Judgment Call: What’s the Value of Litigation?

Litigation is fraught with uncertainty. Valuators are often asked to navigate this maze of uncertainty and estimate the potential monetary value of damages in pending litigation. This value may be relevant to the litigation itself — to determine the reasonableness of a proposed settlement, for example — or it may have an impact on the business’s value.

Litigation matters

For accounting purposes, a pending claim or lawsuit is a contingent asset (for the plaintiff) or a contingent liability (for the defendant). Under Generally Accepted Accounting Principles (GAAP), contingent assets aren’t recorded on a company’s financial statements until they’re recognized. A contingent liability is recorded if it is probable that a liability will be incurred and the amount of the loss can reasonably be estimated.

But regardless of whether an asset or liability is recorded for financial statement purposes, pending litigation has an impact on the value a hypothetical buyer or seller would place on the business because it may increase the risk associated with that business. Even if a judgment or settlement is less than probable, a buyer or seller would consider the contingency in arriving at a price.

To estimate litigation’s value, appraisers must work closely with attorneys involved in the case to determine the probabilities associated with various outcomes as well as the estimated costs. For instance, if a plaintiff would have to invest $100,000 in litigation costs to obtain a $100,000 judgment or settlement, pursuing litigation would have no value.

Litigation as an investment

One of the most effective approaches to valuing litigation is to view it as an investment. As with other investments, a party must weigh the cost of pursuing litigation against the potential returns, taking into consideration the relevant risks.

In evaluating an investment in litigation, one technique that can be illuminating is real options analysis (ROA). ROA increasingly is being used in the corporate finance world to analyze capital investments and research and development projects. ROA invokes many of the same principles used to value financial options (such as stock options).

A stock option gives the holder the right to purchase stock for a fixed price within a specified time period. The holder will exercise the option only if it becomes profitable to do so — that is, if the stock’s market price surpasses the exercise price — and will let the option expire unused if the opposite happens.

Similarly, as a project progresses and the facts and circumstances change, a business has “real options” to pursue various strategies, including adjusting the project’s scope or direction or even abandoning it altogether. By placing a value on management’s flexibility to adapt to changing circumstances and new information, ROA can provide meaningful insight into an investment’s true worth.

A more traditional discounted cash flow (DCF) analysis values a business investment by forecasting the most likely outcome — or an average of possible outcomes — and reducing it to present value using a risk-adjusted discount rate. DCF — which typically assumes that investing in a project is an all-or-nothing proposition — has a limited ability to capture the value of management’s ability to adapt to future developments. ROA, on the other hand, recognizes that most investments involve a succession of decision points. At each one management has the option to change course or abandon the project.

Litigation analysis

ROA is particularly well suited for litigation. In litigation, uncertainty is resolved gradually over time as the parties discover new information and the court rules on legal issues. By recognizing the flexibility of litigants and their attorneys to adjust their strategies as new information is revealed, ROA can often produce more accurate litigation values. Here’s a hypothetical case that illustrates how this method works:

Sapp Co. is considering a lawsuit against Disappearing Inc. for fraud and breach of contract. Sapp’s biggest obstacle is the statute of limitations. There’s some uncertainty over when the statute of limitations began to run, and Sapp’s lawyers believe that the company has a 40% chance of surviving a motion to dismiss. They also estimate costs of $100,000 (discounted to present value) for the discovery and pretrial motion phase of the case.

Assuming the case goes to trial, the outcome also will depend on whether the court allows Sapp to pursue its fraud claim or limits it to breach of contract. According to Sapp’s lawyers, there’s a 50% chance that the company’s fraud claim will be allowed. They also predict that the company would obtain a judgment with a present value of $1 million for fraud, but only $100,000 for breach of contract. A trial would cost around $400,000 (discounted to present value).

Applying a traditional DCF analysis, Sapp has a 40% chance of generating a $150,000 net recovery. The net recovery is the average of the two possible outcomes should the case go to trial ($1 million or $100,000) less $400,000 in trial costs. The value of the opportunity, therefore, is 40% of $150,000, or $60,000. Because the initial investment needed to create that opportunity is $100,000 (pretrial litigation costs), this analysis suggests that litigation isn’t worth pursuing.

ROA, on the other hand, recognizes that Sapp and its lawyers have the option of dropping the case after the pretrial phase if the court disallows its fraud claim. The company probably would not invest an additional $400,000 to recover a $100,000 judgment. Viewed this way, there’s a 50% chance that litigation would generate a net recovery of $600,000 ($1 million fraud judgment less $400,000 in trial costs) and a 50% chance the company will abandon the litigation with no additional cash outlay.

At the end of the pretrial phase, the value of a trial is the average of the two equally probable outcomes, or $300,000. Sapp can recover, however, only if it survives the motion to dismiss, so the value of litigation is discounted to $120,000 (40% of $300,000). Under ROA, litigation is worth pursuing, because a $100,000 initial investment would generate an expected income stream worth $120,000.

A calculated risk

This example is simplified for purposes of illustration. Even relatively simple litigation involves multiple decision points with multiple options, so arriving at a monetary value requires more sophisticated decision-tree analysis or computer simulation.

Litigation is always a calculated risk. But by incorporating real options into the valuation process, the calculations can become more accurate.