Economic Damages

in Not-for-Profit Entities

There is an established body of knowledge that addresses economic damages in connection with for-profit organizations, but little about how these concepts apply to not-for-profit organizations. In this article, the author sets forth how those concepts apply to charitable organizations.

“You will be much more in control, if you realize how much you are not in control.”―Benjamin Graham, The Intelligent Investor

Valuation experts deal with a variety of engagements when it comes to economic damages, which may include loss of profits, earnings (past or future), damage to property, or loss of business value. Most of literature and resources are dedicated to discussing the process and methodology of estimating lost benefits in litigation context that result from an alleged harmful act as it relates to for-profit companies. However, from time to time valuation specialists may come across the scenarios where they are requested to calculate economic damages for a not-for-profit entity.

According to the IRS guideline, non-profit entities are organized for charitable purposes. The IRS defines “charitable purpose” as the following:

“The exempt purposes set forth in Internal Revenue Code section 501(c)(3) are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and the prevention of cruelty to children or animals. The term charitable is used in its generally accepted legal sense and includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.”^[1]

Additionally, charitable and non-profit entities must not be organized or operated for the benefit of private interests.

In the scenario where economic damages are quantified for a typical for-profit entity, lost profits are calculated. However, for a not-for-profit entity, opponents may argue that not-for-profit organizations cannot suffer economic losses because their charitable purpose precludes these organizations from making a profit. It is a common misconception. As any organization, charitable and non-profit entities are dependent on funds and continuous economic benefits to sustain and support their operations.

One of the main nuances when it comes to non-profit entities is that these organizations are precluded against private benefit. Although a charitable entity’s primary goal is to provide public benefit and not maximize its profit, non-profit entities ought to generate profits or economic cash flows to cover their expenses and to provide reasonable compensation to those individuals, owners, and staff members providing the services. Accordingly, it is not only beneficial but also crucial for a charitable organization to generate profit to further its mission and social causes for the benefit of the public. However, to avoid any misconception (where “profit” is a goal for a for-profit entity) in context of non-profit entities, we will refer to “net profits” (i.e., earnings after accounting for expenses) as “contributions” or “net contributions.”

As such, for damages calculations associated with a harmful act in a litigation context for a non-profit organization, a valuation specialist would calculate net lost contributions, which generally include net charitable donations, charitable giving, and other fundraising funds. Similarly, to lost profits engagements, lost contributions are calculated as the amount required to place the harmed party in a position that it would have been before the alleged incident. This would be a position the organization would have been “but for” the alleged acts (e.g., damaging event).

Assuming a liability was determined, it is worthwhile to point out that only lost net contributions are permitted as economic damages, meaning that lost contributions, whether they are charitable donations or fundraising funds, must be reduced by avoided/avoidable costs. Note, a valuation specialist does not opine as to liability, only economic damages associated with the alleged damaging event.

For a non-profit entity, such as a church, for example, funds needed for operation depend primarily on voluntary contributions from its members, congregation, and various fundraising activities. If an alleged negligent act were to take place, a non-profit organization can suffer harm and damages, which may include an interruption of the ministry services, a decrease in membership or congregation attendees, lost donations, or shut down of the entity altogether.

Lost contributions (i.e., donations) are measured as the difference between contributions that would have been realized “but for” the harmful act of the defendants (i.e., negligence) and the contributions realized during a defined period (i.e., damage period). As Burton Malkiel stated in his book, A Random Walk Down Wall Street: “Forecasts are difficult to make—particularly those about the future.” A valuation professional should use caution and avoid speculative nature of forecasting when estimating unrealized future economic benefits.   

It should be noted that lost contributions do not extend into perpetuity. Instead, they are generally estimated for a finite damage period. Furthermore, when it comes to estimating the duration of the period involved, a valuation professional needs to consider various factors, in combination, to create a meaningful estimation of the damage period. To determine the appropriate damage period, typically, the analysis begins on the date of the wrongful act. The end date is when the injured party is returned to the stable position it would have originally been at had the damaging action(s) and event not occurred. For example, an appropriate amount of time can be anywhere from a few weeks or months to several years, depending on the extent of the damage sustained and required remediation efforts.

