valuing lost profits for litigation purposes

VALUING LOST PROFITS FOR LITIGATION PURPOSESVALUATION 2016 SERIES

Premier date: February 26, 2016

Premier Date: February 26, 2016

VALUATION 2016 SERIES

Valuing Lost Profits for Litigation Purposes

© 2016 DailyDAC, LLC d/b/a/ Financial Poise®

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© 2016 DailyDAC, LLC d/b/a/ Financial Poise® 3


meet the facultyPANELISTS

George Apostolides Arnstein & Lehr LLPRichard ClaywellMichael Hobbs PahRoo Appraisal & Consultancy

MODERATOR Kevin Lane Crowe Horwath LLP

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Practical and entertaining education for business owners and executives, accredited

investors, and their legal and financial advisors. For more information, visit

www.financialpoise.comDISCLAIMER: THE MATERIAL IN THIS PRESENTATION IS FOR INFORMATIONAL PURPOSES ONLY. IT SHOULD

NOT BE CONSIDERED LEGAL ADVICE. YOU SHOULD CONSULT WITH AN ATTORNEY TO DETERMINE WHAT MAY BE BEST FOR YOUR INDIVIDUAL NEEDS.

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about this webinarIn business litigation matters, financial experts are often asked to provide an opinion on the quantification of economic damages suffered by an injured party. Business valuation and lost profits are two common damages estimation approaches used by financial experts. This Financial Poise webinar explores Lost Profits damages in plain English – when they are appropriate, techniques for valuing, and common pitfalls to avoid in their calculation.

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about this series“What is it worth?” A valuation (or appraisal, if you prefer) can be performed on virtually any asset: the equity of a company or options to buy the equity of a company; intangible assets (such as patents and trademarks- or even contingent liabilities); real estate; and any sort of personal property. The concept of valuation permeates the business and legal world for reasons that include investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and litigation, among others. Join some of the leading experts in the country as they discuss- in plain English - the basics and the latest in valuation topics and why valuations of assets can vary so greatly from one professional to another.

As with all Financial Poise webinars, each episode in the series is designed to be viewed independently of the other episodes, and listeners will enhance their knowledge of this area whether they attend one, some, or all of the programs.


episodes in this series

Dates above are premier dates; all webinars also available on demand

EPISODE #1 What’s it Worth: Valuing a Business for Sale1/19/2016

EPISODE #2 Valuing Lost Profits for Litigation Purposes2/26/2016

EPISODE #3 Selecting the Right Valuation Expert3/18/2016

EPISODE #4 Valuing Your Brand and Other “Soft” Assets4/29/2016

EPISODE #5 Bankruptcy Valuation Issues: 5/27/2016Valuation in the Context of a Fraudulent Transfer or Preference Attack


FINANCIAL POISE, A DIVISION OF DAILYDAC, LLC©20149

Introduction and Basics• Types of damages

• Actual or compensatory• Nominal• Punitive• Other

• Events leading to claims for damages• Breach of duty• Contracts• Torts

• Methods typically used to calculate damages• Lost profits• Lost business value• Reasonable royalty• Other


Lost Profits Defined• Lost profits are based upon the alleged harm suffered by the

Plaintiff or injured party.• In a business setting, lost profits are determined as the amount

necessary to place the injured party in a position that it would have realized had the incident not occurred.

• Only “Net Lost Profits” are allowable in economic damages – (Net Lost Profits = Lost Revenues less Avoided/Incremental Costs)

• Courts have stated the general rule permitting alternate theories of recovery:

• “[I]f a business is completely destroyed, (then) the proper total measure of damages is the market value of the business on the date of the loss. If the business is not completely destroyed, then it may recover lost profits. A business may not recover both lost profits and the market value of the business.”¹

(1) Montage Group, Ltd. V. Athle-Tech Computer Systems, Inc., 889 So.2d 180, 191 (Fla. App.2004) (internal citations omitted). From “The Comprehensive Guide to Lost Profit Damages,” 2013, Chapter 9

