INSIGHT: Startups Can Thrive Even in the Face of Costly Litigation

August 13, 2020

Hedge fund Elliott Management’s funding of a lawsuit by video startup Eko against rival Quibi entailed a grant of Eko’s equity to Elliott. Eli Schulman, of Validity Finance, says contemporary litigation funders can offer a lifeline to startups that are unwilling—or unable—to allocate resources to legal costs, all without requiring founders to part with their hard-earned equity.

One of the most talked-about entertainment startups today is Quibi, a mobile-only entertainment platform founded by Jeffrey Katzenberg, former chairman of Walt Disney Studios, and Meg Whitman, former CEO of HP and of eBay.

Quibi offers dozens of shows broken up into six-minute to 10-minute “quick bites” designed to be digested by cellphone users on the go. One feature of Quibi’s technology—dubbed “Turnstyle”—adjusts videos to fit the user’s cellphone screen, even when toggling between portrait and landscape views.

Enter Eko, an interactive-video startup backed by Walmart’s investment of $250 million in a Walmart-Eko joint venture. Eko claims that Quibi misappropriated the Turnstyle technology after Eko both pitched it to Katzenberg and shared it, under a non-disclosure agreement, with developers at Snap who later joined Quibi.

Quibi rejects the claim, and the parties have filed competing lawsuits in California.

Recently, the court denied Eko’s request for a preliminary injunction that would have required Quibi to disable Turnstyle immediately. But the cases will go forward in what can be expected to be protracted—and expensive—litigation.

Recognizing the onerous cost of high-stakes litigation, Eko reportedly secured funding for the lawsuit from New York hedge fund Elliott Management and, in return, gave up a portion of the company’s equity. Although the transaction may have involved business considerations beyond funding the litigation, the deal raises issues that any startup involved in a business dispute should ask itself and its lawyers.

Eko’s use of external capital to fund expensive litigation, a step that would have been remarkable a decade ago, has become increasingly commonplace.

A Lifeline for Startups

Litigation finance, or “third-party funding,” allows a plaintiff (and in some cases, a defendant) to turn to a third party to finance the costs of a legal dispute. The funder typically agrees to cover a company’s legal costs in a single case, or those of a law firm in a “portfolio” of cases, in exchange for a share of the recovery from the lawsuit or portfolio.

Access to external funding can serve as a lifeline for startups that are unwilling—or unable—to allocate resources to pay attorneys’ fees or out-of-pocket expenses. Whether a startup faces a breach of contract by a global business partner, a patent infringement by a Fortune 500 powerhouse, or some other wrong, the steep cost of commercial litigation can even surpass a startup’s total value.

Beyond offering access to justice, legal finance has evolved in recent years from a niche solution for vulnerable plaintiffs to a sophisticated financial tool with which large and established businesses hedge risks, reduce millions of dollars of annual legal costs, and free up cash to invest in growth.

The accounting implications are consequential, too. While litigation costs eat into a company’s profits, proceeds of litigation are not booked as revenue, thereby granting litigation an unwelcome spot on a company’s balance sheet.

By contrast, a company that uses litigation funding can both shrink its legal expenses and, for accounting purposes, recognize the litigation-funding investment itself as revenue. Consequently, for large companies, litigation can be a double curse but litigation funding a double blessing.

Three Advantages

Whatever the size of the business, however, Eko’s case is striking in the company’s reported willingness to part with a portion of its equity to finance its litigation. Today’s dedicated litigation funders, whose entire raison d'être is financing commercial disputes, offer three crucial advantages over the far-reaching approach implemented by hedge-fund Elliott and Eko.

First, startups emphatically do not need to give up their hard-earned equity to bring a lawsuit, even an expensive one like Eko’s that may cost millions of dollars. Litigation funders finance cases in exchange for a portion of the outcome of the lawsuit, not a piece of the company. In the world of litigation finance, a valuable claim is itself an asset that can yield a return on investment, separate and apart from the company that owns the asset.

Second, not only do funders typically stop short of seeking equity, their investment in a case also is typically “non-recourse,” meaning that the funded company owes the funder a return on its investment only if the lawsuit successfully results in a recovery.

If the lawsuit fails, the company owes nothing. The consequence: zero risk for the company. This “de-risking” is vastly different from parting, up front and no matter the outcome of the litigation, with a portion of a company’s equity in exchange for funding a case.

Third, litigation funders can provide an additional lifeline to startups. Where a lawsuit is sufficiently valuable, a funder may not only cover legal costs but may also furnish much-needed working capital to help the plaintiff run its business. And the decision whether to provide working capital turns on the value of the legal claims, not on the company’s business plan or performance metrics.

Here, too, the funder’s return will depend on the outcome of the case alone and need not entail a grant of equity.

Time will tell whether Eko can prevail in its lawsuit and whether its investment from Elliott will serve both its litigation and business needs. But startups today have options to protect their rights—and to do so in a way that promotes, rather than frustrates, their broader business goals.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Eli Schulman is investment advisor and head of Validity’s Israel office in Tel Aviv.



Reproduced with permission from Copyright 2020 The Bureau of National Affairs, Inc. (800-372-1033)

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