Business appraisers often find themselves in a litigation setting. After all, much of the work we do has two distinct "sides," whether it is related to a divorce, a shareholder dispute, or a matter before the Internal Revenue Service.
A natural extension of the work is in another litigation setting, commercial damages. The business appraiser is well trained and positioned to do this work since much of the work and analysis done in a business valuation is very similar to that done in a lost profits damages calculation.
Herewith, then, is a primer on lost profits damages calculations.
Commercial damages claims typically are the result of an action, or inaction in the case of a negligence claim (the "damaging act"), that harmed the damaged party financially. Such claims typically arise in one of three settings:
Lost Profits Calculations
Lost profits damages calculations typically require the CPA expert to place the defendant in a "but-for" world. That is, what would the plaintiff have been able to achieve "but for" the alleged damaging act? This analysis necessarily involves an assessment of what might have happened under given conditions. The amount of lost profits is then the present value of the difference between the "but-for" profit or cash flow, and the actual profit or cash flow during the damages period.
As appraisers, in using the discounted cash flow method, we are called on to attempt to predict what the company being appraised will realize for cash flow for some period into the future. If we're lucky, we have management-prepared forecasts to use. In many cases, however, we are not so fortunate and have to create them ourselves with the aid of management. Such an analysis necessarily involves an in-depth knowledge of the company, their products, markets, and competition. It also involves understanding the industry in which the company operates, and the factors that drive that industry that have an impact on the company's performance during the forecast period. And finally, it involves understanding the economic forces that affect the financial outlook for the company.
A Natural for the Business Appraiser
Sounding familiar? It should; these are all factors we consider in every business valuation we do. There is one significant difference, though. In doing a business valuation, we can consider only that which was known or could have been known as of the date of the appraisal. In a financial damages calculation, however, we have the benefit of hindsight. For example, you would have the benefit of knowing what the industry actually did during the damages period, rather than have to rely on forecasts. You would know important facts such as how the competition fared, whether the economy took a nosedive, and any other factors that could have affected the company's financial results. All this information can be built into the financial model to arrive at a surmised level of cash flow or income.
How Lost Profits Damages Are Measured
"Lost profits" can be measured as either lost cash flow, or lost income. Either approach may be appropriate, depending on the facts and circumstances of the particular case. The decision of which approach to use is typically a function of the length of the damages period, and the nature of the cash/non-cash expenses that would have been incurred throughout the period. In either case, the calculation should use income or cash flow that is pre-tax. This is because the financial damages received will be taxable to the plaintiff and to deduct taxes from the damages calculation will result in an understatement of the damages.
Typically lost profits are calculated in three different ways:
- Before-and-after method.
- Yardstick method.
- Market-model method.
Using the before-and-after method, the damages expert makes assumptions about what would have happened during the damages period, based on what the business achieved both before and after the damaging act occurred.
Figure 1 is a simplified example, but close to what you might actually find in practice, when using this approach makes sense. In this example, the "damaging act" occurred in year 4
Figure 1: Company ABC Cash Flow, Years 1–8
The chart shows a clear pattern of cash flow both before and after the damages period. Something reduced the cash flow dramatically in years 4, 5, and 6. From a simplistic point of view, it appears the company "recovered" by year 7 or 8, as that is the point at which it returned to its previous trend of cash flow. You need, however, to consider other factors that might have influenced the company, such as what was occurring in the industry and the economy during that period.
The yardstick method attempts to measure the financial results that the company would have realized had it followed the trends indicated by comparable data for the damages period. The data may be from industry sources, comparable companies, market data, and any source that could reasonably be expected to predict the company's financial results during the damages period.
Assume, for example, you determine that, before the damages period, the company's revenue growth closely followed industry experience. You choose to rely on those industry trends during the damages period to determine what the plaintiff’s revenue would have been. Your comparison of the plaintiff’s experience and industry trends is illustrated by Figure 2 :
Figure 2: Company XYZ Growth Compared to Industry
Again, an oversimplification, but your inference might be that the company should have been able to increase revenues at the same rate as the rest of the industry, and if so, that provides a starting point for assessing where profitability or cash flow should have been.
Using the market-model method, the damages expert literally starts from the ground up, building a spreadsheet with assumptions about sources of revenues and expenses. Assumptions are built into the analysis using data developed from the company, the industry, and the economy. These assumptions are used to build a cash flow or income projection of what the company would have done, were it not for the damaging act of the defendant.
Determining the Damages Period
Typically, financial damages have a beginning and an end. The end is when the company returns to the profitability or level of cash flow that it would have been at had the damaging act not occurred. As you can imagine, determining the period end is seldom straightforward. Here, too, you need to assess factors such as the industry, competition, the economy, and so forth, as well as the company's prior track record, to determine when the damages "end." It may be unrealistic to carry the losses out into perpetuity, unless a business or portion of a business is unrecoverable.
Choosing a Method
Very often, the damages expert uses a combination of the three methods. In fact, although theoretically they are three discrete models, in practice, the methods typically overlap. To build a before-and-after model, for example, you will undoubtedly need to use some yardstick to measure what would have happened. Sometimes, out-of-pocket costs are included as well.
Which method to use in which circumstances depends on the facts of the particular case. As with business valuation, the appropriate method to use is the method for which you can obtain the best data and which applies the most reasonable logic to the case at hand. Often, clients have their own ideas about the amount of losses and how it should be calculated. To the extent that you are able, you're better off requesting that you not be shown or even told of such client calculations. As with business valuation, you need to make independent assessments of damages, irrespective of what clients believe them to be—and you will be much better off during cross examination if you can say you were not influenced by the client in arriving at your damages opinion.
Once you determine a method of assessing damages, the final issue is to discount the stream of lost profits back to the present, which often means to the date of claim or the date of judgment. Three factors typically comprise the rate for discounting profits: a "safe rate," an inflation rate (if inflation is built into the cash flow projections), and risk (unless such risk has been adequately built into your cash flow model). Some states have established rates, so you need to check precedent in your state.
The final issue to consider is mitigation. In most states, the plaintiff bears some responsibility for mitigating damages: What steps could they have taken to offset the damages? The company might have actually taken these steps, or it is conceivable that no steps were taken at all. Part of our job is to determine, with the input of all parties involved, what steps could or should have been taken, and the financial impact of such mitigation.
Lost profits damages calculations are a natural extension of the work that business appraisers already do. As this work is, by definition, litigation support, the issue of appropriate qualifications is critical. As such, qualifications—and your ability to stand up as an expert witness under cross examination—are the keys to succeeding in this area.