STAGING LITIGATION FUNDING
The Case for Staging the Funding of Litigation
Litigation funding is characterized by extreme uncertainty, extreme information asymmetry, and extreme agency costs. The funded litigation is usually at an early stage—perhaps not yet filed, much less having undergone fact discovery. Hence, the extreme uncertainty. The plaintiffs have private information, that funders may not have access to, of the facts of the case as well as of their willingness and ability to cooperate in its litigation. Hence, the extreme information uncertainty. Finally, the interests of the plaintiff and the funder may not necessarily align. For example, one may wish to settle early while the other may wish to press on. Hence, the extreme agency costs. All of these are analogous to the challenges of venture capital where the value of a startup and the likelihood of commercial success is very difficult to discern; where value is to a large degree contingent on the efforts and abilities of the entrepreneurs, and where the entrepreneurs have private information and superior technical knowhow.
The well-developed VC market has created multiple strategies to deal with these issues. Perhaps the most important of these strategies is the use of ‘staged financing,’ which addresses, at least partially, all three problems. Because of the similarity between both forms of finance, we believe that the rising litigation finance industry and its clientele would be well advised to adopt the staged financing mechanism, modified to reflect the differences between funding a startup and funding a claim.
Staged Funding Overview
Staged funding is an iterative process used both implicitly and explicitly to provide the startup with sufficient capital to reach the next stage of its development. Done implicitly, staged funding occurs as a series of investment rounds, each roughly corresponding to a startup’s developmental stage as shown in a chart below. Done explicitly, funding is staged within an investment round, with additional capital being invested as the startup successfully completes a predetermined ‘milestone.’ In either version, at the start of each funding round, the startup company is valued and interested funders purchase shares in the company based on that valuation. At milestones within a staged funding round, however, interested funders purchase more shares based on the valuation and purchase price used at the beginning of the round. The more closings (whether at the beginning of a round or within it) a funder participates in, the more shares it has, although its percentage ownership may grow or shrink depending on the number of shares purchased by others at each closing. Critically, participating in one closing is not a commitment to participate in the next.
Thus staged financing addresses information asymmetry and extreme uncertainty by allowing the funder to reassess its involvement based on an updated valuation as more information is revealed, or to simply decline to participate further. Staged financing also addresses agency costs: the risk of losing future funding incentivizes entrepreneurs to cooperate and expand efforts.
Structuring Staged Funding
In venture capital funding, financing a generic company might look like this table:
Graphic by Nathan Beckord, Venture ArcheTypes, here.
As laid out, the stages mark points in which the risk, information and agency costs of a startup significantly change. A business plan is much riskier than a proven technology; a launched product gaining traction with customers is less risky still and once a product has been scaled up and adopted, risk is further reduced.
The chart reveals a number of points. One is that the value of the startup progressively grows over time (or it fails and is shut down). This implies that valuation is appropriate (and possible) at each stage, although each round of financing typically uses a single valuation. Mechanically, venture capitalists and entrepreneurs negotiate a new contract for each funding round, in which the newly-ascertained value of the portfolio company is reflected and shares are issued and sold to the first-round and later-round financiers (Series A, Series B, etc.). The venture capitalist buys a specific amount of shares at the newly-agreed upon price and that fixed sum funds the portfolio company until the next financing round, or until the next milestone, as the case may be. Second, the chart shows that new investors may join the ranks at every stage while some might drop off. Third, the chart indicates the relationship between milestones and two of the three factors that drive VC investment risk: extreme uncertainty and information asymmetry.
Well-chosen milestones—which are points at the process in which a significant amount of information has been revealed and a meaningful re-evaluation of the risk/reward proposition of an investment is possible— achieve two key functions. One function is to allow risk management and loss minimization by the funder. This is so because the funder can, at that point, opt out of investing additional capital, retain the potential upside already purchased, and cap the losses already sunk. The other key function is enabling a new company valuation and share purchase price, so that both the entrepreneur or, in our case, plaintiff and the funder can get appropriate value in the transaction, in light of the new information. This latter function is compromised by the ‘hold-up’ problem.