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Lost Profits Defined (cont.)• Stated Another Way

• Numerous jurisdictions hold to the view that when the loss of business is alleged to be caused by the wrongful acts of another, damages are measured by one of two alternative methods: (1) the going concern value; or (2) lost future profits. [T]he courts allow a plaintiff to recover either the present value of lost future earnings or the present market value of the lost business, but not both. The ‘going concern value’ is the price a willing buyer would pay and a willing seller would accept in a free marketplace for the business in question. It measures damages by awarding the difference between the going concern value and the price actually received by the plaintiff upon sale of the business.1

(1) Protectors Insurance Service, Inc. v. U.S. Fidelity & Guaranty Co., 132 F.3d 612 (10th Cir. 1998) But see Cooper Distributing Co. v. Amana Refrigeration,Inc. 180 F.3d542 (3rd Cir. 1999) From “The Comprehensive Guide to Lost Profit Damages”, 2009, Chapter 8.

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Causation and Burden of Proof• Credible lost profits include economic damages that are natural,

proximate, probable, or a direct consequence of an act, excluding remote consequences.

• Courts generally rule that Plaintiffs must establish lost profits to a reasonable degree of certainty.

• Calculations cannot be speculative, vague or contingent, unreasonable, or unforeseeable factor.

• Keep in Mind• The approaches, methodologies, analytical procedures, and analyses

must relate to the specific information of the issues in dispute. • The link between liability and causation is necessary to establish

economic damages.• Damages for net lost profits are recoverable only if the plaintiff

establishes legally sufficient proof that the financial expert’s economic damages are reasonable and that reliable factors were utilized.

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Loss Period• Can vary depending on the underlying cause(s) of action and the

underlying facts of the case.

• Typically begins on date of the harmful act.

• End date is generally when plaintiff returned to the position it would have originally occupied had the alleged damages actions not occurred.

• Trial date may not provide the end point to the loss.

• Future damages periods need to be discounted.13


“Time is Money”• Lost profits occur over time but are calculated as of the date of trial

or date of injury• To calculate lost profits:

• Past losses should be accumulated to present value• Future losses should be discounted to present value

• Choosing the right interest rate • Basis - the rate that would compensate the plaintiff as

though the damage had not occurred – i.e. making the plaintiff whole

• Common rates:• Risk-free rate of return• Risk factor relative to the earnings projection• Company’s weighted average cost of capital (debt and

equity)• Statutory

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Mitigation• Defendant has the burden of pleading or proving (a/k/a/ “doctrine

of avoidable consequences”).

• Plaintiff should take reasonable steps to mitigate damages caused by the defendant’s conduct

• Does not require unreasonable or unprotected actions

• The injured party will not be compensated for those damages that the injured party could have avoided by reasonable efforts or expenditures

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Questions to Consider in Determining Lost Profit Damages

• What caused the loss?• Who caused the loss?• Might other things have caused the loss?• What is the best measure of the loss?• What is the period of damages?• What kind of financial and operational information is available? Is it

reliable?• What were the trends in the business and industry at the time of

the loss?• What is the capacity of the business? Could it have generated the

lost sales?• What are the primary risk factors facing the business?

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Lost Profits - What are we Quantifying?• Lost profits as measured by:

• Lost incremental revenue, less related incremental costs

• Gross margin often = incremental loss (within a relevant range)

• Consideration of semi variable costs, capacity, etc.• Truly fixed costs typically excluded

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Lost Revenue - Commonly Accepted Lost Profits Methods

Market Share Approach

Before-and-After

Approach

Yardstick Approach

Sales Projection Approach

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Lost Revenue - “Before-and-After” Approach to Lost Profits

Estimate of lost profits based on a comparison of the plaintiff’s sales before the damaging event with a projection of sales that would have been achieved had the damaging act not occurred (“but for” sales) reduced by incremental costs.1. When Appropriate

a) When reliable historical data existsb) When growth trends are steady and predictablec) In relatively static competitive environments

