Business disputes require measuring the financial harm caused by a particular action or event, typically in the form of lost profits, not just determining who is at fault. Unfortunately, measuring lost profits is not straightforward. Business performance can be influenced by many things including operational challenges and broader economic factors unrelated to the alleged wrongdoing. This is where valuation experts can help calculate lost profits. They can translate complex case facts into defensible conclusions based on financial data, industry conditions, and company specific factors.
Common Methods
Quantifying lost profits and other types of economic damages begins with a simple question: Where would the business be today “but for” the defendant’s alleged wrongdoing? Valuators frequently rely on the following three established methods to answer that question:
1. The before-and-after method. Here, the expert assumes that, had it not been for the breach or other tortious act, the business’ historical operating trends would have continued at the same pace as in the past. In other words, lost profits equal the difference between expected and actual performance. A similar approach quantifies damages as the difference between the business’ value before and after the alleged tort occurred.
2. The yardstick method. Using this technique, the expert benchmarks a damaged business’ performance against external sources, such as publicly traded comparables or industry guidelines. The presumption is that the business’ performance would have mimicked that of its competitors if not for the tortious act.
3. The sales projection method. Projections of expected cash flow serve as the basis for damages under this method. Damages involving niche players and start-ups often call for the sales projection method, because they have limited operating history and few meaningful comparables.
Valuators consider the specific circumstances of the case to determine the appropriate method (or methods) for the situation.
The Time Value Of Money
Because lost profits often extend into future periods, valuators must convert loss estimates to present value. Some jurisdictions have prescribed discount rates, but in many instances, experts subjectively estimate the discount rate based on their professional opinions about risk.
Small differences in the discount rate can generate large differences in valuators’ conclusions. As a result, the discount rate is often a contentious issue.
Mitigating Factors
Another key step is to address mitigating factors. In other words, what could the damaged party have done to reduce its loss? For example, a retailer that suffers a business interruption should lessen the impact by resuming operations at a temporary location, if possible. Likewise, a wrongfully terminated employee needs to make a reasonable effort to find another job.
Most jurisdictions require plaintiffs to take reasonable actions to mitigate their damages. Similar to discount rates, this subjective adjustment often triggers widely divergent opinions among the parties involved.
Tax Issues
Experts also consider whether awarded damages will be taxable. Taxes can materially affect the plaintiff’s actual economic loss. Some parts of an award, such as return of capital, may be nontaxable and require an after-tax estimate.
Taxes also need to be handled properly when lost profits are discounted to present value. In other words, if damages need to be calculated on a pretax basis, the expert should use pretax discount rates. Applying an after-tax discount rate to pretax cash flows can overstate damages.
We Can Help
In cases involving breach of contract, business interruption, shareholder disputes, or fraud, business valuation professionals can help quantify financial losses. But there’s no universal approach, and your valuator must carefully evaluate various factors to arrive at a reliable conclusion. Contact us to discuss what’s right for your situation.
