Calculating Damages for Lost Profit: Part II
This week we are continuing our semi-monthly blog series with a blog about forensic accounting and calculation of commercial damages. This blog is focused on lost profits and is the second of a three-part series discussing lost profits. In our last blog we discussed calculating lost profit damages based on product profitability and in our upcoming blog, we will discuss lost profits based on reasonable royalty. This week's blog discusses calculating lost profits based on the diminution in business value.
Lost Profits Calculated Using a Diminution in Business Value Approach
The damages suffered by a plaintiff in a lost profits claim will be the dollar value, adjusted for the time value of money, required to return the plaintiff to the financial position it would have enjoyed "but for" the alleged bad acts of the defendant.
The lost business value approach to determining lost profit damages is most frequently applied when the lost business covers an undefined period of time or when plaintiff's business has been destroyed or bankrupted.
When using a diminution in business value approach, it is critical to understand everything material affecting the value of the business. If there are other factors materially affecting the value of business, or contributing to its demise, then these factors must be taken into account in the damage claim. For example:
- If there is a general decline in the market size that occurs simultaneous to a loss in market share due to the bad acts of the defendant, then the diminution in business value caused by the market's overall shrinkage may have to be considered when determining the damages ascribed to the defendant due to its alleged bad acts, or
- If there is a general increase in the cost of component materials causing a decline in the plaintiff's profitability, then the diminution in business value caused by the decline in gross profit resulting from increased material cost generally would not be included in the damages ascribed to the defendant due to its alleged bad acts.
Typically, to determine the plaintiff's damages using a lost business value approach, the damage expert will have to determine the value of the business at two points in time. The first point is immediately before the event, giving rise to the lost profits or the point in time before the defendant's bad acts. The second point is a time after the defendant's bad acts have been fully realized and can be accurately quantified.
Often, a key question faced by the damages expert is whether the valuation can take into account facts that are learned after the valuation date that would have affected the value conclusion if they were known on the valuation date. How this question is answered will depend on the laws and case precedent in the jurisdiction in which the matter is being adjudicated. Consideration may also be given to whether the owner of the business might have sold the business and when this sale might have occurred.
There are three different approaches to determining the value of the business. These approaches are the 1) income approach, 2) asset approach, and 3) market approach. The income approach includes projecting future cash flows and discounting them to a present value. The asset approach is based on determining the value of the plaintiff's tangible and intangible assets and then subtracting the value of the plaintiff's liabilities. The market approach is based on finding comparable businesses that were sold in an open and fair, market based, transaction (i.e., "Comp's"). The Comp's are then used to determine the value of the business through application of financial and other multiples to data obtained from the business being valued.
All of these business valuation approaches should result in the same conclusion; however, some of these approaches may require data that is not easily obtained in certain situations. For businesses, the income approach is the method most often used, while for non-income producing real estate, the market approach is preferred.
The damage expert can use one of several different approaches to determining lost profit damages. One approach is to determine the diminution in business value. This approach is preferred when lost business covers an undefined period of time or when plaintiff's business has been destroyed. When using this approach, consideration must be given to other factors affecting the value of the business and to whether or not facts that become known after the valuation date can be taken into account when preparing the valuation.
Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for complex litigation, contract compliance, and fraud. ResX is based in Michigan and serves clients throughout the United States. For more information and to learn about working with ResX, please visit our website: www.resxpc.com.
The preceding narrative presents concepts that are dependent on facts and circumstances. These concepts can change depending on the specific facts and circumstances of an individual matter.