Looking Back to Go Forward
A Review of the Basics for Lost Profits (Part II)
In this second part of our series reviewing the basics for lost profits, we will contrast the differences between valuing a lost business and calculating an ongoing business’s lost profits. Because many experts calculating lost profits also provide business valuations, both in and out of litigation, it is good to be reminded of the similarities and differences between these two approaches when assessing commercial damages. In this article, we review five key categories that separate the approaches for calculating lost profits from valuing a lost business. It also is a reminder of why we calculate lost profits this way.
This is the second article in a series reviewing the basics for calculating lost profits. Part I provided a broad-brush outline for the series. In the second part of this series, this article will contrast the differences in valuing a lost business as opposed to calculating an ongoing business’s lost profits. Because many experts calculating lost profits also provide business valuations, both in and out of litigation, it is good to be reminded of the similarities and differences between these two approaches when assessing commercial damages. In the article, we review five key categories that separate the approaches for calculating lost profits and valuing a lost business. It also is a reminder of why we do it this way.
Lost Profits vs. Lost Value of Business
When hired for a commercial damages’ assignment, an expert should, as soon as possible, determine if the economic damages should be valued by lost profits or lost value of the business. The expert should work with the attorney in determining which type of loss has been claimed or will be claimed by the plaintiff.
As an example, several years ago I was hired in a case to calculate the economic damages for a business. On examining the documents, I found the business had been destroyed (closed and out of business) by the alleged wrongful acts. I told the attorney I would provide a lost business value to reflect the losses. He informed me he had already filed the petition claiming lost profits. We had a meeting to resolve this difference and ultimately, I prepared a lost value of business for that case.
“Business damages may be expressed as the value of a lost stream of economic income with a valuation date as of or following the date of defendant’s legal wrongdoing. Plaintiff’s loss may be measured either as lost profits or as the lost business value, particularly when the lost business value is determined based upon the income approach. Since both lost profits and lost business value may be based upon the discounted cash flow methodology, some practitioners believe the alternative damages values rely upon the same financial and economic principles, including a discount rate commensurate with the risk plaintiff would have borne. As a result, some experts opine that the related damages amounts should be approximately equal but, in any event, lost profits damages cannot materially exceed the lost business value.”[1]
“Lost profits and lost business value damages will be equal only if the alternative computations employ the same premises and calculation factors, including but not limited to the same valuation date, standard of value, information set, unresolved risk factors, loss period, discount rate, and offsetting mitigation … [T]he facts and circumstances related to a particular case, coupled with the court’s objective to measure plaintiff’s loss of ‘but for’ economic income in terms of the potential award amount needed to make the plaintiff economically whole, may require a lost profits damages computation that is markedly different than standard business valuation.”[2]
While other categories may be included, it is the differing approaches to these five categories when calculating lost profits as opposed to valuing a lost business that heavily impact the “markedly different” results that may occur.
- Expenses
- Loss Period
- Income Taxes
- Ex Ante/Ex Post
- Discount Rate
Expenses
One of the most significant differences between a lost business value and lost profits analysis is the handling of expenses. To determine the lost value of a business that has been destroyed, the value is based on the lost overall net cash flow (revenue less expenses equals net income).[3] To determine lost profits, the loss amount is based on lost net profits, which is defined as revenue not generated less avoided expenses equals lost net profits. Because the alleged injured business is continuing to operate, some expenses have not been avoided (e.g., fixed income, like rent). Therefore, any lost profits estimate will exclude the incurred expenses from the expenses to be deducted from the revenue that was not generated.
