There are 7500 companies in the United States that are “portfolio companies” of private equity funds and venture capital funds. Those portfolio companies share common characteristics which include
- leveraged or thinly capitalized balance sheets,
- a sensitivity toward avoiding expenses that will consume cash and/or diminish EBITDA,
- relatively short term horizons before their sponsors will expect a liquidity event, and
- lean management teams with focus and competence for business plan execution.
Of course many of these companies are also victims of unfair business practices, theft of intellectual property, breach of contract or commercial fraud among other actionable wrongs. Many of the claims arising from those events are strong on the merits and involve significant damages. However, absent an urgent business need many of these claims are not pursued because management will generally find it very difficult to get the funding from traditional equity or debt sources to pursue the claims. Even where funding is available, management often has a hard time justifying expending cash and impairing EBITDA to pursue claims that might not be resolved until after the portfolio company’s anticipated liquidity event.
While it seems counter intuitive to let the statute of limitations expire on these valuable meritorious claims, the sponsor’s and management’s primary focus has naturally been on business execution and driving toward a liquidity event rather than seeking to recover damages. The perceived costs and risk of prosecuting the claim with the company’s resources often appear to outweigh the potential return. In addition, management typically lacks the skill set and experience to assess the merits of the claim and the relative difficulty of prosecuting it.
Accounting treatment also weighs against pursuing claims for the portfolio companies. The expense of pursuing the litigation, if funded by the company, is recoded as a current expense and reduces reported EBITDA. If the case is successfully resolved before the liquidity event, the recovery is typically recorded as an extraordinary income item below the operating line. The company’s operating EBITDA is not adjusted to restore the EBITDA reduction from the expense of the litigation in prior periods. The lack of alignment in accounting treatment complicates the valuation process at sale. If the case is not resolved at the time of the liquidity event, no income will have been realized to offset the expense and the buyer will argue that the claim is difficult to value because of the future cost and uncertainty of outcome. That uncertainty is likely to further complicate the liquidity process.
Claim Based Funding is a product which addresses all of these challenges that the sponsor and management face in monetizing their claims. Claim Based Funding is nonrecourse financing that will pay for the cost of legal fees and out-of-pocket expenses to pursue meritorious commercial claims. With the emergence of Claim Based Funding as a tested and successful corporate finance strategy, these portfolio companies can pursue claims without raising money, expending cash or incurring any accounting expense and corresponding EBITDA reduction.
Claim Based Funding provides management and the sponsor with an expert assessment of the merits and value of the case at no cost. The funder will undertake due diligence to evaluate the merits and value of the claim as well as the strategy for prosecution. As the case progresses the funder will monitor the litigation process. By using Claim Based Funding, the issue of management’s ability to evaluate and manage the case is largely mitigated. The funder’s assessment and investment validate management’s perceptions to the board and offer an independent second opinion from a knowledgeable entity with aligned interests.
Claim Based Funding enables the company to develop an asset in the form of a damages recovery. If the claim is resolved by the time of the liquidity event the value will have been realized by the sponsor. If the claim is unresolved when a liquidity opportunity arises, the sponsor has the option of selling the claim along with the business. If the buyer is wary of assuming the claim, the sponsor can keep the claim until it too is liquidated and retain the recovery as a secondary source of return on the portfolio company investment.
At Themis we understand that it may take some time before private equity funds and venture capital funds realize how powerful a tool Claim Based Funding can be to unlock additional value in portfolio companies. But as awareness of the utility of Claim Based Funding grows we are confident that more of these opportunities will be identified.