To avoid the high cost of litigation, many contractors fail to pursue even strong claims or settle for far less than they deserve. This article explores an increasingly popular option that may help with this dilemma: third-party funding, in which an outside party agrees to finance some or all of a claimant’s legal costs in exchange for a portion of any recovery.

How Does it Work?

Third-party funding involves engaging an outside party (that is, one without a current interest in the dispute) to finance some or all of a claimant’s legal costs in exchange for a portion of any recovery. Essentially, it’s a nonrecourse loan secured by the claimant’s rights to any judgment, arbitration award or settlement. “Nonrecourse” means that, if the claimant is unsuccessful, the third party receives nothing.

Such arrangements are also available for defendants, who pay a premium to the funder in the event their defense is successful. With these arrangements, it’s critical for the parties to agree upfront on what constitutes a successful result. For example, it might mean dismissal of the claim or settlement below a specified amount.

Not all claims are suitable for third-party funding. Typically, they’re limited to commercial, rather than individual, disputes. And litigation funding firms generally won’t get involved with claims that have a low probability of success or are expected to drag on for extended periods of time, increasing their expense and risk.

Funders will also evaluate other factors. They’ll assess the quality of the law firm representing the claimant, and examine the defendant’s financial strength to gauge the likelihood that any judgment or settlement will be collectible.

What are the Benefits and Risks?

The most obvious benefit of third-party funding is that it enables parties to bring claims that they would otherwise lack the resources to pursue. But the benefits may go further than that.

Because the financing is nonrecourse, third-party funding shifts some or all of the risks associated with litigation or arbitration from the contractor or other party to the funding firm, which is better equipped to bear that risk. Another benefit of nonrecourse financing is that it may allow a claimant to keep litigation expenses off his or her financial statements, making it easier to continue operating while a dispute is pending. Contractors who finance claims themselves may find that significant litigation expenses hurt their ability to secure loans or surety bonds.

Third-party funding may also be available for claims that have been settled but not yet paid. For instance, they may allow a contractor to convert pending settlement funds into cash they can use to finance ongoing business operations.

As you can see, third-party funding offers a variety of benefits. But they come at a hefty price. Third-party funders assume a great deal of risk, and they expect to enjoy returns that are commensurate with that risk when claims are successful. It’s not unusual, for example, for a funder to receive 40% of the proceeds. Add in contingent attorneys’ fees and the percentage left for the claimant is relatively modest.

Is it Right for you?

If you’re contemplating third-party funding, be sure that you understand the payment terms and weigh the costs against the potential benefits. Your CPA can help you calculate a cost vs. benefit analysis.