“In theory, lost profits and lost business value are both based upon the forgone net economic income caused by the defendant. In practice, however, the scope of the saved or avoided expenses deducted from the lost revenue may be quite different. Lost profits analysis often involves a business loss for a finite period for an otherwise continuing enterprise. As such, the damages are measured as the lost contribution margin—the lost sales revenue less the saved variable expenses. Typically, a lost profits analysis treats some costs as fixed for the damages period and, thus, not saved or avoided. As a result, a lost contribution margin often exceeds the overall net cash flow margin that considers both variable and fixed costs that would have been incurred but for the wrongdoing.”[4]
Loss Period
When using the income approach for estimating the fair market value of a destroyed business, the calculation captures the lost net income from the date of injury to perpetuity. This is because the business is no longer operating, and it is assumed will not reopen. When making a lost profits calculation, the injured business is continuing to operate. It may have lost a significant amount of its business or only one segment of its operation. But the calculation of lost profits assumes, that at some time in the future, the business will be able to return to its prior level of profitability. Therefore, the period of loss is limited to the time from the date of the alleged wrongful act to the return of the business to its “but for” status.
“In a lost profits calculation, the damages are typically measured for a specific or limited period. In general, the loss is the difference between what the business would have produced in earnings or cash flow during the loss period and what it actually did produce during the loss period … When an entire business is destroyed, the financial expert’s task remains to determine the business ‘s lost future cash flow, but the earnings or cash flows are lost in perpetuity, rather than a finite period.”[5]
One of the most difficult portions of any assignment is to determine the loss period. For some assignments, the losses are in the past. The injured business was able, after a period of disruption and loss, to find other sources for a lost supplier or replaced the damaged equipment and returned to its normal operations. Therefore, the losses only lasted a few months or years. Other businesses may be continuing to experience loss due to the alleged wrongful act.
In setting a loss period, it is important for an expert to understand the nature of the lawsuit; is it a breach of contract or a tortious interference case or both. The contract that was allegedly breached may have contained a termination clause that would allow one or both parties to terminate the contract after given a certain number of days’ notice. Some courts have adopted the notice of termination period as the loss period for estimating lost profits.
In Mood v. Kronos Products, Inc., the plaintiff claimed the defendant, a manufacturer, breached their distributorship contract by terminating it without giving the 60 days’ notice as prescribed in the contract. In this matter, the court held the loss period was not limited to the 60-day notice period.[6]
“Mood concedes his direct damages for breach of the notice provision are limited to profits he lost as Kronos’s sole distributor in the exclusive territory for the 60-day notice period. He argues, however, that his recovery of consequential damages in the form of lost profits is not so limited. We agree with Mood that the termination in violation of a notice provision could have a severe impact on the continuation of a well-established business and might include the loss of customer goodwill or damaged customer relationships.”
In Mood, the financial expert estimated a loss period of 10 years. The court felt that period was too long and ultimately limited the loss period to 60 days after notice.
The loss period under tortious interference (e.g., fraud) may run so long as it may be shown the injured business will not be able to return to its “but for” status. “In determining the length of the damages period, financial experts should consider all factors that could limit or extend the life of a specific income or cash flow stream; those could include items such as a product’s life cycle, competition, changing technology, or modifications to the regulatory environment. In addition, courts impose an obligation on the plaintiff to mitigate any losses that may be incurred. Because of the inherent limitations on the life of an income stream, courts have generally been reluctant to award lost profits damages over extended periods, given the speculative nature of such projections and their lack of reasonable certainty. However, illustrating the fact-intensive nature of the term of the damages period, in PSKS, Inc. v. Leegin Creative Leather Products, Inc.,[7] the court found:
The duration of the period during which plaintiff might be expected to profit will vary from case to case; it is susceptible of no precise information, and must be left to the processes of the jury informed by the presentation of conflicting evidence.”[8]
Income Taxes
When valuing a business for lost business value, it is typical for the expert to consider income taxes as a part of the valuation. The generally accepted definition of fair market value is “the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”[9] “The hypothetical buyer (generally, an individual investor) invests dollars and receives a cash return after payment of all expenses and income taxes. It is those net after-tax cash flows that the hypothetical buyer values and for which he or she is ultimately willing to pay.”[10]
This is not true when calculating lost profits. “Lost profits damages typically are considered to be taxable income to the recipient. As the Supreme Court pointed out in its Hanover Shoe[11] decision, ‘since [the plaintiff] will be taxed when it recovers damages from [the defendant] … to diminish the actual damages by the amount of taxes that it would have paid had it received greater profits in the years it was damaged would be to apply a double deduction for taxation, leaving [the plaintiff] with less income that it would have had if [the defendant] had not injured it.’”[12]
This position was echoed in other financial literature. “For example, lost profits damages often reflect the loss of the business’s taxable income, so the award is subject to business income taxation. If the business is the plaintiff, the pre-tax damages award should be sufficient to yield an after-tax damages award that is economically equivalent to the enterprise’s after-tax profits.”[13]
Ex Ante/Ex Post
Ex ante and ex post are Latin terms used to identify differing approaches in valuing a lost business or lost profits. Ex ante is translated as “from before” and ex post is translated as “from after.” For valuing a lost business, an ex ante approach is used. This means the date of valuation is tied to the date of the alleged wrongful act. For calculating lost profits, an ex post approach is commonly used.[14] This means the date for estimating the damages (usually the date of trial) will be after the date of alleged wrongful act. Because of this, there will be a period of past lost profits from the date of the alleged wrongful act to the date of trial (judgement) and future lost profits, if applicable, from the date of trial to the end of the loss period.