The so-called hold-up problem is the term used to describe the disproportionate bargaining power the funder has by virtue of its ability to shut down the company by ceasing funding. (An alternative hold up scenario is when an entrepreneur has disproportionate bargaining power because it can threaten to cease to work for the company, a problem that is addressed by contractual provisions like non-competes). A monopolist funder may hold up the claimant at each valuation negotiation. Research on staged funding by monopolist VC funds shows that such funding produces sub-optimal outcomes, meaning companies that would have succeeded if not held up fail. A similar impact could be expected on worthy claims.
Hold up is resolved, and an entrepreneur’s/plaintiff’s ability to gain from improved information as well as its efforts to enhance value in between funding rounds is increased, if multiple funders participate in later rounds. The funding competition equalizes the bargaining power between funder and funded. Research also shows that the entrepreneur’s ownership share increases with the value of the project when later stages of the investment are syndicated.
Re-Structuring Staged Funding for Litigation Finance
Litigation differs from a startup company in a few critical ways that we believe justify modifying the staged funding approach while embracing its core logic. One difference is valuation; others relate to the relative vulnerability of entrepreneurs and litigants if funding runs out prematurely, and during funding round negotiations generally. After laying out the issues, we describe how the model addresses them.
First, a claim’s potential value differs from a startup company’s potential value because they ‘sell’ to ‘markets’ that are completely different. In litigation, the ‘market’ is the trial judge, jurors and appellate judges, and during settlement negotiations – the defendant. The parties have very little ability to affect who their target market is, beyond the crude tools of forum shopping and preemptory challenges. In contrast, entrepreneurs can choose their target markets very carefully, and shift among markets in a way unimaginable to a plaintiff. Moreover, after ‘selling’ the claim to the judge, a jury or even to appellate judges, the claim value is fixed. In contrast, a company can expand its customer base and therefore value in a potentially unlimited fashion. (While litigation has an analog to increasing sales in pre- and post-class certification, the model is based on financing a corporation’s or a sophisticated high net worth individual’s commercial claim, not on financing class claims).
Beyond potential market size, entrepreneurs can affect potential value by freely adapting their products in response to test marketing, while litigators have more limited options. Not only can positions taken lock litigants in to a suboptimal approach, rules, law and, of course, the facts limit the ways ‘the product’ can be reinvented to appeal to the ‘marketplace.’ In sum, many adaptations entrepreneurs can embrace to increase their odds of success, and thus the value of their company, are not open to litigants. As a result, the value of a commercial claim can rise and fall, but changes of an order of magnitude are very unlikely. (Other than the claim value suddenly plunging to zero.) This means that the transaction costs of negotiating a new valuation at a milestone are not justifiable unless the parties can point to evidence showing a material change in claim value. While the chart above indicates what such moments generically are for a startup, litigation’s equivalents are not so predictable.
For example, a dispositive motion such as a motion to dismiss or a motion for summary judgment can happen before, during or after discovery. While a claim may still be valuable after losing a motion to dismiss if an appeal appears winnable, the risk profile has changed and thus the risk-discounted value of the claim has too. Similarly, the close of discovery is a likely point at which sufficient information has been gathered to reassess the claim and make a more informed valuation, but no one knows when discovery will close when negotiating an investment in a claim that has yet to be filed, nor if discovery will increase or decrease claim value, and if so, whether it will do so materially.
Beyond the value differences, startup companies and litigations differ in the risks posed by funder exit and ‘share’ re-pricing. Both actions are fundamentally riskier for plaintiffs than for entrepreneurs because litigants have opponents, while startups have competitors. Opponents can not only act to exploit a plaintiff’s weakness if its funding runs out and the opponents know of the vulnerability, but they can also derail timetables and upset strategies with a focus that competitors do not share, increasing the chances that funding will run out. The institutional context of litigation, namely a judge’s control over deadlines and the overall timeframe, can exacerbate the plaintiff’s vulnerability at funding round negotiations by imposing timetables and other conditions that the plaintiff cannot alter and must address while finance negotiations are ongoing. These two factors combine to render plaintiffs particularly vulnerable if the claim runs out of funding prior to reaching the next milestone.
