lost profits or lost business value – round peg in - · pdf files. todd burchett, cpa,...

S. Todd Burchett, CPA, ABV, ASA, CFFPartner

Lost Profits or Lost Business Value –Round Peg in a Square Hole?

BKD Forensics Institute

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


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


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


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


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


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


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


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


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)


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


Income Stream

Lost Profits• 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

Business Valuation• 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


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


Damage Period (cont’d)

0100,000200,000300,000400,000500,000600,000700,000800,000900,000

1,000,000

2007 2008 2009 2010 2011 2012

Projected "But For" Profits

Actual/Projected "Impaired" Profits



• 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)



• 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


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


Method of Measurement

Lost Profits• 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

Business Valuation• 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


Discount Rate

Lost Profits• Based on a risk assessment, which

must match risk in cash flow– Some jurisdictions have allowed risk-

free rate– Many jurisdictions require risk-

adjusted rate, based on plaintiff’s risk

• After-tax risk rate is used in order to compensate plaintiff for fact that award will be taxable

Business Valuation• 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


Interest

• Pre-judgment & post-judgment interest is typically considered in both lost profits & lost business value scenarios


Use of Hindsight

Lost Profits• May consider facts after date of

alleged damaging event

• Post-breach events are analyzed to discern appropriate way to handle in damage model

Business Valuation• Normally not considered

• May need to consider facts until date of trial & make adjustments as appropriate

• Seek guidance


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


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


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


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


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)


Questions?

Todd [email protected]

210.341.9400


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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