Lost profits or business valuation to measure business damages?
Economic experts are often asked to quantify economic damages in business litigation matters. Business valuation and lost profits are two ways to approach damage estimation. Neil J. Beaton, managing director with Alvarez & Marsal Valuation Services, and Michael A. Fahlman, partner at Grant Thornton in the Forensic and Valuation Services practice, examine the distinction between analyzing lost profits and conducting a business valuation in the context of measuring business damages.
Although the two approaches share economic and financial principles, the differences between them can lead to distinct outcomes. This highlights the importance of knowing the difference in order to choose which method will provide the most accurate and reliable results in a case.
Business valuation
Business valuation measures damages based on the difference between the value of the business but-for the action of the defendant, and the actual value of the business. It is the method that is applied in a case that involves business destruction, shareholder oppression, a dissenting shareholder, or family law and tax court issues. Claims of defamation, slander and intentional business destruction are ideal fits for business valuation.
Lost Profits
Lost profits are calculated based on the difference between the expected profits assuming the event in question had not occurred, and the actual profits. It can measure damages for a specific period of time, or when the injury is related to separate cash flow. This method is appropriate for cases involving breach of contract and intellectual property infringement.
Can both methods be used?
The authors answer the question by stating that both lost profits analysis and business valuation analysis can be performed, as long as it does not produce duplicative damages. They describe the measurement of damages in this dual-analysis as “the difference between the but-for expected profits and the actual profits received from the date of the harmful event to the date the business ceased operations, plus the loss of the but-for business value on the date operations ceased, less any salvage value.” They provide the useful diagram to the right to illustrate the concept.
Although the definitions of the two methods are generally accepted, not every aspect of damages analysis, case by case, is universally agreed upon. Experts disagree on the question if lost profits can exceed business value. Two variables that lead to differences in both business valuation and lost profits damage calculations are the time period and the discount rate.
Special considerations and differences between the methods
The authors present a thought provoking case example that demonstrates the ‘ex-ante versus ex-post debate’ (ex-ante = date of harm, ex-post = date of calculation/trial). What are the damages for a stolen $1 willing lottery ticket, stolen after purchase but before the winning number was drawn? Is it worth $1 or $100 million? Obviously any difference in opinion of this kind in litigation will produce different damages.
The discount rate used in a business valuation analysis is related to the overall risks of a company’s invested capital. The discount rate in a lost profits analysis may only relate to certain risks. This means different discount rates can be used in the two methods of damage calculations. The authors briefly mention two additional differences between the two methods, involving expenses and taxes.
To read more on the subject, Kenneth M. Kolaski and Mark Kuga, Ph.D. wrote ‘Measuring Commercial Damages via Lost Profits of Loss of Business Value: Are these measures redundant or distinguishable’. The article was published in the Journal of Law and Commerce and provides an in-depth exploration of the evaluation of damages in commercial litigation.
To learn more from the point of view of the economic expert, visit Dr. Dwight Steward’s ‘business profit losses’ page or Anderson Economic Group’s ‘strategy and business valuation’ page.
Finally, you can check out ‘Measuring business interruption losses and other commercial damages‘ by Dr. Patrick A. Gaughan, Economatrix.
