Litigation Myths

It’s never easy to generalize, but it’s a fair bet that many within the tech venture capital world – especially those targeting early-stage startups – would see themselves as bold adventurers who dare to go where others fear to tread.

And yet, in one significant respect, the tech VC community is shockingly timid.

If you’ve ever been involved in a corporate transaction, you’ve probably seen a due diligence checklist. It’s a mind numbingly detailed catalogue that’s easy to gloss over, in large part because much of the requested information isn’t applicable.

But if your tech startup has anything to share in response to a due diligence request for information relating to “pending, threatened, or ongoing litigation,” you will feel a lot like someone having to disclose a sexually transmitted infection on the first date.

VCs tend to treat litigation as the kind of problem that makes a startup untouchable.

Like many widely held heuristics, this view sweeps aside a lot of nuance and leaves an enormous amount of potential economic value on the table. In a market with enormous sums of capital chasing a relatively small number of plum opportunities, this is precisely the kind of market inefficiency VCs should be looking to exploit.

To understand why the current approach is so flawed, let’s consider a few widely held myths.

 

Myth #1: Litigation is always a liability.

When I ask the VCs I know about potential litigation, they usually tell me litigation is expensive. The outcome is unpredictable. It’s a distraction from running the “real business.”

Sometimes that can all be true, but let’s keep in mind there’s a colossal difference between being a plaintiff and a defendant.

Defendants get sued. Plaintiffs do the suing.

Plaintiffs decide whether litigation starts, and once it has started and new information is learned – through discovery, motions, and settlement discussions – whether or not it will continue. If the prospect of success is questionable you don’t sue. If it starts out good but something changes along the way you stop.

In a choice between being a plaintiff and a defendant, you will choose being a plaintiff 100% of the time.

I’m aware how obvious that sounds, but any VC that flees from all litigation clearly misses that point. The decision to threaten litigation or to actually proceed and file a statement of claim is a strategic one and no different from any other corporate decision about where to invest scarce financial and human resources.

It’s true that defendants can make counterclaims – and in that sense become plaintiffs themselves – but if you have a potential claim with no foreseeable counterclaims, you have a corporate asset that warrants further due diligence rather than a knee jerk “pass.”

 

Myth #2: Suing someone isn’t really business.

I think at least some of VCs’ aversion to litigation has to do with a vague perception that getting rich off a lawsuit is somehow “icky.”

As a law school classmate once observed, society definitely needs rights, but a society in which everyone enforced every single right would be a terrible place to live.

I don’t sue my neighbors for trespass when their toddler plays on my lawn, but I probably should do something if a squatter community takes up permanent residence.

Much of the tech sector exists precisely because developed countries offer robust intellectual property rights protections. When those rights are infringed, they can and should be enforced.

It’s no accident that the world’s most innovative tech players, from Apple to Xerox, all actively enforce their intellectual property rights vigorously. Their survival and continued profitability depends on it.

For many startups, lawsuits are often about preventing a competitor from taking one’s own property to divert customers. Indeed, the remedies available in a lawsuit, which include an accounting of profits and injunctive relief, are designed to redress those specific wrongs.

Patent trolls may indeed “lie in wait” for someone to trip over a patent claim and do the hard work of building a business before the troll swoops in to grab the profits. But just as not all litigants are defendants, not all plaintiffs are patent trolls.

There’s nothing inconsistent about a startup trying to build a real business while simultaneously enforcing its legal rights any more than there is about Apple selling iPhones and suing Samsung for patent infringement.

The complexity of the issue is perhaps best illustrated by the ongoing debate over whether (and how) to reform U.S. patent laws.

On one side are those like James Bessen of the Harvard Business Review, who claim that patent litigation is a drag on the economy and stifles innovation. There is certainly academic research to support that claim.

But an equally compelling argument has been advanced by folks like VC investor Scott Sandell, who recognize the need to curb frivolous suits but note that the actual legislation that’s been proposed in the past would serve the interests of established tech players by giving them an effective pass to infringe the rights of startups.

Separating the trolls from those protecting legitimate business interests is not always the easiest task, but it’s one worth doing.

The justification for that exercise is as much about profit as it is about supporting the startup ecosystem.

 

Myth #3: Litigation is unpredictable.

In a diverse and tolerant society hating any specific class of human is generally frowned upon. But if you roll your eyes and grit your teeth at the prospect of spending hours trapped in the company of lawyers – with their exorbitant and indeterminate fees (more on that later) and the secret language of their cabal – you’ll get a pass from most people.

VCs tend to see litigation as an unknown and unknowable, and therefore fundamentally different from everything else in which they invest.

That view does not help VCs. It also overstates the extent to which they know the other businesses in which they routinely invest.

