Lost Profits or Lost Business Value –
Round Peg in a Square Hole?
S. Todd Burchett, CPA, ABV, ASA, CFF
Partner
Key Objectives
• Common elements between lost profits & lost business value
damage calculations
• Matching benefit stream with discount or capitalization rate
• Duration of damage period
• Identifying errors in calculations
• Professional standards
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Premise of Our Discussion
• Damage calculations are facts- & circumstances-driven
• Each case has its own unique circumstances & legal standards
• Financial expert & attorney should discuss appropriate
damage analysis early in case
• Our discussion centers around a case where total destruction
of a business is being alleged
• Liability is assumed
• Causation of foreseeable economic loss is assumed
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Damage Calculation
• Restores plaintiff to position it would have been in, if not
for defendant’s actions that caused damages
• Includes applicable past stream of lost income & applicable
forecasted future stream of lost income
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Does the Peg Fit Into the Hole?
• Attorney & financial expert must work together to ensure
components of damage model fit facts of case
• This is critical in determining damages with reasonable
degree of certainty
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How Are Lost Profits Calculated?
• Lost profits are calculated by measuring incremental lost
revenues & subtracting avoided costs or
• Lost profits are difference between net profits company
would have attained “but-for” damaging event & net
profits actually attained
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How Is Lost Business Value Calculated?
• Lost business value is calculated by measuring difference
between value of business prior to event that is being
disputed & value of business after event occurred
• In each instance, value may be determined by calculating
present value of projected future cash flow
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Business Valuation Theory
• Things you need to know
– What are valuation dates?
• Before alleged damage event
• After alleged damage event
– What is definition or standard of value?
• Statutory fair value – often used in shareholder oppression
• Fair market value – similar to IRS definition
• Investment value – value to a particular investor
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Business Valuation Theory
• Fundamentally, value of a business is measured by
quantifying
– Present value of expected future stream of cash flow
– Present value of expected future appreciation in capital investment
– Combination of the two
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Relationship Between Lost Profits & Lost
Business Value
• If value of lost profits damages is present value of lost future
cash flows and
• Value of a business is present value of its future cash flows (if
entire business is destroyed then all cash flows are lost), then
• It would seem that lost profits must be less than or equal to
total value of a business
(Past profits are not related to a business valuation calculation)
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Variables in Common
• Two different damages analyses have similar components
– Income stream
• Incremental net income
• Before or after tax
• Length of damage period
–
–
–
–
Method of measurement
Discount rate
Interest or time value of money
Use of hindsight
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Income Stream
Lost Profits
Business Valuation
• Incremental revenue, net of
avoided costs or costs saved
• Before income tax
• Past period calculated through
date of trial
• Future period (until recovery) is
discounted to present value as of
date of trial
• Some jurisdictions require
discounting to present value as of
date of alleged injury
• Net cash flow available to equity
or to total invested capital is used
• After tax income
• Past period is not applicable since
a valuation is a measurement of
value of future expected cash
flow
• Future cash flows are discounted
to valuation date
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Damage Period
• Projections must not be speculative (must be reasonably
certain)
• Plaintiff typically has a duty to mitigate damages
• Lost profits calculation usually falls under one of these
scenarios
– Temporary losses
– Immediate destruction of business
– Slow death of business
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Damage Period (cont’d)
1,000,000
900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
Projected "But For" Profits
Actual/Projected "Impaired" Profits
2007
2008
2009
2010
2011
2012
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Damage Period (cont’d)
• In determining length of damage period, financial experts will
typically consider a number of factors, such as
–
–
–
–
–
Product’s life cycle
Competition
Technology
Regulatory environment
Length of contracts
(Remember, reasonable certainty & mitigation)
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Damage Period (cont’d)
• When a business is permanently destroyed, future stream of
cash flow is lost forever
• Value of business after damage in some situations is
