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Looking Back to Go Forward

A Review of the Basics for Lost Profits (Part VI)

The first five installments of this series have been a review of the basics for calculating lost profits. In the series, lost profits was defined, the common methods used for calculating lost profits (yardstick, before and after, sales projections, market) were discussed, the court standards for assessing lost profits (foreseeability, proximate cause, reasonable certainty) were reviewed, the way of discounting future lost profits to present value was presented, modeling lost profits calculations and how these factors impact the discount rate were discussed. In addition, this series has addressed the differences between assessing and calculating lost profits and the loss of business value in a litigious situation. For this final installment, the author shares how to tie these different parts together when assessing lost profits.  

Looking Back to Go Forward: A Review of the Basics of Lost Profits (Part VI)

When this series started, I noted that I felt it is important to occasionally return to the roots of the work we do. To ask, why do we do it that way? The first five installments have been a review of the basics for calculating lost profits. In it, we have defined lost profits, discussed the common methods used for calculating lost profits (yardstick, before and after, sales projections, market), reviewed the court standards for assessing lost profits (foreseeability, proximate cause, reasonable certainty), discounting future lost profits to present value, modeling lost profits calculations, and how these factors impact the discount rate. In addition, this series has addressed the differences between assessing and calculating lost profits and the loss of business value in a litigious situation. For this final installment, I want to share how my practice ties these different parts together when assessing lost profits.

The views expressed in this final installment are based on my experience, education, and training. This article discusses how I move forward when receiving a commercial damages assignment from the plaintiff attorney in a commercial damages litigation. Each expert will have his or her own way of approaching assignments. These may vary slightly or greatly from my practice. No method is wrong so long as the expert applies commonly used methods and his or her analysis meets the standards expected by the courts.

Initial Contact

Regardless of how contacted (an e-mail or a phone call), my first response is to seek a conflict check. This ensures that I do not have any conflicts based on opposing counsel or a relationship with any of the involved parties. Having cleared that hurdle, I ask to speak with the attorney hiring me. We can speak by telephone, Zoom call, or in person.

During this initial meeting, I seek to define the assignment. Through a series of questions and working with the attorney, we can determine the type or types of economic damage calculations that need to be made. First and foremost, we can decide if this assignment is for lost profits or loss of business value.

The questions to help determine this issue run along this line of thought:

  1. Is the injured business continuing to operate or is it closed?
  2. Did the alleged wrongful act impact all of the products or services sold by the injured business or only a portion?
  3. Has the injured business been able to mitigate the loss caused by the alleged wrongful act and if not, when will it be able to mitigate this loss?

This list is not all-inclusive but gives an example of the types of questions used to determine if this is a lost profits case or a loss of business value.

After determining what I am being asked to assess, I ask for initial documents to review. This list includes, but is not limited to, the following:

  1. Initial pleading (complaint, petition) for this case,
  2. Last five years’ income statements and/or business income tax returns (Forms Schedule C, 1065, 1120S, 1120),
  3. Brief history of the business,
  4. The name of the industry to which the business is identified,
  5. The market the business served or serves,
  6. Competitors,
  7. Depositions relating to the claimed economic damages in this litigation.

As the initial meeting ends, I ask for the attorney to set up a time with his or her client (business owners and/or management) for us to talk. This meeting could be in-person, a Zoom call, or by telephone.

Under most circumstances, I then prepare an engagement letter. This letter is based on my initial discussions with my client and includes an explanation of my assignment and the activities I anticipate performing to complete it.

Review of Initial Data

The next step is to review the requested data or at least, review the data that is available and forwarded. The first document I review is the current complaint. This document gives me an understanding of how the attorney(s) is trying to explain the wrongful act. The language being used in the complaint may be an important reality to the narrative of my report.

Next, I turn to the financial data. I create spreadsheets containing the income statement data. While loading this information, I look for unusual expenses or revenue changes. I also look for unusual transactions and/or additional other income or expenses.

In one of my cases, the injured business had two separate transactions in one year that impacted the overall analysis. The business purchased an airplane for several million dollars. It also sold the airplane it had been using prior to the purchase of the new plane. These transactions impacted not only capital expenditures but also impacted depreciation and the recapture of depreciation. As these were not annual or even bi-annual transactions, I adjusted that year’s income statement moving the purchase and sale to the other income and expense line. Therefore, the operating income was not impacted by the adjustments, except for the amount of depreciation taken for the new airplane.

After getting an understanding of the recent financial history of the business, I review the other data and/or depositions relating to the damages claims. This allows me to prepare a list of detailed questions for the business owners or management.

I like reviewing this information before meeting with the attorney’s clients because it allows me to address the specifics relative to the data and/or trends found in the data. It also limits the number of times I need to ask questions of management or owners and the delay in getting to talk with them or getting return e-mails with answers.

Meeting with the Injured Business Owners and/or Management

This meeting is very important. Not only is the expert able to begin a discussion about issues found in the financial data, but also speak directly to those who will be testifying at trial prior to the expert taking the stand. This meeting allows everyone to make sure they are “on the same page” with the analysis and claim(s) for losses.

The expert should take the lead in asking questions. I like to explain why the questions are important and how they will help me in making my lost profits calculation. Some of the questions may address the proximate cause issue. If so, I explain how I must consider other causality and how the owners/management’s insight will help me understand the business environment at the time of the injury. The hiring attorney will normally help in addressing this issue.

The attorney’s clients may have their own thoughts on losses. Be prepared to listen and discuss how your analysis will address their thoughts on the damages, not address their thoughts, or be modified to include them. The expert will need to consider what additional information may be needed and ask for that data during the meeting. The attorney should also participate in this discussion. This is to ensure the claim fits within the framework of the current complaint and the law. Also, the attorney will need to discuss what modifications may be needed to be made to the complaint filed with the court.