2. Strengthsa) Relies on plaintiff’s actual, historical financial results as basis for comparison

to estimated future resultsb) Courts often favor financial projections based on past results

3. Limitationsa) Requires sufficient historical datab) May not account for industry changesc) Periods before and after damaging act may not be comparabled) Unavailable for newly established firms 19


Lost Revenue - “Yardstick” Approach to Lost ProfitsEstimate of the plaintiff’s profits based on a yardstick – e.g., a comparable company, division or industry benchmark - that is not affected by the damaging act1. When Appropriate

a) When reliable yardstick existsb) With newly established firmsc) Accounts for differences in time periods

2. Benefitsa) Can provide objective, reliable benchmark for estimatingb) Yardstick is independent of effects from damaging actc) Accounts for changes in industry or market

3. Limitationsa) Lack of comparability between plaintiff and yardstick (e.g., size, sales

channels).b) Yardstick data may not be available

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Lost Revenue - “Market Share” Approach to Lost Profits

Calculates lost profits based on the difference between the plaintiff’s “but-for” market share and its market share after the damaging act.1. When Appropriate

a) When reliable market share data existsb) When plaintiff company products/services fit within “market”

2. Benefitsa) Can provide objective, reliable basis for estimatingb) Other companies in “market” are independent of damaging actc) Accounts for changes in the industry during relevant period

3. Limitationsa) Difficult to determine market share – lack of data, comparabilityb) Difficult to assess due to dynamic markets

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Choosing the Right Approach1. Consider the availability of information – from the company, the

industry, competitors, industry analysts, etc.2. Consider following factors prior to damaging act:

a) Were plaintiff’s sales trends steady and predictable?b) Were plaintiff’s sales trends comparable to another company or

industry as a whole? c) Which approach is most consistent with facts in case and

market conditions during damage period?d) Is company’s financial information reliable?

3. Which method is the most practical to use? a) A combination of approaches can be used.

Source: Robert L. Dunn, “Recovery of Damages for Lost Profits”, Volume 1,§5.5

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Estimating Costs1. Know your subject company and how they track costs2. Apply reasonably supportable methods

a) Statistical Methods (e.g. regression analyses or attribute sampling)

b) • Non statistical Methods(e.g. detailed account analyses, direct assignments, accounting estimates, cost accounting allocations, ratio analyses, etc.)

3. Consider market and economic conditions4. Understand the fixed, variable, and semi-variable cost

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Estimating Costs (cont.)1. Costs that should be deducted from lost revenues to determine lost

profits.a) Cost that would have been incurred in connection with the

generation of the claimed lost revenues/economic damages b) Damages are equal to the revenue that would have been

derived, less additional costs that would have been incurred, in performing the contract

c) Reasonable certainty requires proof of gross profits and generally, evidence of overhead expenses or other costs of producing income

2. Starting point for the cost structure analyses generally is the determination of fixed versus variable costsa) Fixed cost – will be expended regardless of sales volumeb) Variable cost – will be spent only to generate additional sales

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Estimating Future Profits1. Must be based on reliable information and reasonable assumptions2. Common sources:

a) The plaintiff’s prior, actual experienceb) The plaintiff’s subsequent, actual experiencec) The plaintiff’s budgets, forecasts, or projections (prepared prior

to the damaging event in the normal course of business)d) Identified lost customerse) The comparable experience of others, including its own

experience at other locations or divisionsf) The defendant’s subsequent experienceg) Industry averages (i.e., yardsticks).

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PROVING LOST PROFITS: Expert Testimony

Is an expert needed?• If yes, what kind of expert do you

need?• If no, is it best practice to hire an

expert anyhow?

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EXPERT TESTIMONY CONSIDERATIONS

Must expert be qualified by court?

What standards must expert follow or meet?

What kind of work product and methodology is expected of expert?

How will experts calculate lost profits?

