Calculating Damages: Lost Profits vs. Business Valuation

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What is the correct measure of damages to use in your case – lost profits or business valuation? Could both be applicable? To answer these questions, let’s step back and review the purpose of the damages calculation. The damages calculation should put the injured party in a position economically equivalent to where they would be if the wrongful act had not occurred.

Of course, a critical step in evaluating economic damages is to recognize that each case has specific case law, precedent, facts and circumstances that must be considered before determining an appropriate approach.

When Business Valuation Makes Sense

Although each case is unique, there are circumstances when business valuation almost always prevails over lost profits. Business valuations are performed by financial experts to determine the value of an entire business or a specific ownership interest in the business. In doing so, the financial expert will use an asset, income and/or market approach.

Under the asset approach, a company’s tangible and intangible assets and liabilities are valued at fair market value. This approach is most commonly used for holding companies. Under the income approach, a company’s value is determined based on the expected future cash flow it will generate, discounted to reflect the inherent risk in achieving those cash flows. Under the market approach, a company is valued based on transactions of similar businesses in the marketplace. Both the income approach and the market approach are commonly used for operating companies.

In general, business valuation is used in matters involving shareholder oppression, dissenting shareholders, tax court, family law or business destruction. In a shareholder oppression or dissenting matter, the shareholder’s ownership interest in the business must be valued. Similarly, tax court and family law matters commonly involve valuing an interest in a business for gift and estate tax purposes or to get a complete picture of the marital estate. In a business destruction case that involves the loss of the entire business, the measure of damages is often the value of the business immediately prior to the wrongful act less any profits, compensation or salvage value received.

Of course, there are some cases in which a business’s value is permanently impaired (i.e., diminution of value) yet the business is not totally destroyed. These types of cases often include merger and acquisition disputes, defamation, slander and intentional business destruction, to name a few. In these instances, the appropriate measure of damages may be the difference in the business’s value had the wrongful act not occurred compared to its actual value.

When Calculating Lost Profits May Be More Appropriate

Alternatively, lost profits are commonly used in matters involving breach of contract, intellectual property and general commercial litigation. Generally speaking, lost profits can be an appropriate measure of damages when the injury is confined to a specific period of time. Lost profits are commonly calculated based on the difference between profits expected if the wrongful act had not occurred and profits actually received.

Methods of calculating lost profits include the before-and-after method, the yardstick method and the “but for” method. As one might suspect, the before-and-after method compares the profits of the company before the wrongful act with its profits after the wrongful act. Equally apparent, the yardstick method compares the company’s profits to a similar company or industry benchmark. The “but for” method, however, needs additional explanation. This method requires a financial expert to project what the company’s profits would have been had the wrongful act never occurred and then, compare the projections to the company’s actual historical or expected future profits.

When Both Approaches Can Be Used

Could you ever have both lost profits and lost business value? Yes, but only if the damages are not duplicative – a rare occurrence. One scenario in which it may be appropriate to calculate both lost profits and lost business value is when a business experiences a “slow death” because of the wrongful act. A slow death is when the business continues to operate for a period of time after the wrongful act, but eventually fails. In this instance, lost profits would be calculated for the period of time the business continued to operate and lost business value would be calculated as of the date the business ceased operations.

When you are trying to evaluate the potential damages related to your next case, call on your financial expert to assist with determining what measure of damages, be it lost profits, lost business value, or both, may be appropriate in your case. As stated previously, the above represents generalities and it is imperative to always look at the case law, precedent, facts and circumstances when determining what method of damages is most appropriate.   Jennifer Schiefert 

Jennifer Schiefert

Jennifer Schiefert is a manager in the forensic accounting and valuation services area at Schechter Dokken Kanter with over 10 years of experience in accounting, tax and consulting. She has worked with clients in the banking, mortgage, manufacturing and professional services industries. Ms. Schiefert assists in providing litigation support services to legal counsel and their clients. She has worked on economic damages calculations, forensic accounting and fraud investigation engagements. Ms. Schiefert has also assisted with business valuations for estate and gift tax, marital dissolutions and shareholder dispute purposes.

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