It’s a truism that a patent is only as valuable as the patent owner’s willingness and ability to enforce it. And therein lies the challenge faced by companies or institutions with substantial IP assets when they attempt to justify allocating resources to pursue claims.
By the time a patent exists to enforce, the company has likely already made a substantial investment to develop the asset. Protecting it through litigation will require still more money to be invested. The challenge is not only the very high price tag of that additional investment—it is also its high degree of risk, given the even more uncertain outcomes of IP litigation compared to other forms of commercial litigation. As a result, many companies, universities and other entities find themselves with untapped IP assets because of their inability to bear the additional cost and risk of protective litigation.
It gets worse. Companies that are able to overcome the hurdle of added cost and risk, and move forward with IP litigation, face a further challenge in the negative impact of litigation spending on corporate balance sheets. And although private practice lawyers tend not to think about balance sheets, GCs—and CFOs—think about them a lot, and they know that litigation impacts corporate balance sheets in ways that reduce profits and pull down earnings. Indeed, this was specifically cited by 23% of GCs surveyed as part of Burford’s 2016 Litigation Finance Survey as a reason their companies stopped pursuing a viable claim—because legal expenses were hitting the company’s bottom line. For the same reasons, many more choose not to pursue the claims at all.
To understand how negatively IP litigation impacts corporate balance sheets, one must understand how litigation is treated as an accounting matter. A pending litigation claim to enforce IP rights is a corporate asset, similar in form to any other contingent receivable. However, spending to pursue that claim, and increase its asset value, is peculiarly not added to its asset value, or “capitalized”, and instead is immediately expensed, flowing through the P&L and reducing operating profits. Indeed, a pending litigation claim—despite having legal status as an asset, or a “chose in action”—is affirmatively not an asset for accounting purposes. It is found nowhere on financial statements. Finally, when a significant litigation claim succeeds, the associated income from the claim is often not treated as operating income on the P&L. Instead, it’s put “below the line” as a non-operating or one-off item.
In practical terms, the GC responsible for generating a lot of IP litigation expense and risk is likely going to be persona non grata in the CFO’s office because no matter the ultimate value of that IP litigation to the company, the immediate hit to earnings can be significant. Obviously, companies want to maximize their profits and minimize their expenses. Being hit with expenses as a litigation matter goes forward and then not later recognizing the income from the win is a bad outcome. The situation is even worse for publicly traded companies with significant IP litigation. When investors and stock market analysts look at the balance sheet and don’t see an asset, they don’t credit it; and when they see the kind of expenses associated with high value IP litigation, they may take an overly negative view of the company’s risk factors and value.
Yet despite all of this, the situation is far from dire. Companies have new options. Litigation finance is growing rapidly in the IP space as part of a broader growth trend that saw a quadrupling of litigation finance use by leading U.S. law firms between 2013 and 2016, according to Burford’s latest research. Among the reasons for its growth in the IP space is its ability to neutralize the negative impact of IP litigation on corporate balance sheets and to shift the cost and risk of IP litigation to a third party. In simplest terms, outside finance enables GCs with significant IP assets to move the cost and risk of pursuing litigation off their corporate balance sheets—because the litigation financier assumes the cost and risk of the IP litigation. The financier provides capital to cover fees or expenses, or both, typically in exchange for a portion of the proceeds if the litigation is successful. Due to the risky nature of IP litigation, the more innovative finance providers will most often develop bespoke financing approaches including portfolio deals where risk is diversified across a pool of matters.
Moving litigation cost off the balance sheet immediately removes any concern about the negative accounting impact of litigation on earnings and profits. When a litigation financier pays the costs of proceeding, those costs do not flow through the company’s P&L, thus conserving the company’s profitability from its operations. Working with an outside financier also enables the company to husband its cash to use for other purposes—and to avoid having it flow out of the company’s coffers and thus reducing its asset value. As a result, when the company wins its claim, the very first time its financial statements are impacted by being a litigant is when it has a positive cash and income event. That obviously yields a far happier accounting outcome for clients.
In sum, outside capital gives GCs a dramatically de-risked platform to unlock the asset value of IP litigation claims—and it also provides longevity and the ability to commit to the long-term nature of IP litigation, whatever the business situation of the company.