Litigation is a Fact of Business
As an investor, your goal is to find companies or businesses with the potential for growth and profits. But what happens when you have identified a prospective company, but then discover that there is pending litigation?
You face a quandary – you don’t want to let a potential investment slip through your fingers, but you also don’t want to be stuck in a bad situation if the litigation is material.
How do you assess the legal risk?
In today’s litigious society, it is nearly impossible to find a company not involved in some sort of litigation. You can no longer afford to only evaluate companies on the management team’s talent, available cash flow, and the product’s market penetration. You also need to assess the effect the litigation will have on your investment.
Bottom line – you want to make money with the least amount of risk possible.
Expert help is of strategic importance, yet attorneys are costly and not naturally accustomed to aligning their efforts with an investor’s goals and budgets. Attorneys may not have the business acumen to understand the factors involved in the litigation, and may not give an accurate assessment of the potential impact the litigation could have on the company’s viability.
Investors and companies are turning to a new breed of litigation management experts to complete these risk assessments quickly and efficiently.
It is not unusual for potential legal risk relating to a business’ past or current activities to cause an investor to shun what could have been a valuable investment. The ability to accurately quantify and qualify legal risk is essential in making any investment decision. — Scott Troeller, Partner, Veronis Suhler Stevenson.
Litigation managers are attorneys with significant business backgrounds who work with investors and executives to evaluate the legal risk in potential investments. A litigation manager will assess the potential legal risks of the target company from an entirely different perspective than a traditional attorney.
Three Critical Evaluation Criteria
Based on my years of conflict management and dispute evaluation, I have formulated three critical criteria that I use to evaluate litigation. The focus of these criteria is to determine the effect of the litigation on the company’s health, bottom line and future growth. The impact of analyzing litigation from these three criteria is to offer a clear view of how the litigation will affect the company. Decisions about the viability of the potential investment can then be made with reasonable certainty.
The three evaluation criteria to assess a company’s legal risk are:
- Materiality of the litigation
- Potential for future suits
- Connection between the litigation and the business plan
1. Materiality of the Litigation
When evaluating a company’s pending litigation, it is imperative to compare the cost and timeline of the litigation with available funds. If the litigation will cost the company more than they can afford, bankruptcy may rear its ugly head.
It is also important to determine the potential for a bad result and the costs associated with it. If it is likely that litigation will end in a negative result for the company, investors and executives need to know if the company can handle the financial repercussions.
2. Potential for Future Lawsuits
Does the current litigation have the potential to spawn other lawsuits? Other parties involved in the company may be sued later. Potential plaintiffs may sue based on the same or a similar set of facts or claims in the current litigation. Investors and C-level executives need to know the possibilities of future litigation that will affect the profitability of the company.
When looking at a potential company to invest in, I want to be advised that the legal process for pending litigation is aligned with the goals of my company to achieve the best possible results. In my experience of working with a litigation manager, I have been secure in my decisions, knowing that I am fully informed about all the variables that can affect my company’s future. -John Pappanastos, CEO, EFG Companies
These first two steps in the analysis are commonly used by traditional attorneys to provide guidance to their clients about a potential investment. But what if there is an unidentified conflict in the target company’s business model that could potentially generate more lawsuits? That is a key fact for the investor to know, and one that may not be revealed by traditional risk analysis.
3. Connection Between the Litigation and the Business Plan
Traditional attorneys tend to only focus on the materiality of the litigation and the potential for further suits. Litigation managers also answer the question, “Does the lawsuit expose a problem with the company’s business model?” The litigation may be a one-time anomaly or it may be the result of a process or action addressed in the company’s business plan. If the latter is the case, there is potential for more suits.
For example, a large bank sought to acquire a title company to facilitate its real estate lending practice. The title company had several pending lawsuits, claiming faulty underwriting. The bank sought to evaluate the legal risk, damage model, resolution time and the potential for future litigation. The litigation model of the general counsel was also assessed, because they were directly involved with closing documents in question. With the litigation manager’s advice, the acquisition was successfully completed, the litigation was resolved, and the business model was corrected to eliminate the risk of future conflict.
Litigation does not have to be an uncontrollable factor in the valuation of any business. By properly evaluating the potential for materiality, future litigation and the connection between the litigation and the business plan, investors can make informed decisions. Information is knowledge, and investors can avoid costly mistakes when they have a full understanding of the legal risk associated with a potential company.
Please note: This article is for general information purposes only and should not be considered legal advice. You should not act on information received from this article without first seeking advice from your legal counsel.
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