A final difference relates to the hold-up problem and syndication. Syndication of later rounds is an imperfect solution to hold up in the litigation finance context because syndication works in the VC context by exerting upward pressure on share price during negotiations. But for the reasons discussed above re-pricing is warranted less often in litigation. The best way to get the plaintiff-benefiting pricing impact of syndication is to have competitive bidding at the outset of the claim, as well as at any later re-pricing round, if any. The more re-pricing a litigation finance contract allows, the more effective syndication will be at maximizing plaintiff value in terms of price per ‘share,’ however multiple re-negotiations destroy value too by increasing costs and uncertainty.
The suggested provisions therefore strike a balance between the anticipated desire of a funder to limit its risk, the anticipated desire of a plaintiff to not be held-up and to have stable funding from milestone to milestone, and the anticipated desire of both to be able to incorporate new pricing information into their relationship.
(1) First, the provisions require a funder to finance through to the next milestone, even if the initially invested capital falls short, unless the funder is willing to surrender all value already bargained for, or, unless the funder brings in a replacement financier. Mechanistically, the contract requires the accelerated investment of capital ‘committed’ to financing at the next milestone and the investment of new ‘supplemental’ capital if committed funding is nearly spent but the milestone/completion of the claim has not been reached.
This adaptation treats the entire litigation as a single funding round, in that in a staged funding VC contract round the investor will ‘commit’ a certain amount of capital to the round, but only invests a part of it at each milestone closing within the round. This litigation-funding-as-a-single-VC-round approach makes sense in that the analogy between litigation finance and venture capital is strongest at the ‘seed’ or ‘early’ stage of VC funding. The adaption goes beyond the VC approach by requiring the acceleration of the next milestone investment as needed, but we believe the departure is justified by the differences between litigation and startup companies discussed above and is in any case a relatively small departure given that the funder can still exit at the milestone.
The suggested provisions deviate from the idea of a single VC funding round by suggesting that ‘shares’ are purchased for at least two different prices during the litigation. (Because the claim is not incorporated, the suggested terms deal with ‘Litigation Proceed Rights’ rather than ‘shares,’ but for this conceptual discussion ‘shares’ is appropriate. One Litigation Proceed Right entitles the owner to 1% of the Proceeds of the Claim.)
(2) The suggested provisions define two types of milestones, one which allows exit only, and one which allows both exit and for the purchase of as-yet-unsold ‘shares’ at a new price. Critically, the re-pricing focuses not on the value of the claim, but on the risk discount applied to the claim value. At the completion of discovery, for example, the plaintiff and funders have much more information than they did at the outset, and can better assess the risk that the claim will fail to lead to a favorable settlement or judgment. As a result, they can decide whether a ‘share’ should cost 20% of its agreed potential value (high risk) or 50% (low risk) or any other number. If a syndicate of funders bids at the discovery milestone closing, the risk discount should be less than if there is no syndicate, unless the parties agree ex ante on a reasonably favorable number. The transaction costs of re-pricing at the discovery closing should be low, because either the discovery risk discount is negotiated ex ante or it is done by competitive bidding by funders who should not have great difficulty figuring out what kind of risk discount is appropriate.
To make this concept work in practice, the model contract includes a term called ‘Initial Claim Value’ which is intended to be a heavily negotiated, good faith agreement on claim value at the time the contract is entered into. This is the benchmark against which the risk discount is applied. Specifically, a ‘share’s’ price is 1% of the Initial Claim Value times the risk discount. With the exception of the situation where the Claim has proved much less valuable than expected, the Initial Claim Value plays no other role; a Litigation Proceeds Right holder gets 1% of the Proceeds, the actual claim value.
3. If the Claim is revealed to be much less valuable than expected, by an otherwise acceptable settlement offer or by a final judgment, then the funder is issued additional ‘shares’ until the funder has a sufficiently large slice of the Proceeds to gain the return expected by owning the funder’s original number of ‘shares’ of proceeds worth the Initial Claim Value. This type of re-pricing is limited, however by the plaintiff’s right to a minimum recovery.
