This article was originally published in The Daily Record.
In commercial litigation, a primary role of a financial expert is to compute economic damages that may have been suffered by a party.
In order to quantify economic damages, experts are commonly asked to calculate lost profits and/or lost business value. As a result, they must determine which approach is most appropriate to use. The calculation of economic damages is meant to restore the party to the financial position the party would have been in, “but for” the offender’s alleged harmful acts.
When determining either lost profits or lost value, the use of estimates and projections are customary. The underlying assumptions must be corroborated as the accuracy of the calculations should be the primary focus.
A fundamental difference between lost profits and lost value is the expected duration of the loss. Lost profits are a measure of damages typically utilized when a business or segment of a business continues to operate but suffers reduced income for a finite period; and measurement is calculated for a period until the business regains the position it would have been in had the alleged damaging act not occurred.
Lost profits represent the incremental change in revenue attributable to a particular action, plus or minus the change in expenses arising from that change in revenue attributable to a particular action. Losses into the future are discounted to present value using an appropriate discount rate. Lost profits are generally calculated before the deduction of income taxes because lost profits awards are taxable upon recovery.
Conversely, lost business value occurs when a business never commences operations, ceases all or part of its operations, or permanently loses a segment of its business. The damage period continues in perpetuity, since the business’s earning capacity is permanently lost.
Lost value relies on net cash flow, after the deduction of all expenses. Therefore, it is a measurement of a return to an investor using net after-tax cash flows that are discounted to a present value.
Lost profit approaches
Generally, when using lost profit approaches, all information available up to the date of trial, irrespective of the date of harm, is considered in calculating damages, noting that the date of harm is not considered a cutoff date.
There are three common approaches:
- The before-and-after analysis compares profits before and after the harmful event.
- The yardstick approach benchmarks a damaged company’s performance to external sources such as publicly traded companies or industry guidelines. In this approach, the expert assumes that the company’s performance would have mirrored that of its competitors.
- The third approach is the sales projection method, where a comparison is made between the forecasted profits before the harmful event to the actual profits after the event. Here, the discount rate is reflective of risk associated with specific cash flows. Startup and niche companies typically utilize this approach because they have a limited history of earnings and only a few comparable transactions exist.
Lost business value approaches
There are three generally accepted approaches utilized to determine lost business value:
- The asset-based approach involves calculating the net equity (assets minus liabilities) of the business.
- Depending on the income method chosen, the value is derived by applying a capitalization rate or a discount rate to the expected future earnings to arrive at a present value of the future benefit stream. The discount rate used is reflective of the overall risk of a business (i.e., invested capital).
- Lastly, the market approach applies pricing multiples obtained from sales transactions and applies them to the appropriate performance measure (metric) of the company being valued.
These approaches are performed before and after the date of harm and the difference is considered the lost business value.
When valuing a mature business where historical cash flow is a proxy for the future cash flow, the before-and-after analysis is employed. However, with startups/new businesses where cash flow will grow by varying rates and eventually stabilize, using historical cash flow, if any, will undervalue the business.
Instead, “but for” cash flow should be grown and present-valued to a date in the future, typically the trial date. It is this “but for” value that should be compared to the current (after) value as of that specific date.
When calculating the value as of the date of harm, information available subsequent to the date of harm is typically excluded and only information known or knowable as of the date of the harm is considered in calculating this value.
Depending on the facts and circumstances of litigation, either lost profits or lost business value approaches can be utilized — but not simultaneously. Whichever approach is used, the financial expert should ensure that the methodology and related processes are described fully and correlate to the cause of damage.
Robert N. Cantor is a manager in the litigation, forensics and business valuation department at Hertzbach & Company, P.A.