Originally Published August 25, 2017
It's unquestionable that legal funding as a business model has proven successful- the industry is as strong as it's ever been, and it continues to grow at a rapid pace. It's a great time to build a profitable business in the field, and many funding businesses have done just that in recent years.
Unfortunately, as with any industry, many funding companies go under...fast.
You may have encountered one of these failed businesses during the course of your own company's dealings. Perhaps you suddenly never hear back from a certain funding company after working on a payoff. Or maybe you received a bounce-back e-mail from a dead account and realized that funding business was suddenly no longer in operation.
Funding company fatalities are strewn across the country and, while we can't tell the future, we can guarantee many more will fail even as the industry thrives.
As always, we're here to help. This article will cover a short selection of seven things that can quickly lead to liquidation.
Overfunding on investments
If there is any commonality among failed funding businesses, it would have to be poor underwriting (or, significantly worse, no underwriting) in addition to funding too much early on.
Granted, optimism is important for anyone involved in finance! But skipping the necessary analysis and being over-optimistic about very complicated, perhaps unprecedented (to your business) case types or new clients can lead to financial disaster.
Keep your ear to the streets for big opportunities, but be sure to carefully explore your options to avoid rushing into things prematurely. This is easier said than done, especially when you have investors pressuring you to put their money to work. Just remember, it takes times to figure out what works best for your business, and things will certainly evolve over time.
Case servicing: Too little, too late
When new funding companies join the legal funding market with no prior background in pre-settlement plaintiff finance, or, at most, tangentially-related industry experience, such as mortgage lending, a common and deadly oversight is not servicing their funded cases.
We spill quite a bit of (digital) ink on this topic: 6 Commandments of Kick-Ass Case Tracking
Funding uncollectible claims
Time and time again, people start funding based on "fantasy value." They see a huge potential settlement estimate on paper and, whether based on prior similar claims or other notable funding company successes, make a beyond risky investment. Blinded by the dollar signs.
One common example: class action lawsuits.
Newsworthy class actions are notorious for extremely high payouts, given the number of potential plaintiffs joining the class. An inexperienced funder might want to jump right into the deep end and try to join in on the action. Novices rarely comprehend just how long a class action suit can take, and ignore the very real possibility that the suit can go south for the horse they're betting on.
Tip: never direct too much risk on a single bet -- be it a class action, or a single high-value case.
As with any funding, you have to be cognizant of the amount you should be funding and the potential overall settlement. Don't get starry-eyed at huge numbers and always do your research and underwriting properly - if it looks too good to be true, it often is.
Unclear terms with capital providers
Capital sourcing is crucial for a burgeoning legal funding business.
We always urge funders to be transparent, honest and realistic in all aspects of their funding business, and it's doubly important here. When seeking capital, you have to be well-informed of and up-front about your potential rates of return.
Don't oversell an investor on a rate of return too high to deliver. If you do so, and then provide a lesser return and slower recoupment on this hypothetical investment, said investor may just cut you off. Once your numbers are off, investors will start to question everything about the business model (and spread the word). Your business can't afford this kind of distrust!
Contract terms make payments uncollectible
We can't sugar coat it: funding companies have gone under because of poorly structured contracts, which ruin their chances to recoup enough investments.
It's surprisingly easy to mistakenly structure contracts so cases are uncollectible (or at least at high risk).
The most common slip? Not taking into account specific state legislation.
For example, many states require that a funding contract contain a "Consumer's Right to Cancel" provision. This gives plaintiffs the right to cancel a contract scot-free within a certain number of days from funding activity. Ohio requires a five-day "right to cancel" period for consumers entering into a funding contract. Well, if you forget to include this cancellation provision in your Ohio contract, the plaintiff has a very strong argument against you in court, even well after the five-day period: "Your honor, I really needed to cancel it but didn't think I had the right to."
Even the seemingly simplest details can give a plaintiff or attorney ammo for invalidating a contract. To give an extreme example: some states require certain information be in a particular font (e.g., bold size 12) or on a certain page. Imagine losing a lucrative return on your investment because you forgot to embolden a phrase or used the wrong typeface, and a surly judge decides to follow the law to the letter! Learn the rules.
Follow the rules.
There are many similar examples that can be critical to your success.
Check out our post, 12 "Must Have" Legal Funding Contract Terms, to learn a lot more about contract drafting.
Starting a company in a bad jurisdiction
We just addressed the importance of structuring contracts in accordance with local law. There are preventative measures to take to avoid this issue. Number one course of action: don't start a funding company (or do any business) in states hostile to legal funding in the first place!
This sounds obvious, but you'd be surprised how often people try to start businesses in the worst possible cities given the local legislation.
Why would anyone do such a thing? Misinformation. Overconfidence about "beating the system." Some states have banned funding outright, such as Alabama, where it's considered a form of "gambling" and thus against public policy. In some states, the local government has regulated funding so strictly (under the guise of consumer protection) that turning a profit there would be nearly impossible.
So, do your best research early on to make sure potential business sites are viable and productive for funding.
As discussed in an article on Above the Law, Florida, Texas, New York, and Ohio are some of the best states to fund in. Alabama, Colorado, Kentucky, and Pennsylvania are among the worst.
Failing to learn how to run efficiently (scale)
As you may have read in our e-book, there are countless ways to improve and optimize your funding business. The right information, resources, and people are out there! If you dismiss these key aspects of improving or correcting your business, you might sink.
For example, there is no easier way to lose money than poor case tracking. Why wouldn't you take every possible step to ensure you actually collect money owed to you? This and many other organizational issues might happen if you are using outdated software (or worse, nearly none at all). You must strive for efficiency to watch your bottom line. As we stated earlier, not taking care of your cash flow (and in-turn profit margins) can lead to serious financial distress.
It pains us to see a promising legal funding business burn out before it really gets cooking. There is a lot of information out there on how to successfully run both a small business and a funding business, so take the time to inform yourself and prevent the common errors that shut the doors on so many businesses in their prime.
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