When it comes to selecting a reasonable methodology to calculate lost contributions, one of the most common approaches is the before-and-after method. The before-and-after method allows a valuation specialist to estimate economic contributions for the damages period by comparing the subject entities’ financial performance before the wrongful act took place and once the effects of the harmful event are no longer affecting the subject entity’s operations. Based on the valuation specialist’s analysis, if a proven and reliable track record of donations, fundraising, and other charitable giving funds exist, it can be used to establish a post-damage estimate of contributions lost, and a valuation specialist can rely on the before-and-after method as a meaningful indication to calculate the organization’s lost contributions.

Accordingly, the first step in the determination of lost contributions is the calculation of lost donations or contributions. To estimate expected contributions, financial analysis of the subject organization should include an analytical and quantitative review of the organization’s operating results, as presented in its tax returns, financial statements, or other financial records, to understand the growth pattern and stability of donations of the subject organization. A valuation professional may rely on the historical information to determine the “giving” and fundraising patterns and project the appropriate level of expected charitable funds inflows on a forward-looking basis.

After the gross lost contributions are determined, any actual donations or cash inflows received are deducted to compute the net economic damages. A word of caution is that while it is not possible to precisely predict the actual financial results for any organization, a valuation analyst should be able to estimate a typical pattern based on the stability of donations experienced prior to and after the damages period and based on the comprehensive discussions with management. As part of the quantitative analysis, we recommend presenting the organization’s historical contributions (e.g., profit and loss) statements (per tax returns or other financial documents), along with the common size statements for the historical time period. This analysis should discuss financial performance and drivers for any growth or decline in the operating results. 

In addition to performing quantitative analysis, a valuation analyst should consider and account for outside factors impacting the subject organization, including an analysis of the industry in which the organization operates, economic factors, and trends to which it is subject. A thorough industry and economic analysis needs to be included as part of a due diligence process. This analysis should highlight which factors may positively or negatively affect the subject company’s contributions and cash flows and whether they relate to local market conditions, competition, economic environment, technology trends, human resources challenges, or others. Additionally, a valuation specialist should discuss industry forecasts and what growth rate would be appropriate for the subject analysis during the discrete forecast/damage period.

The second step is to determine the incremental avoided, or avoidable costs which should be deducted from donations, charitable giving, and other funds received to determine net lost contributions. Such costs (avoided or saved) are those costs the plaintiff would have incurred in connection with the generation of its expected contributions. Accordingly, a key aspect of a lost contributions analysis is to determine what portion of total costs is fixed (i.e., will be expended regardless of donations volume) and what costs are variable (i.e., will be spent only to generate additional donations). Only variable costs ought to be subtracted from expected contributions in determining net lost contributions because only the latter is saved as a result of the incident.[2]

The next item to consider is the appropriate discount rate. A discount rate is a factor, often expressed as a percentage, by which a future amount is reduced to a present value. Generally, the present value of one dollar received in one year is less than a dollar today because the recipient can use the money now to generate some level of economic benefit. Accordingly, to reflect the time value of money and risk, contributions lost in future years must be converted to a present value at the estimation date, using an appropriate discount rate. Expected damages are typically discounted to the date of the incident using the plaintiff’s estimated cost of capital. A valuation analyst should consider applying a mid-year convention[3] in their analysis; it presumes that lost contributions will be received evenly throughout the year. In some cases, prejudgment interest is applied from the time the damages occurred to the date of the trial.

Overall, economic damages analysis for not-for-profit entities mirrors the approaches and methodologies of lost profits calculations. The same caution and foresight should be exercised. A qualified valuation expert must possess relevant and necessary education, experience, knowledge, and training, and use reliable data and assumptions to prepare a well-supported analysis for any engagement.

[1] IRS: Charitable Organizations and Other Non-Profits; Source: https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-section-501c3-organizations

[2] Business Valuation Resources – Lost Profits Damages. A BVR Special Report https://www.bvresources.com/

[3] Present Value Factor

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Ms. Kalava is a finance professional with approximately 10 years of professional experience in the financial services industry, including business valuation, public accounting, and financial planning and analysis (FP&A). Ms. Kalava works with private, closely held companies and public Fortune 500 Companies. She earned a master of science degree in finance from the University of Tampa and a bachelor of science in international business and management. Ms. Kalava is a Certified Valuation Analyst (CVA) and is an owner and president of Araliya Valuation Consulting LLC (AVC).  

Ms. Kalava can be contacted at (813) 777-9706 or by e-mail to nataliya@araliyavaluation.com.