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December 2020 - Measuring Damages - Lost Profits vs. Lost Business Value

Since we at Abo Cipolla Financial Forensics, LLC are often brought in by attorneys, Courts or other third parties to evaluate and quantify damages, we thought some of the key takeaways from seminars we’ve periodically provided to attorney groups would interest clients and friends of the firm.

Business damages are calculated by two common damage measurement concepts - lost profits and lost business value. Damages under the latter approach are based upon the decrease in value caused by the defendant’s misconduct. This approach to calculating damages is measured by the decrease in value as measured by the value before and after the defendant’s misconduct. A business valuation or an appraisal of the underlying asset may be necessary to calculate this measure of damages.

Clear as mud, eh?  Well, we only wanted to give you a “taste” of what we do besides QuickBooks, accounting, tax returns and business planning.  If we’ve piqued your interest feel free to pass it along to your attorney friends as we do.

Sooooo, consider:

•           Some states may limit this measure of damages to only tort action. For us non-lawyer peeps, we are advised that a contract claim arises when the dispute relates to a contract entered by two or more parties.  These parties to a contract and third parties identified in the contract are the only parties who can raise contract claims.  As you probably guessed, in a contract claim, the purpose of the damages award is to place the injured party in substantially the same position as the party would have been in had the contract been performed and not breached.  A tort claim we are told is a civil wrongful act that arises when a dispute is not related to a contract.  While a contract claim relates to a breach of contract, a tort claim typically relates to a breach of fiduciary duty. Like the contract claim, the purpose of the damages award is to place the injured party in substantially the same position as that which was occupied before the tortious activity.

•           In either of these two approaches we want to put the plaintiff, the injured party, in an economically equivalent position.  In both a tort matter and a contract matter, we, as damage experts, must get direction from the lawyer and consider liability, proximate causation, and reasonable certainty.  If solely in the contract arena, we also need to consider foreseeability (i.e. explicit or implicit expectation of damages). Thus, here be the three general standards for recovering lost profits: proximate cause, foreseeability, reasonable certainty. Each is considered separately, yet they are intertwined. Proximate cause examines if the defendant’s actions caused the plaintiff’s loss. Foreseeability assesses whether the defendant, while negotiating a contract with the plaintiff, would have foreseen or contemplated such actions would have caused economic damage to the plaintiff. Finally, reasonable certainty demonstrates there is reasonable certainty the estimated lost profits would have been generated had the “wrongful” actions not occurred. All separate, but all tied to reviewing how the alleged action of one party affected the profits of another

•           One 10th Circuit case we read stated it well: “Numerous jurisdictions hold to the view that when the loss of business is alleged to be caused by the wrongful acts of another, damages are measured by one of two alternative methods:  (1) the going concern value; or (2) lost future profits. The courts allow a plaintiff to recover either the present value of lost future earnings or the present market value of the lost business, but not both.   The “going concern value” is the price a willing buyer would pay and a willing seller would accept in a free marketplace for this business.  It measures damages by awarding the difference between.  The award of lost profit damages besides this amount, however, was an improper double recovery.”

•           It is our opinion from cases we have read about in certain states which ruled that both lost profits damages and lost business value damages can both be awarded to a plaintiff are wrongly decided. Such decisions appear to ignore that a business valuation, however performed, is a measure of the anticipated profits or cash flows of the business. Fortunately, cases harboring this misimpression appear to represent the minority position but the word of caution is to check the “lay of the land” in the particular state the matter is being determined.

•           Courts thus will often see the real purpose of compensatory damages for lost business value to place an injured party in the same position as it would have been had there been no injury.  Thus, the decrease in value will be measured by the value before and after the defendant’s misconduct. This should be the same as compensatory damages for lost profits or the amount required to make the injured party whole and put it in the same position it would have been but for the defendant’s action.

•           A professional colleague of Marty Abo hailing from Jacksonville, Josh Shilts, CPA/ABV/CFF, said it well for us that “…In my opinion, the duration of the impact on the business is just as important as the cause. Lost profits are for a finite period whereas lost business value occurs when the impact is indefinite or permanent.”

•           When determining lost value as well as computing lost profits, the use of estimates and projections are required, thus throwing more variables into the mix.  Corroborating the underlying assumptions of any such projections is a critical component and we need to effectively focus in on the accuracy of such calculations and their underlying assumptions. 

•           “Lost profits” damages are generally considered taxable income to the Plaintiff (As an aside, there may be exceptions when damage measurement by use of “lost profits” is used in a personal injury or wrongful death action.  See Marty Abo’s separate handout on this).  As a result, Courts will typically not reduce the gross award from the Defendant. Doing such would certainly not leave the Plaintiff whole ”but for” the alleged wrong resulting in incurring an effective double tax.  In addition, public policy is considered better served by the defendants having to pay the full amount of the damages they caused. The Plaintiff company would receive the award pre-tax, then pay applicable taxes and would presumably be left in the same after-tax position it would have been “but for” the alleged wrong.  Such is why we experts would, usually compute the benefits stream for a “lost profits” calculation before income taxes.

•           Conversely, in valuing a company in a lost business computation, an appraiser will often apply income taxes to the benefit stream being used in the income approach.  A shareholder will also typically receive cash flow after-tax and, thus, any lost value from the appraisal is based on after-tax earnings.

•           In lost profits damage calculations we generally use a specific time period computing what the enterprise would have earned during the limited period of loss rather than the actual loss suffered. Losses into the future are discounted to present value at an applicable discount rate, risk adjusted or court determined, generally to trial. If the business is destroyed than, in a business appraisal, the “but for” income is computed into perpetuity rather than a specific time period as under the lost profits methodology.  An appraiser may reconcile how this lost income translates to the lost value of the business. Desirous of assessing “economic certainty” , Courts are obviously hesitant to grant lost profits damages for long periods where such projections become more and more imprecise too far into the future.