Litigation Funding vs Traditional Financing

Overview

The financial burden of litigation in recent years, entwined with significant attorney fees, court disbursements and expert witnesses’ expenses, amongst others, have crippled litigation motivators and have amplified the financial risk associated with, for both individuals and businesses alike. Consequently, alternative methods of funding have been explored and utilised, namely litigation funding and traditional financing.

Litigation funding enables a third party to cover the costs associated with litigation in exchange for a share of future proceeds. Unlike traditional loans, it is a non-recourse arrangement, meaning that the claimant’s obligation of repayment lies only in successful outcomes, i.e., the case has been won/settled. In comparison, traditional financing involves borrowing funds through more common methods, such as business loans, credit cards and lines of credit. Unlike litigation funding, this arrangement chains the borrower/claimant to his repayment obligations, regardless of the case outcome. Consequently, the principal amount, coupled with accruing interest adds significant financial strain and pressure on cash flow, should the case be unsuccessful.  

How does Litigation Funding Work?

Litigation funding offers both risks and rewards for claimants. The main risk lies in the portion of recovery that must be shared with the funder, which varies based on the agreed terms. Funders usually charge a multiple on the capital they invest; In the event of a successful case, the funder receives its initial investment along with the multiple return. While this arrangement reduces the claimant’s share of the final award, it also provides a key advantage; if the case is unsuccessful, the claimant bears no financial risk. Unlike traditional loans, there is no debt to repay, and the claimant is protected from personal financial liability, as the funder absorbs the entire financial risk. 

Numerical example

• Amount the funder lends: £1.9 million
• Funder’s multiple on Capital Deployed: 2.50x

In this example, if the case is won, the funder receives £6.65 million, and the claimant retains £11.35 million. However, if the case is lost, the claimant owes nothing, and the financial risk is entirely absorbed by the funder. This arrangement allows claimants to pursue legal action without the fear of financial loss.

[Disclaimer: The above financial terms included are for the purposes of the article. The actual terms will be calculated based on the specifics of the case in question and the terms could include a success fee on the net proceeds amount or a combination with the multiple.]

How does Traditional Financing Work?

Traditional financing in the context of litigation refers to conventional funding methods used to cover legal expenses. These include business loans, lines of credit, personal savings, credit cards, and other debt-based instruments that require repayment regardless of the litigation outcome. The main risk is that the claimant must repay the loan even if the case is unsuccessful. This obligation can lead to financial distress if the claimant lacks the resources to cover the debt. However, the reward is that if the case is won, the claimant retains most of the recovered amount. Moreover, traditional financing provides the claimant with full control over the case strategy, without any influence from a third-party funder.

Numerical Example

• Loan amount: £1.9 million to cover the legal fees
• Interest rate: 10% per year, compounded annually

In this example, if the case is won, the claimant recovers £18 million, repays £2.41 million (including interest), and retains £15.59 million. However, if the case is lost, the claimant is still required to repay the full £2.41 million, leading to a significant financial burden.

[Disclaimer: The above financial terms included are for the purposes of the article. The actual terms will be calculated based on the specifics of the case in question and the terms could include a success fee on the net proceeds amount or a combination with the multiple.]

Advantages of Litigation Funding vs. Traditional Financing

Benefits of Litigation Funding

Litigation funding offers significant advantages, including the absence of repayment obligations if the case fails, protecting the claimant from financial risk. It also has no impact on credit scores or debt ratios, preserving the claimant’s ability to secure future financing. For businesses, this implies that working capital remains available for core operations, while litigation expenses are managed off the balance sheet. As funders succeed contingent to claimant’s success, both parties share an incentive to maximise recovery. Lastly, given that funders bear the financial risk, they are motivated to support cases with strong legal merit and substantial recovery potential, which ultimately benefits the claimant.

When to use Traditional Financing?

In certain circumstances, traditional financing may be more suitable option. For example, for cases with a high likelihood of success, traditional loans often at lower interest rates are usually more cost-effective than the higher fees associated with litigation funding. Traditional financing can support cases that fall outside the scope of litigation funding, such as lower-value disputes, non-monetary relief, or family law and probate matters. Furthermore, for short-term needs, such as bridge financing or covering specific legal expenses, traditional financing can be a more practical solution.

Conclusion

All in all, both litigation funding and traditional financing offer distinct advantages depending on the nature of the case and the claimant's needs. Litigation funding provides a risk-free option for claimants, as they only pay if the case is successful, and offers no impact on credit scores or debt obligations. This makes it ideal for high-risk cases or those requiring substantial resources. On the other hand, traditional financing may be more cost-effective and offers a practical solution for short-term or smaller disputes. Ultimately, the best option depends on the specifics of the case and the claimant's financial situation.