Lost Profits versus Lost Business Value
Differences Between the Two Values
Damages remedies often focus on lost profits and lost business value, with such remedies typically calculated by financial experts. There continues to be a trend in the courts to preclude experts from testifying, or to disregard them altogether because their opinion does not meet the reasonable certainty standard. Either of these outcomes can be a devastating result for the client. These results occur, in part, from a lack in understanding of the proper calculation of lost profits or lost value. A relevant and reliable opinion, able to withstand the court’s scrutiny in litigation, needs to consider the differences between lost profits and lost value, as well as the appropriate use of these remedies together.
Damages remedies often focus on lost profits and lost business value, with such remedies typically calculated by financial experts. ¬†There continues to be a trend in the courts to preclude experts from testifying, or to disregard them altogether because their opinion does not meet the reasonable certainty standard.¬† Either of these outcomes can be a devastating result for the client.¬† These results occur, in part, from a lack in understanding of the proper calculation of lost profits or lost value.¬† A relevant and reliable opinion, able to withstand the court’s scrutiny in litigation, needs to consider the differences between lost profits and lost value, as well as the appropriate use of these remedies together.
On-Demand Webinar:¬†Calculating Business Damages
On Demand Webinar:¬†Elements of Lost Profits And Introduction to Lost Profits
On-Demand Webinar:¬†Other Considerations in Lost Profits Calculations
Although lost profits and lost business value are commonly used damage measurements in litigation matters, there are notable differences between the remedies.¬† In the context of a damages claim, an experienced expert can provide invaluable insight into the nuances identifying the appropriate damages remedy required to restore a plaintiff to the position they would have been in, had the damaging actions not occurred.
A fundamental difference between lost profits and lost value is the expected duration of the loss.¬† Lost profits are a measure of damages typically utilized when a business or segment of a business continues to operate, but suffers reduced income.¬† The damage period is finite; measurement is calculated for a period until the business regains the position it would have been in “but for” the alleged damaging act.¬† Conversely, lost business value occurs when a business never commences operations, ceases all of its operations, or permanently loses a segment of its business.¬† The damage period is into perpetuity, since the business’s earning capacity is permanently lost.
This underlying difference between lost profits and lost business value may appear simple in theory but, as is often the case, facts and circumstances are far more ambiguous.¬† In fact, it is rare for damages to be observed as a distinct, easily quantifiable impact stemming from a single event, or simply as the loss of an entire business.¬† In many cases, the extent to which a business will improve is not clear at the time the damages are calculated, and the expert will need to make a determination based on the best available evidence of the most likely outcome.
After considering the duration of damages and applicable remedies, several other aspects differ between lost profits and lost value calculations:
Deduction of expenses – Lost profits use variable or incremental expenses to determine those additional expenses the defendant incurred while generating the revenues in question.¬† Lost value relies on net income, after the deduction of all expenses.
Income taxes – Lost profits are generally calculated before the deduction of income taxes, while the valuation of a lost business considers after-tax income streams.¬† This distinction is the result of a lost profits award being taxable upon recovery, whereas lost business value is a measurement of a return to an investor using net after-tax cash flows.
Discount rates – A discount rate captures the risks of a cash flow, and therefore may vary between lost profits and lost business value calculations, even for the same company.¬† Additional case law can also define the applicable discount rate.¬† Ultimately, a discount rate must make sense in the context of the evidence.
The expert also needs to consider the definition of value when calculating lost business value.¬† In the legal context, the definition of value can, and often does, depend on applicable case law.¬† Terms such as fair market value, fair value, and market value are not consistently defined, either among varying purposes or across jurisdictions.¬† Different standards of value can cause materially different value conclusions.¬† Regardless of the expert’s testifying skills, a valuation opinion can be rendered meaningless if the definition of value does not match the context of the claim.
Misunderstanding the differences between lost profits and lost business value may lead to damage calculations erroneously double counting income in both lost profits and lost business value calculations.¬† Although specific language varies by jurisdiction, the courts agree that double counting lost profits and lost value in damages is not allowed.¬† This does not prevent a remedy from including both lost profits and lost business value, with each covering different time periods.¬† For example, consider the case where a restaurant experienced a damaging event, after which, it tried for three years to recover, but eventually was forced to shut down.¬† In this circumstance, generally, the restaurant may claim lost profits for the three years they tried to recover, and then claim lost value upon closing.
Consideration of mitigation adds to the complex relationship between lost profits and lost value remedies.¬† For example, after being informed that a disruptive construction project will extend years instead of months, a plaintiff can undertake mitigation by reducing staffing to cut expenses and remain profitable.¬† Eventually, the plaintiff’s business could become unprofitable and cease operations, at which point the lengthy period of lost profits could easily exceed the lost value being claimed.¬† The plaintiff generally has a duty to mitigate to limit their loss, and the defendant generally bears the burden of proving mitigation.
Further complicating the understanding of damages are other remedies that are often confused with lost profits.¬† The other remedies represent entirely different damages calculations.¬† For instance, one measure of unjust enrichment generally seeks to disgorge the alleged ill-gotten gains of the defendant.¬† In some instances, the amount of disgorgement is calculated as the defendant’s ill-gotten profits.¬† Unlike a lost profits claim, the unjust enrichment damages is not measured based on the plaintiff’s, but rather, the defendant’s results.¬† Experts applying unjust enrichment as a remedy commonly confuse the defendant’s disgorged profits with the plaintiff’s lost profits, resulting in an irrelevant damage measurement.
Absent a thorough understanding of the relationship between lost profits and lost business value, a damages expert, and his or her opinion, can be excluded.¬† According to the most recent PricewaterhouseCoopers annual study on Daubert challenges to financial experts, from 2000 to 2014, 44% of financial expert witnesses who were challenged were excluded in whole or in part.¬† Lack of reliability was the primary reason for the exclusion of financial experts.¬† This indicates the intense scrutiny of experts’ relevance and reliability under the relevant admissibility provisions of the jurisdiction.
The many differences between lost profits and lost business value are as complex as they are varied.¬† The examples discussed here demonstrate some of the underlying issues a damages case may pose.
Laura Pfeiffenberger, MBA, MSA is a Director in the Portland, Maine office of Meyers, Harrison & Pia Valuation and Litigation Support, LLC. She has significant experience in matters involving economic damages, including the determination of damages related to contracts, torts, infringement of intellectual property, personal injury/wrongful termination, post-acquisition disputes, and shareholder disputes. She has also performed valuations of business interests for a variety of purposes, including estate and gift tax matters, transactions, and litigation.
Ms. Pfeiffenberger can be reached at (207) 775-5111 or by e-mail to firstname.lastname@example.org.