of going to the marketplace for the bridge financing is to allow new funders to participate.

      Further, the idea that accelerated investments are bad because they almost certainly guarantee a funding shortfall later proves too much. If there’s a shortfall, there’s a shortfall; it can either be experienced now or later. Postponing the shortfall is better than experiencing it between milestones for a few reasons. First, because the Claim may settle, the shortfall may not be experienced after all. Second, if the milestone is reached before the ultimate shortfall–before supplemental investments prove necessary–everyone should have a material amount of new information to use in pricing the next investment. If the funding shortfall indicates the claim will take much longer than initially thought to conclude, that risk need not be met by repricing for a new purchase; as Prof. Rhee suggested, a time triggered anti-dilution provision could be included.

      In addition, the termination without cause provisions work like this: the funder gives notice, and then must take additional action (returning an executed contract amendment) to make the notice effective. As a result, the funder can essentially trigger a new round of negotiations (the parties could quickly agree to extend the time the amendment is due) if it seems truly necessary.

      All that said,your point about having the attorney make the additional investment by accepting proceed rights as payment when the attorney has driven the cost overruns is a good one and we’re thinking through language.

      A final thought: regardless of whether the accelerated/supplement investment concept is used by parties or they opt for VC-type bridge financing, the critical term is likely the threshold balance in the litigation account that triggers the investment. If it is high enough, the parties should have plenty of time to work out a deal. Too high, however, starts a process that may not be necessary.

      Thanks again, and I hope to read your thoughts on the intra-milestone need to reprice litigation proceed rights v. start up shares.

  2. Naturally running out of funding during the course of litigation is destabalizing. It would seem that the situation is not dissimilar to a venture capital backed company running out of funds before achieving its milestone – which happens quite frequently. In the VC context, the solution is that the company has to raise an additional round of funding in the market and/or from existing investors, negotiate the terms of a bridge financing with existing investors on mutually agreable terms or tighten its belt and make deals with vendors to defer payments until the next milestone is achieved.

    In the litigation funding environment, the proposed solution of requiring the funder to advance funds that have been earmarked for a subsequent stage of the case – virtually assuring a future funding shortfall – or advancing additional funds in excess of its committed amount is, similarly, only one way to address the potential of funding running out before achieving a milestone. Other solutions include requiring the claimant to sell additional litigation proceeds rights in the market even though the milestone has not yet been achieved – giving investors a repricing opportunity and right to opt out without material penalty, requiring the attorney – a vendor – to “invest” in the case by converting the amount of fees in excess of the budgeted amount into litigation proceeds rights or requiring the claimant to fund the excess amounts out-of-pocket until the next milestone is achieved.

    The appropriate solution may well depend upon the reason that costs have exceeded the funding prior to achievement of the milestone. The cost overrun may have resulted from affirmative decisions made by the client in consultation with the lawyer such as the decision to retain another expert witness or take additional depositions. It may occur because the lawyer simply under-budgetted or failed to properly manage the legal team. It may occur because the client consciously sold insufficient litigation proceeds rights hoping to demonstrate higher value of the case at the next milestone – a situation made more likely by assuming that, if funding ran out, money could be called from the funder. It may occur because of delays caused by the court or the claimant’s adversary. It is difficult to think of a scerario in which the delay would have been caused by conduct of the funder.

    Putting the burden entirely on the funder is likely to have several negative consequences. First, it will probably increase the cost of the funding because the funder cannot rely upon a cap on its funding commitment and will be required to reserve an unspecified amount of its capital for future calls due to potential cost overruns. Because of the uncertainty and inefficiency the funder will charge a premium. In fact, for some funders this may be sufficient to cause them to pass on the investment opportunity entirely. Second, it creates a moral hazard by allowing the claimant and the attorney a degree of control over the funder’s checkbook to fund litigation strategies that may deviate from the plan at the time of the initial investment. Finally, although the defendant often has incentive to delay the proceedings and drive up costs, it will now have the additional incentive of knowing that it may create friction in the relationship between the funder and the claimant.

    It would seem that, at least in the case of an overrun occasioned by the claimant and/or its attorney, the responsibility for funding the overrun should fall upon them in the first instance either by deferring payment, funding out of pocket or raising new capital by selling additional litigation proceeds rights.

    • Your thoughtful comment raises many interesting points.

      The point about the moral hazard of the Plaintiff selling too few rights up front is well taken. Presumably funders will have the ability, as part of the initial round negotiations, to make clear their thoughts about how much total investment is needed to get to the milestone, (whether or not any individual funder is willing to invest all of it), and could condition investment on the plaintiff getting sufficient commitments to reach that level.

      The idea that the attorney, if to blame for the overruns, should be forced to take payment in litigation proceed rights is a very good one; would you like to offer some language?

      We agree that the funder is unlikely to be to blame for the cost overruns, and that putting the burden on the funder seems inappropriate as a result. To our knowledge, the litigation funding market does not yet have the number of funders or the syndicates of funders that VC currently does. If we are right about that, we are concerned the plaintiff would be unable to “sell into the marketplace” and would instead be essentially be re-negotiating with its existing funder. In such a scenario the bargaining power of the funder would be so extreme as to create a “hold up” problem. Alternatively, the accessible “marketplace” might be so small as to again create a hold up problem. Finally, while the VC and litigation scenarios are very similar, both the presence of opponents instead of competitors and the judicial/legal system structuring of the timeline leave plaintiffs more vulnerable than entrepreneurs, we believe. Accordingly the ability to “sell into them marketplace” relatively quickly becomes particularly important, which further weakens bargaining power.

      However, as noted, we premised the idea of accelerated and supplemental investments on the idea that the litiigation funding market is still relatively opaque and illiquid from a plaintiff’s point of view. If that is not the case, the hold up risk is much less and a straight mirroring of the VC marketplace–selling into the marketplace for bridge financing–may well be appropriate.

      Can you share your thoughts on how accessible and liquid the market currently is? What kind of timeline–days, weeks, months–would be needed to effectively find the bridge investment, and how many funders could a plaintiff reasonably solicit as part of that?

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