It is not unusual during this meeting to find additional data are needed and available. All of the parties involved should have a list of the needed items before leaving.

For me, these meetings normally take one to two hours. However, I have had some run all afternoon (i.e., four hours). Getting a feel for the business, how it operated before the wrongful act, how it is operating now, and how the management is working to mitigate the loss or just keep the business open provides great insight into the loss and helps the expert with the narrative of the loss calculation.

Completing Calculations and Report

Having received the financial data, general information of the injured business, researched information about the industry and the market served, and spoken with the owners/management of the injured business, the expert should be ready to calculate lost profits. Most experts will rely on the yardstick, before and after, or the sales projection methods. Most often, I use the sales projection method.

Proximate cause must be considered. If other causation is found, the projected lost revenue and expenses must be adjusted to reflect this. This other causation may be due to increased competition, a downturn in the economy, or other factors.

This is also a good time for modeling the projected revenue and expense numbers. The expert must be comfortable with the calculations. If the expert feels the figures are too optimistic, the figures should be adjusted downward. If modeling is used, a risk adjusted discount rate may be applied. If the figures are not adjusted, a greater discount rate may be used. The discount rate will be based on the facts of the case and whether the expert used modeling.

I believe the narrative of the report should include a description of the lawsuit, a brief history of the injured business, a brief discussion of the market served by the injured business, its current economic condition (growing, steady, declining), a brief discussion of conditions for the local, regional, or national economy (whichever is appropriate for this particular set of facts), the definition of lost profits, and then the lost profits analysis.

This narrative should include citations from data resources and financial literature. The citations provide support for the expert should there be a Daubert challenge. The hiring attorney may argue the expert is following commonly used standards as can be seen by the citations from these various supporting resource materials.

I attach a limited number of spreadsheets; usually two to four. Although the report is a mathematical analysis, it is usually being read by those who are not math or business majors. The narrative is important to explain the analysis itself. The spreadsheets are the results of the work discussed in the narrative. My spreadsheets provide key data but do not overwhelm the reader with numbers.

With the report completed and reviewed for errors grammatical and otherwise, it may be forwarded to the hiring attorney. Then the expert waits for deposition, potential updates, and/or trial.

Depositions

The expert’s report should provide a roadmap to follow during a deposition. Reviewing the report while preparing for the deposition will remind the expert of the reasoning for choosing the method used. It will also be reminded of how the expert addressed proximate cause and reasonable certainty and how his or her calculations are tied to the facts of this specific case.

Reviewing the opposing expert’s critique and affirmative response (loss calculations) will prepare the expert for the questions to be asked.

Should the opposing expert find an error (mathematical, grammatical, or reasoning), the expert must be willing to admit the error and address how it impacts (if any) the results of his or her analysis. The hiring attorney should be made aware of this prior to the deposition. In this way, both the expert and the hiring attorney are prepared to address the issue when it arises during the deposition.

Updates or Supplemental to Reports

In some cases, factors may change over time which will create a need to update or supplement the expert’s report. The attorney and expert should agree that a new report is needed before the expert begins work. These updates may be due to a change in the injured business. It may have closed due to the injury or moved into a new market which limits its loss. The local, regional, or national economy may have changed. Any of these factors may give rise to a need to change earlier calculations.

In one case in which I was retained, I had to update the report five times. I was involved in the case for more than seven years. The injured business was a part of the oil and gas industry. The alleged lost profits were tied to the business’s service activity. The service activity was tied specifically to the price of a barrel of oil.

During those seven years, oil prices fell from a near record high, to a deep trough low, and then increased to a price just short of the previous high. This second high price was well above the lowest price for a barrel of oil. While my methodology and formulas remained the same, the change in oil prices and changed productivity changed the loss figures each time.

I was deposed in this matter after my last update. The case settled after my deposition and just prior to trial.

Trial

The trial is where all of the expert’s hard work is presented to the trier-of-fact. The expert’s report is seldom allowed to be introduced as an exhibit given to the jury. This is because it is considered hear-say. However, an expert’s report continues to provide a great outline for the expert’s testimony reminding him or her why they did what they did.

The expert may use the report to explain to the trier-of-fact the nature of the injured business, the market served, the financial data reviewed, and the meetings with the owners/management. The expert can explain to the trier-of-fact how all of this helped him or her better understand the business and its injury. I believe relaying this information gives the expert greater credibility. It makes the trier-of-fact more ready to listen to the results of the lost profits calculations.

Conclusion

The work performed by an expert will not win a case at trial. That is up to the attorney and the presentation of the case itself. But an expert may benefit his or her client by showing the trier-of-fact that they not only understand the ways of calculating lost profits but also took the time to understand the facts and issues of a particular litigation.

The financial expert is an important part of any team hired by an attorney(s) in litigation. Aside from knowing the theory and reasoning for calculating lost profits, I believe it is important for an expert to have a good understanding of the claims being made in any assignment. Reading the depositions of parties with knowledge regarding the financial injury and meeting with the owners/management of the injured business will provide greater insight into the injured business and its claims. It also provides credibility to the expert.

Performing the upfront work in preparing a lost profits analysis will make the overall process easier for the expert and continue to make that expert a value added to the attorney in each assignment.


Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over 20 years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the areas of financial and forensic economics, and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings. In 2021, Dr. Needham received a NACVA Outstanding Member Award. He is also a member of NACVA’s QuickRead Editorial Board.

Dr. Needham can be contacted at (817) 348-0213 or by e-mail to aneedham@shippneedham.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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