What care/precautions should lawyer take when preparing and working with expert?Is present value taken into account by lost profits expert?

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Lost Profits vs Lost ValueThe following table summarizes the differences between lost profits and lost business damages:¹

(1) ”The Comprehensive Guide to Lost Profits Damages”, 2009, pg. 8-6, Business Valuation Resources

Attribute Lost Profits Loss of ValueIncome Stream Incremental income stream, net

of avoided costs Typically net after tax income

Income Stream Before income tax Typically after tax incomeIncome Stream Typically limited life Into perpetuityValuation Methods Present value of post trial lost

incremental income added to pretrial lost incremental income including appropriate pre-judgement interest added to the date of trial

Discounted net income or net cash flow model, supported by other valuation methodologies as needed

Discount Rate Based on either risk assessment, risk free rate, or plaintiff’s use of the funds depending on the circumstances

Based upon risk assessment

Prejudgment and post judgment interest

Considered Considered

Use of hindsight (the “Book of Wisdom”)

Typically considered Seek guidance 28


COMMON ISSUES IN MEASURING DAMAGES• Causation – Should the damages expert opine or assume?• Causation – Can the damages expert rely on another expert?• “Externalities” – in the industry; in the company• Methodology – generally accepted? applied properly?• Use of hindsight (on projections)• Present value discount rates applied to financial projections• Business Valuation discounts:

• Lack of Control (Minority Discount)• Lack of Marketability/Liquidity (Marketability Discount)

• Reliability of management’s projections

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RECAP: FRAMEWORK FOR CALCULATING LOST PROFITS

1. Analysis of macroeconomic and industry trends2. Analysis of factors causing the loss3. Analysis of plaintiff company’s financial trends4. Estimate of incremental lost sales - “But for” sales minus actual

sales5. Estimate of incremental costs associated with lost sales6. Lost profits = Incremental revenues – incremental costs 7. Discount future lost profits to present value using risk-adjusted

discount rate

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More About The Faculty: D

GEORGE APOSTOLIDES [email protected]

George Apostolides is a partner in the firm’s Chicago office and Chair of the Litigation Practice Group. His practice focuses on business and bankruptcy litigation, and he handles cases in federal and state courts both in Illinois and nationwide. He has practiced with the firm since his graduation from Northwestern University School of Law in 1995, and has years of experience managing business risk for his clients, litigating disputes, and, if necessary, taking cases to arbitration or trial. Mr. Apostolides’ clients range from Fortune 500 companies to small businesses and individuals. He provides a range of services for those clients, including litigation avoidance consulting, prosecuting claims for damages, and defending cases filed against the clients. His focus is always on his clients’ needs and interests in both the short and long term.

Mr. Apostolides has handled hundreds of cases in jurisdictions throughout the country and has first-chair trial experience both in courtrooms and before arbitration panels. He also has handled numerous appeals and has argued before the United States Court of Appeals for the Seventh Circuit. Mr. Apostolides has extensive experience handling commercial disputes, including: breach of contract; avoidance and recovery of fraudulent transfers under the bankruptcy code; avoidance and recovery of fraudulent transfers under the state law; Uniform Commercial Code violations; avoidance and recovery of preference payments; guaranty collection matters, post-judgment proceedings; real estate litigation; breach of fiduciary duty claims; and shareholder disputes.

Mr. Apostolides is holds degrees from Northwestern University School of Law (J.D., 1995) and Princeton University (A.B., magna cum laude, 1992). 31

More About The Faculty: D

RICHARD [email protected]

Richard is a practicing Certified Public Accountant, and holds the additional designations of Accredited in Business Valuation, Accredited Senior Appraiser, Certified Business Appraiser, International Certified Valuation Specialist, Certified Valuation Analyst, Certified in Merger & Acquisition Advisor, Master Analyst in Financial Forensics, Certified in Fraud Deterrence, Accredited in Business Appraisal Review. Richard has been valuing closely held companies since 1985. Richard’s practice is restricted to business valuation, economic damages, profit enhancement and exit planning.

