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Law firm economics: Comparing the costs of self-finance vs. outside finance

  • Aviva Will

Burford’s latest research affirms what I’ve heard repeatedly in conversations with lawyers over the eight years we have been in business: At first glance, litigation finance seems “expensive”—until one takes the time to compare the costs and benefits of self-financing versus utilizing outside capital.

For obvious reasons, we’re committed to helping lawyers understand why litigation finance costs what it does, and to making the case that it often is the better economic choice. To that end, in the Summer 2017 Burford Quarterly, I provided a financial model to help lawyers talk to their clients about the relative costs and benefits of legal finance for litigants. In the case studies below, I analyze the relative costs and benefits of law firms using outside capital to address a few of the challenges they encounter on a regular basis. The case studies are hypothetical and offered solely for illustrative purposes, but they demonstrate how litigation finance works to facilitate a firm’s growth without pushing it beyond its natural appetite for risk.

Case study: Hourly firm takes on risk

A respected law firm that works almost exclusively on an hourly fee basis is approached by the former co-owner of an international energy company with a breach-of-contract dispute after his former partners failed to share profits resulting from their venture. The firm thinks the claim has strong legal merits, and estimates potential damages at $70 million.

The potential client—which is talking to other, competing law firms—does not have the means to pay the firm’s hourly fees for the duration of the litigation. Firm management is unwilling to expose the firm to the risk of taking the case on full contingency, although it is willing to consider a reasonable discount to its regular fees with a corresponding uplift from any award.

The partner assigned to the case does not want to lose the opportunity to work with the client, and she contacts a third-party litigation finance provider. She receives the following proposal:

  • The law firm can accept the case on a fully contingent basis, and the litigation finance provider will finance $4 million of the $5 million budget, with the firm risking $1 million
  • In exchange, upon successful resolution of the case, the litigation finance provider receives its investment back, the firm receives its $1 million investment and uplift and the finance provider receives the remaining contingency

After reviewing the proposal, the law firm determines that the financing arrangement bridges the gap between the firm’s hourly model and the client’s budget issues, enabling the firm to pursue a strong case that will add value to the business.

Without financing With financing
The firm fails to work with the client $0 The law firm establishes a relationship with a new client and generates new business for the firm without upending its hourly model $3 million in revenue for the law firm with $1 million at risk and subject to an uplift upon successful resolution; $1 million in expense costs passed through to the funder

Case study: Contingency firm seeks efficiency

A leading IP boutique has historically represented its clients on full contingency. But recent developments in the space have resulted in a heightened risk environment, making the firm reconsider its willingness to absorb pure contingency risk.

Concerned that the firm may soon have to choose between taking on too much risk or turning down good clients, a partner requests a proposal from a third-party litigation finance provider:

  • The litigation financier will provide $15 million in non-recourse portfolio financing--which is half of the expected $30 million needed to pursue a portfolio of three IP claims with different clients, each with a total budget of $10 million and expected proceeds in excess of $150 million across the cases.
  • With the IP boutique having secured a 40% interest in the proceeds of each case in exchange for full contingency arrangements, the litigation finance provider will receive 50% of the law firm’s contingent proceeds generated by the three cases.

The firm does the math and determines that financing enables  the firm to mitigate 50% of its downside risk and generate $15 million in fees as the cases are litigated, all while giving up only 25% of its proceeds if the claim is successful ($15 million). Financing enables the boutique to fund legal fees and expenses for new IP matters, ensuring that the firm can balance its risk without sacrificing opportunities to continue growing its practice. The financing arrangement also supports new business: With less of its risk tied up in these cases, the firm can pursue new business with competitive terms and further diversify its book of cases.

Outcome Without financing With financing
Successful claim The case entitles the IP boutique to its entire contingency Total case proceeds of $150 million entitle the firm to $60 million The case entitles the boutique to its fees plus a significant win Resulting proceeds of $150 million entitle the firm to $45 million--$15 million in fees and $30 million in contingent proceeds
Unsuccessful claims The firm spends years investing an enormous amount of  its resources in the case $30 million in firm resources must be written off as a loss The firm mitigates its downside exposure by engaging the funder to bear half the costs $15 million in revenues even if all three cases result in total losses

Case study: Improving tax outcomes to increase firm profits

A law firm that does a mix of hourly and contingent fee work is approached by one of its existing corporate clients with a new case. Because the client has already exhausted most of its litigation budget for the year, the client asks the firm to take the case on risk.

Based on the strength of the merits and what the firm expects to be the ultimate damages, the firm decides that it is willing to risk its hourly fees. But the firm’s CFO has been exploring finance solutions to help the firm run more efficiently. The CFO has concerns about the negative tax implications of the firm’s practice of self-financing expenses. Unlike salaries and overhead, expenses are not tax-deductible, meaning partners effectively cover the cost using after-tax dollars—ultimately reducing firm profits.

A litigation financier gives the firm CFO a proposal that will ease the burden of paying ongoing expenses while enabling the firm to keep most of its contingency from a successful case outcome:

  • The litigation finance provider will provide $3 million of financing to be used only to pay out-of-pocket litigation expenses
  • In exchange, the litigation finance provider receives its outlay back and a 1.5x multiple return on its invested capital, collected only from future case proceeds

The financing frees up capital that the firm can redirect into the firm at year-end as expected. But the firm's CFO also recognizes another advantage of the arrangement: By dedicating outside capital to cover expenses, partners no longer have to contribute after-tax dollars to cover case costs—which (at a 39.6% top marginal tax rate) the CFO expects to increase firm profits by $5 million in the current year.

Without financing With financing
The firm’s partners spend income from other cases to cover this client’s expenses $5 million in pre-tax income paid out by partners to cover $3 million for the current year’s expenses In addition to avoiding the risk of a $5 million loss on expenses, the firm preserves cash to distribute as profits and invest in firm, with added tax savings Not having to contribute $3 million from profit results in a tax savings of $2 million