Anyone who has worked for or invested in a startup understands the delicate dance between those who run things on a day-to-day basis and those who write the checks.

There is no shortage of lingo in the tech startup world that tries to euphemize the very real and painful process of trying to figure out what one’s business is, let alone hire the right people, build product, find customers, and get someone to buy you out and take what you started to the next level before you run out of money or fall behind competitors

If you say you’re “figuring things out” or “finding yourself,” you sound like some loser who dropped out of college, couldn’t find a job, and moved back in with your parents after spending a few months wandering around India (I’m aware that sounds a lot like Steve Jobs’ story, but odds are pretty good you’re not Steve Jobs).

But if you’re “pivoting,” well then you’re just doing what startups do all the time and who knows – maybe you have a unicorn in you after all.

As many VCs will complain, startups are often chameleons and tailor the message about what their business actually is and what it could be to the audience. So, for example, labels like “SaaS”, “disruptive” and “enterprise,” which often don’t have fixed or agreed upon meanings, get bandied about depending on what the founding team thinks the VC wants to hear.

Where VCs do an excellent job is distilling the information they’re given into a conclusion about what the company actually wants to do and how likely it is to succeed. The fact that they manage to do this despite the massive information asymmetry between them and the companies they consider funding (and even the ones they ultimately do fund) is rather remarkable.

They get there by applying a mixture of experience, internal and external subject matter experts, and plain old business judgment.

Like any other subject matter expert, a good lawyer can provide a litigation risk assessment that should significantly reduce uncertainty and provide a reasonable evaluation of possible outcomes for potential litigation at relatively low cost.

Any VC that doesn’t have that kind of trust in their lawyer needs to find another lawyer (full disclosure: I am not a litigator and not trying to drum up business here).

And until I see VCs raising funds, investing in businesses, and exiting investments without employing at least one (and usually more than one) lawyer, I find it hard to take the disdain for lawyers too seriously.

 

Myth #4: The high costs of litigation will bankrupt the company.

Cash is always tight in tech startups, and it’s a fair question to ask whether paying –and taking the time to work with – lawyers is the best use of scarce corporate resources. Of course the answer to that question will depend very much on the complexity of the litigation and the estimated likelihood and value of winning, but the emergence of a litigation funding industry has increased the range of options.

While contingency arrangements are well known, a plaintiff with a good case has lots of other choices available when deciding how much of the risk and reward of litigation it wishes to retain.

Some law firms will offer a full contingency arrangement, which means the startup is only investing its time, but will also take a hefty share of the proceeds of the litigation. Meanwhile, others will offer a partial contingency/mixed retainer arrangement, meaning some of their fees are paid by the company but the rest are deferred in exchange for a more modest share of the proceeds.

Compared to venture investors, law firms are both risk averse and highly focused on short-term profits. As a result, when a respected firm is willing to invest its own resources in a claim, that fact should not be treated as meaningless.

Some firms won’t work on any kind of contingency arrangement, often because of concerns about their own cash flow or politics between litigators and the other practice groups.

In those circumstances a third party litigation financier, which funds the entire legal costs of the lawsuit in exchange for a share of the proceeds, may step into the breach.

Just as law firms carefully screen matters before agreeing to a contingency arrangement, litigation financiers perform their own rigorous analysis before funding a claim.

Where a startup already has a contingency arrangement with its law firm and/or an established litigation financier in place, that should be taken as a strong signal that independent market players with the expertise to value a claim are willing to put their own skin in the game precisely because they believe the litigation is in fact valuable. Moreover, these kinds of arrangements eliminate the VC’s concern that their money will be going to fund the litigation rather than the rest of the business.

VCs with a high degree of confidence in the litigation might want to see the company fund more directly; whereas, others might prefer to have a contingency arrangement and/or a litigation financier fund everything and leave the company and its investors with less upside in the event the claim is successful.

In this sense litigation can be seen as a kind of hedge against the rest of the business.

 

Why should investors care?

Understanding litigation is no different from understanding any other aspect of a tech startup. It’s not easy work, but to pretend that it’s fundamentally different from valuing other corporate assets or that all litigation is a liability not only does a disservice to tech startups whose rights have been infringed – it also misses a potentially massive financial opportunity.

A tiny handful of the world’s top VCs may have enough high-quality opportunities come across their desks that they can randomly exclude anybody who ticks the “pending, threatened, or ongoing litigation” box and not notice the difference.

The rest of the VC world earn their keep (and the confidence of their own investors) by being as shrewd as possible. Taking a good hard look where others aren’t paying attention is a pretty tried and true way of doing that.

It’s fine to be skeptical about the value of litigation. In the end the investor and the company may both decide that suing someone isn’t the best use of scarce resources.

But if you’re running from a business in which you might otherwise invest because it has the option to sue somebody, that’s pure folly.

 

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