Richard received his Bachelor of Science in Accounting in 1979 from the University of Houston – Clear Lake. He then received certification as a Public Accountant in 1983. Over the years, Richard has earned additional accreditations that relate to business valuations, economic damages and fraud. Richard has been an instructor for the National Association of Certified Valuation Analysts for many years, has been an instructor for the Internal Revenue Service and the International Association of Consultants Valuators and Analysts (IACVA). Richard is currently the Director of Education for the IACVA and is responsible for the business valuations materials being taught in 55 countries. Richard has taught business valuation or economic damage courses in China, Korea, Taiwan.

Richard has performed over 1,000 business valuations since 1985. Richard has testified in Texas County Court, Texas State Court, Bankruptcy Court and Texas State Courts. Richard has given testimony in economic damages (lost profits), shareholder disputes, personal injury, wrongful termination and divorce.



More About The Faculty: [email protected]

MICHAEL HOBBS

For more than two decades, Michael has been employing his energetic style to the industries of Real Estate, Energy Efficiency and Entrepreneurship/Private Equity. Coupling his strong financial background and operating experience, with his impassioned approach to delivering results, he has consistently transformed existing businesses into profitable enterprises through streamlining, process improvement and superior customer service experiences.

In today's turbulent real estate markets, property owners, investors, lenders and portfolio managers turn to Michael & PahRoo Appraisal & Consultancy for guidance and valuation insight on their real estate assets. Whether analyzing underwater real estate, determining market valuation for litigation matters, valuing green/high-performance/energy-efficient properties, or consulting property owners on sale/divestiture options or even bankruptcy proceedings, Michael's extensive market knowledge is a valued asset for clients seeking profitable solutions and opportunistic results.

Michael and his team are the ones that get called in when people have a valuation problem they want to solve or have experienced a sub-par appraisal and need competent, expert professionals to address and resolve the matter.

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More About The Faculty:KEVIN LANE

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[email protected]

Kevin is an accomplished financial professional with over 15 years of experience in private equity and consulting leadership positions. He has led and performed dozens of valuation assignments, including the valuation of small and medium size businesses, intellectual properties, joint ventures, and emerging technologies for a variety of purposes including litigation, technology commercialization, mergers and acquisitions, and tax planning. He currently leads Crowe Horwath’s outsourced corporate development practice.

Kevin has provided expert accounting and valuation testimony, prepared expert reports and analyses, and scrutinized the work of opposing experts related to economic damages in complex commercial litigation matters - testimony venues have included Federal District Court, American Arbitration Association, and formal mediation

Having spent almost three years in the private equity industry, Kevin is also experienced in all aspects of the investment process, including financial modeling, evaluating investment opportunities, performing due diligence, negotiating transactions, and obtaining financing. Kevin has been a guest lecturer at The John Marshall Law School and Loyola University Chicago School of Law on topics including accounting for business combinations, intellectual property valuation and taxation, and economic damages.

Kevin is a Certified Public Accountant (CPA) Accredited in Business Valuation (ABV). He holds a Bachelor of Business Administration, Accountancy and Computer Applications from the University of Notre Dame and a Masters in Business Administration, concentrations in Finance and Economics, from the University of Chicago Booth School of Business. © 2016 DailyDAC, LLC d/b/a/ Financial Poise® 34

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Important Notes

• THE MATERIAL IN THIS PRESENTATION IS FOR GENERAL EDUCATIONAL PURPOSES ONLY.

• IT SHOULD NOT BE CONSIDERED LEGAL, INVESTMENT, FINANCIAL, OR ANY OTHER TYPE OF ADVICE ON WHICH YOU SHOULD RELY.

• YOU SHOULD CONSULT WITH AN APPROPRIATE PROFESSIONAL ADVISOR TO DETERMINE WHAT MAY BE BEST FOR YOUR INDIVIDUAL NEEDS.