considered to be zero
• Thus, determination of damages is based on
– Calculating lost profits into perpetuity or
– Valuing business just before events that are being alleged to have
destroyed business
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Damage Period & Business Value
• Valuation of a business measures stream of cash flow
available to investors into perpetuity
• Thus, capitalization of an earnings stream or damage
model containing a lost business value assumes a
damage period that is a permanent
• Are lost profits & business value measured at same
date? They should be
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Method of Measurement
Lost Profits
Business Valuation
•
•
•
Calculation of incremental lost
revenue, reduced by costs not
incurred due to revenue not being
produced
Methods for gathering evidence
– Before-&-after method – using
company data
– Yardstick method – using guideline
companies
– Sales projection method – using
company projections
– Market model method – projection
of market share
•
•
•
Income approach – discounting
future cash flow to present value
Asset approach – adjusting assets &
liabilities to their market values as of
valuation date
Market approach – applying sales of
comparable companies or multiples
of publicly traded companies to
subject company
How do asset approach & market
approach reconcile with income
approach
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Discount Rate
Lost Profits
Business Valuation
•
•
•
Based on a risk assessment, which
must match risk in cash flow
– Some jurisdictions have allowed riskfree rate
– Many jurisdictions require riskadjusted rate, based on plaintiff’s risk
•
•
Based on a risk assessment
Must be matched to risk in cash flow
to equity or cash flow to invested
capital
After-tax risk rate is used
After-tax risk rate is used in order to
compensate plaintiff for fact that
award will be taxable
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Interest
• Pre-judgment & post-judgment interest is typically
considered in both lost profits & lost business value
scenarios
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Use of Hindsight
Lost Profits
Business Valuation
• May consider facts after date of
alleged damaging event
• Post-breach events are analyzed
to discern appropriate way to
handle in damage model
• Normally not considered
• May need to consider facts until
date of trial & make adjustments
as appropriate
• Seek guidance
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Is it Possible for Plaintiff to Claim Both Lost
Profits AND Lost Business Value?
• It’s possible, such as when a business has ceased
operations at date of trial & closing of business was
caused by defendant
• Past lost profits are not part of calculation in valuing a
business, so they would not be double counted
• However, care should be used not to double count any
future lost profits calculation with lost business value
being claimed
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Can a Lost Profits Claim Into Perpetuity Be
Higher than Lost Business Value?
• In some circumstances
• For example, if plaintiff continued in business, continued
to incur losses & continued to fund business, losses might
be higher than lost value had business been closed at date
of injury
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Limits on Amount of Damages in Damage
Calculations
• Information obtained during discovery
• Damage period
– Mitigation or recovery of business
– Limited life of contract
• Discount rate
– Risk & uncertainty – this can be accounted for by using a proper
discount rate
• Calculated income stream with assumed growth rates
• Others
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Professional Standards
• CPAs
– For lost profits calculations
•
•
•
•
AICPA’s Statement on Standards for Consulting Services, No. 1
AICPA’s Code of Professional Conduct
AICPA’s Rule 101, Independence, of the Code of Professional Conduct
AICPA’s Rule 203, Accounting Principles, Code of Professional Conduct
– For providing opinions of value
• AICPA’s Statement on Standards for Valuation Services, No. 1
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Professional Standards
• Non-CPAs
– For lost profits calculations
• None known
• Check professional organizations to which they belong
– For providing opinions of value
• American Society of Appraisers (ASA’s)
– ASA’s Principles of Appraisal Practice and Code of Ethics
– ASA’s must perform appraisals in conformance with Uniform Standards of
Professional Appraisal Practice (USPAP)
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Questions?
Todd Burchett
[email protected]
210.341.9400
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Bibliography
Weil, Roman L., et al., eds. Litigation Services Handbook: The Role of the
Financial Expert, 4th edition. 2007
Fannon, Nancy J., ed. The Comprehensive Guide to Lost Profits Damages
For Experts and Attorneys 2009
Dunn, Robert L., Recovery of Damages for Lost Profits, 6th edition.
Hitchner, James R., ed. Financial Valuation, Applications and Models, 2nd
edition. 2006
Thompson, Michael & Christian Tregillis. Differences Between Lost Profits
and Diminution in Business Value as a Measure of Damages
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