We set a minimum plaintiff recovery because of the public policy concern – indeed one of the main critiques of litigation funding – that plaintiffs will be exploited and that funders ‘profiteer’ from others’ actionable injuries. By providing a minimum the parties minimize the risk that courts will refuse to enforce the finance agreement on grounds such as unconscionablility. (The underlying theory of such critiques being that legal claims are a unique, personal kind of asset. This idea is quite intuitive in the context of tort and divorces cases, which are increasingly receiving third party funding.) While the plaintiff’s minimum recovery will be heavily negotiated, the standard for minimum recovery set by the courts in the contingency fee context is a logical guideline. Such a minimum also minimizes the risk of buyers’ remorse-type satellite litigation in which plaintiffs decide, after having received the funding and an award actually having been rendered, to challenge the enforceability of the finance agreement.
To further simplify this downside risk management re-pricing, lowering transaction costs and risk, the suggested terms state that the purpose of this type of re-pricing is strictly to preserve the economic equilibrium of the bargain, not to allow for renegotiating that equilibrium ex post. Re-pricing is mechanistic, not negotiable; the expected value that the re-pricing aims to replicated is known; the actual value and how much it deviates from the expected value is known; and how many additional ‘shares’ can be issued is easy to compute at any given time. Therefore, this risk-management re-pricing should not increase transaction costs too much.
The VC analog for conserving the initial bargain and limiting the funder’s downside risk as value changes over time are conversion-price anti-dilution provisions. These terms are justified as preserving the bargained-for deal against the risk that the initially purchased shares were priced much too high because information barriers prevented accurate pricing at the outset. According to this view, the present, much reduced value of the startup is simply the value that would have been assigned at the outset if the information barriers did not exist. (Another example of transactions in which provisions that seek to preserve the economic equilibrium of the initial deal are found are foreign direct investment (FDI) transactions. In recent years there’s an increase use of so-called ‘stabilization clauses’: clauses that require parties’ to renegotiate certain provisions of their deals if certain predetermined events occur.)
Because the suggested provisions aim to preserve the exact initial bargain—provided enough deviation has in fact occurred—the concept most closely mirrors the ‘full-ratchet’ version of conversion price anti-dilution rights. In that approach, a fall in the value of the startup company (as evidenced by the share price at later funding rounds versus the one the VC funder purchased in) reduces the price at which a VC can convert its preferred shares into common shares proportionately, so that at conversion the VC ends up with the ‘right’ number of shares to achieve the original deal. The analogy between the suggested terms and full-ratchet is not perfect, however, because the suggested terms limit the size of a funder-favoring pricing shift by defining a minimum recovery for the plaintiff.
Giving the funder some downside risk protection is appropriate because the information barriers at initial pricing are extreme, as in VC, because the funder is enabling access to justice, and because the protection is not absolute; the plaintiff gets its minimum.
4) One of the difficult balances for a plaintiff to strike is how many ‘shares’ to offer at each closing. Offer too few, and funding will run out prematurely, forcing accelerated and perhaps supplemental closings. Offer too many and the plaintiff will wind up with more financing than needed, and thus will have reduced its share of the proceeds unnecessarily. This problem is compounded by the fact that ‘shares’ at the initial closing will be cheaper, because of a greater risk discount, than shares offered at the discovery closing. The plaintiff will want to sell fewer shares at the first closing, and more at the discovery one. In addition, the litigation counsel may be working partly on contingency, as is often the case, and one or more ‘shares’ may need to be transferred to her, taking them out of the pool that could otherwise be sold.
We presume, based on the analogy to the contingency fee case, that a plaintiff will not want to sell more than 33.3 ‘shares’ in its proceeds, but the plaintiff may well succeed at selling significantly less while gaining sufficient financing to fund its whole claim, or the plaintiff may end up selling every ‘share’ it can until it reaches the limit imposed by its minimum recovery. Although our terms do not so state, residual risk remains that we have not allocated: it is possible that the plaintiff will run out of ‘shares’ to sell and money to conduct the claim. In such a scenario the parties can agree that the funder will bear the risk, and will continue funding without receiving more ‘shares’; that the plaintiff will bear the risk by selling more ‘shares’ and reducing its minimum (and thus potentially, create an unconscionability or buyer’s remorse problem); or that they share the risk.