October 31, 2022
Traditional lenders have been willing to treat consistently generated fee revenue as an income stream against which to lend. But it is only more recentlythat the individual litigations themselves have begun to be treated as assets that can be monetized. This process, litigation finance, is by now familiar, below I discuss the next step for that industry: financing the business of law itself.
The capital structure of the typical law firm has barely changed in living memory, but the traditional barriers to innovation are slowlycracking, creating opportunities for great lawyers to build the best professional homes for themselves. It is not accidental that fundingthe creation or growth of law firms and practice groups has tended to follow a traditional path. Rather, this circumstance is acombination of traditional legal temperament and structural barriers to innovation. Recently, there have been changes to both.
Let’s start with something simple: why the tech industry has venture funds and incubators, but the legal industry does not. Mostobviously, there are widespread prohibitions to law firms being owned by non-attorneys, whereas anyone can own a piece of a techcompany. While that limitation is weakening, especially in states like Arizona and Utah which are experimenting with non-lawyerownership, it’s not likely to disappear any time soon. But there’s also a second reason that is less obvious. Traditional lenders havebeen willing to treat consistently generated fee revenue as an income stream against which to lend. But it is only more recently that theindividual litigations themselves have begun to be treated as assets that can be monetized. This process, litigation finance, is by nowfamiliar, but below I discuss the next step for that industry: financing the business of law itself.
Sources of Capital for Law Firm Operations
Starting a new law firm, opening a new office, or lateralling a practice group takes money. Between salaries, overhead, and marketingcosts, even a financially sound operation may find itself in need of capital in order to grow. Without outside investors, that money hastraditionally had to come from one of two sources: bank loans or the partners of the firm.
Law firm executive directors, chief operating officers, and partners have legitimate concerns about bank loans and equity partnerfinancing, as both avenues carry significant risks to the partnership. Bank loans are “recourse,” meaning that the loan is collateralizedby all the assets of the firm. In addition, bank loans are not well suited for funding growth because the availability of the loans arebased primarily on the value of what a law firm has already, not on what it is trying to build. Equity partner financing, obviously, requireseach individual partner to risk their own financial well-being. For this reason, among others, law firms are hard to start and hard to growother than incrementally.
But there is a form of financing out there that specializes in valuing lawyers’ futures: litigation finance. Litigation finance has typicallyinvolved a third-party funder investing in a lawsuit in return for a share of the ultimate award. The whole premise of the industry is thatlitigation is an asset class that can be analyzed, valued, and turned into a financial instrument. In overly simple terms, the case returnsgenerated by litigators are the revenue stream akin to the profit from making widgets. And just like there are investors who know how tovalue a widget-making company, litigation has funders who know how to value the work of litigators.
A less widely known use of litigation finance is as a source of operating capital for expanding or founding law firms. Funding a newoffice, new firm, or new practice group is not entirely the same as the more familiar case-based litigation funding, which covers some orall of the costs of litigation (and can also providing working capital to a law firm) in exchange for an interest in the case’s proceeds. Withlaw firm business funding, the capital addresses business needs rather than case-specific needs. These arrangements certainly can be based on the fees and costs necessary for a specific portfolio of cases, but more frequently they are premised on how much working capital is required to carry the law firm or group through the first few years until it is generating sufficient revenue to sustain itself. For a lateral move, this might just mean the group’s salary guarantees. For a start-up law firm, it could include everything from salaries to stationery.
Advantages of Law Firm Business Funding
The structure of law firm business funding is much the same as for traditional funding. The funder’s return will come from litigation fees earned by the law group—although unlike case funding, business funding could be collateralized by contingent or hourly fees. And, most essentially, the funder’s return will be non-recourse as to any other assets of the law firm or partners, meaning that if the litigations that serve as collateral do not pay out, the funder loses their investment while the law firm is shielded from risk. Typically, the law firm or practice group seeking business funding has a group of seed cases. But those cases are often encumbered by a prior law firm’s fee entitlement, or subject to some other uncertainty. It is not unusual for the seed cases to not fully justify the amount of funding sought.
The fact that the seed cases frequently do not justify the full amount of funding is a crucial difference from case funding. In case funding, the relationship between the case’s expected returns and the funding commitment is the single most important metric around which the deal is built. To move away from that focus even a little bit requires significant creativity. Most crucially, the funder must underwrite the ability of the law group to generate additional cases and fees. Doing so requires an examination of the group’s track record and an understanding of their business plan. This process is not dissimilar to how a hiring law firm would evaluate a lateral group or how founding partners would examine their business plan for a new law firm.
A corollary of the need for something beyond the seed cases is that the addition of new cases to the collateral may not increase the funder’s commitment. These cases may unlock additional funding that was part of the original arrangement—for example, the second or third year of funding may require that additional cases have been generated—but the top-level number likely won’t change. The original funding arrangement already takes into consideration that the first batch of cases didn’t justify the total funding commitment, and new case generation will support funding to float the law group through the first few years.
Funding offers a way to manage risk by offloading it to a third party. Taking on traditional debt does not defray the financial risk of starting or growing a legal practice—indeed, it can magnify it by encumbering your other assets. And while traditional case funding matches clients and counsel who want to work together but have different financial needs or goals, law firm business funding focuses on the lawyers themselves, empowering lawyers to create and build the teams they want.
This form of funding is not a single transaction that’s signed and then done—it is a business partnership. But it is also not an equity investment. A law firm’s relationship with a funder can be long-term, with funding built in as part of the firm’s or practice group’s business model, or it can be more temporary, smoothing the first few years of operation and providing the runway necessary to be successful. However it is used, the existence of this form of business funding offers a chance to open up the legal market and allow more innovation in the business of law. If done well, it will also facilitate groups that traditionally struggled to raise the capital to start and grow their firms, providing a new avenue into true ownership. At a minimum, it is a resource that should be empowering to the great lawyers and firms out there that have vision and potential but lack capital.
From The New York Law Journal, ALM | LAW.COM, Copyright © 2022 ALM Global, LLC. All Rights Reserved.