The news is out: SCO is losing money. Fast. Considering that SCO has no revenue and lots of expenses, the news is not surprising. Raising revenue and cutting expenses might help, but neither will be easy.
The company reported a significant net loss in the third quarter, which it blamed mostly on a loss of income from SCOsource licensing and litigation costs that were higher than it expected.
Sales were down by 44 percent, from US$20.1 million to $11.2 million. Income from licensing agreements fell from $7.3 million a year ago to $678,000, a drop of 91 percent. Altogether, SCO lost $7.4 million in the third quarter compared to a net income of $3.1 million for the same period last year.
Losing Ground to Linux
SCOsource licensing is down, which indicates that SCO’s Unix is losing ground to Linux.
Part of the reason for this might be objections to the licensing models SCO employs and the concerns over SCO’s claims to Linux. SCO does not license its Unix as openly as Linux is licensed. So IT directors will choose Linux over SCO because they can buy the same kind of support terms SCO offers for Unix but are not subject to licensing restrictions.
With Linux, open-source developers can modify the software and benefit from the improvements other developers make. Add to that the animosity from the open-source community toward SCO, and it’s no wonder that marketing SCO operating systems is a very tough sell right now.
SCO isn’t getting much revenue from Linux licenses either. If SCO wins its $5 billion lawsuit against IBM, maybe consumers will line up to buy Linux licenses from SCO. That’s a big gamble, especially because any settlement is still a long way off, and most everyone is taking a wait-and-see position.
Raising Cash and Cutting Expenses
Without an easy way to raise revenues, the only other way to keep from running out of cash is to get more investors or reduce expenses. At the moment, there’s not a lot of smart money looking to take a piece of SCO. That means taking a serious look at the expense side of the balance sheet.
SCO has about $43 million in cash reserves and is losing $7 million a quarter. At this rate, it will run out of money about seven quarters from now. If a ruling in the SCO-IBM lawsuit is reached as early as 18 months from now, don’t expect it to end in SCO’s favor. That means without an expense reduction, it would exhaust its reserves before it gets to the end of the game.
SCO announced plans to close offices in Spain, Italy and Ireland, and to move 30 workers from Santa Cruz into a smaller space in Scotts Valley. However, the biggest piece of the company’s expense pie is litigation expenses. SCO’s legal fees involving IBM are estimated at $15 million so far, and legal fees involving IBM, Novell and others totaled $7.2 million for the quarter. Reducing those legal fees could help SCO extend the game and improve its chances for long-term survival.
Much of SCO’s litigation is being done on a partial contingent basis. SCO pays for some legal items, parts of others and the rest is deferred until a recovery occurs, at which point the legal team gets paid the rest of its fees out of the recovery. One way for SCO to reduce litigation costs is a revision of its contingent arrangement so that more is contingent and less is paid for up front.
Contingent-fee arrangements are often used in personal injury lawsuits where the injured cannot afford to pay legal fees up front to have an attorney represent them against a well-funded defendant. Now we are seeing an increasing trend toward businesses opting for contingent arrangements in cases involving complex litigation, even when there are cash reserves to pay for the litigation on an hourly basis.
These types of arrangements are common in patent disputes, antitrust disputes, and in the case of SCO, licensing disputes. What is not so typical is for the terms of the contingent arrangement to change in midstream, which is exactly what SCO and its law firm recently agreed to do.
Change Is Good
SCO is represented by David Boies, of Boies, Schiller & Flexner, the firm that initially took the case against IBM on a partial contingency. You might recall Boies as the attorney who argued before the Supreme Court on behalf of Al Gore in the dispute over the 2000 election results in Florida.
The original agreement was for the lawyers to receive a flat 20 percent of any settlement. The new agreement caps SCO’s legal fees at $31 million, which could end up being between a 20 to 33 percent contingency depending on the eventual outcome of the settlement. SCO and Boies both had to agree to the change.
SCO is potentially giving away up to 13 percent of future revenues in exchange for a reduction of attorney’s fees. After its recent messy stock transaction with BayStar Capital, SCO must have decided this was a better option than trying to sell off a percentage of the company for more money than it gained through the reduction in legal fees.
What’s in it for Boies, Schiller & Flexner? They have to pony up the cash (or skip paying themselves) for more than they were already on the hook for. In exchange, they could get a bigger percentage of any future recovery.
The firm has a reputation for striking favorable deals, but this might be a case of being stuck with accepting something rather than nothing. After investing millions of dollars in time and expenses on contingency and faced with the prospect of getting none of it back if SCO runs out of cash and goes out of business, Boies must have figured that his firm had no choice but to forgo being paid the portions of the fees and costs that SCO agreed to pay in the original agreement.
Renegotiating in Midstream
In most situations, renegotiating a contingency agreement midstream is difficult for the lawyers. If the case is going well, the client will not agree to give up a higher percentage of the recovery and will opt to put in cash instead. The lawyers will not agree to take a smaller percentage.
They would rather continue putting up the money to cover the expenses they are obligated to meet. The only reason to change contingency agreements in midstream is because the client has cash-flow problems unrelated to the litigation and is forced to cede some of its interest — or because the case is going nowhere fast.
When things are going poorly, lawyers don’t want to agree to a higher percentage because they’ve already invested too much. Only if they realize that collecting the cash would put the client out of business, would they decide to prevent that from happening by not charging so much up front.
Too Late To Turn Back
This type of shifting-the-risk is not used in litigation alone. It is common in professional sports, for example. Athletes sign long-term contracts in return for deferring payments to help make sure the team stays in business long enough to pay off the contract. In the recording industry, a studio typically covers the costs of recording time in return for a percentage of the artist’s CD sales, banking on the future success of the artist.
For SCO and Boies, at this point it is a case of too late to turn back now. They’ve already invested millions. The fact that SCO is willing to give up a potentially higher pay-off might mean it is less confident in the outcome. At some point, if it looks like the recovery will be less than the investment, everyone might decide to look for a way out by wrapping up the case.
Like a sports team trading a high-priced star and even paying the other team a portion of the player’s salary, sometimes the best business move is to cut your losses. That time is not now for SCO. The company is confident the new agreement with Boies gives it more financial flexibility.
It is now in a better position to see the litigation through to its conclusion. The attorneys are probably confident too that getting something instead of nothing makes this new agreement a good deal for everyone.
Phil Albert, a LinuxInsider columnist, is a patent attorney and partner with the San Francisco office of the intellectual property law firm Townsend and Townsend and Crew LLP.