“Lost business valuation is determined as of the date of the wrongdoing by discounting all then-future losses to this initial valuation date, as if the entire loss occurred at this single point in time. Pre-judgement interest may then apply to the total lost business value from the initial valuation date to the award date. Lost profits damages may include both past and future losses, valued as of the anticipated judgement date. Past losses may thus be subject only to any pre-judgement interest (i.e., non-discounting), while future damages would be discounted to the anticipated award date without pre-judgment interest.”[15]
The difference between the ex ante and the ex post approaches is significant in the consideration of the data to be used when valuing a lost business or lost profits. When valuing a lost business, generally events after the date of wrongdoing are considered. That is, unless the willing buyer and willing seller would have known this future event was going to occur as part of their “reasonable knowledge of relevant facts.” There can be exceptions (e.g., knowing the amount of proceeds from the sale of the assets of the destroyed business), but these exceptions are case specific. Therefore, for many valuations of lost businesses, a curtain drops on the date of alleged wrongdoing and facts after that date are not considered. On the other hand, the ex post approach allows the expert to rely on events that occur after the date of wrongdoing because these events may have affected the injured business’ ability to make a profit had the alleged wrongful act not occurred.
“To calculate lost profits damages, the relevant period begins on the date of when the injury occurs and continues until the losses caused by the injury have stopped or when the plaintiff has been able to mitigate the damages and resume operations. In many cases, however, the losses may continue through the date of trial. One of the most significant differences between a lost profits calculation and a business valuation performed for purposes is that, in typical business valuation for other purposes (for example, estate and gift tax engagements), an expert will not consider facts that take place after the applicable valuation date (subsequent events) unless these facts were ‘known or knowable’. To expand on the ‘known and knowable’ concept, business valuation standards outside of litigation require a valuation professional to consider only the information known or knowable as of the date of the valuation (sometimes called an ex ante approach) … However, a financial expert may consider subsequent information (ex post) when estimating damages. Whether subsequent information should be considered necessarily depends on the specific facts and circumstances and relevant case law.”[16]
Discount Rate
“The discount rate used in a business valuation can be, and often is, different from that used in lost profits calculation for the same company. It is important to note the differences in calculating lost profits versus lost business value. In short, the risks of the specific cash flows in question may be different. Discount rates can vary tremendously depending on the facts and circumstances. For example, some cases have used a risk-free rate, while other cases have held that a risk-adjusted discount rate is appropriate … In addition to the traditional risk-adjusted discount rate, courts have held that a discount rate based on a conservative investment may be appropriate, that is, a rate of return for the award to be invested in to keep the injured whole.”[17]
One of the reasons for differing discount rates between valuing a lost business and lost profits is the loss period. The valuing of a lost business calculates the present value of the lost business’ income to perpetuity. The loss period when calculating future lost profits may be only a few years. In most cases, the risks for generating the projected income to perpetuity are greater than the injured business not being able to generate the projected loss over five years or less.
“In general, either the projected stream of lost economic income or the discount rate may be the primary focus of adjustments for unresolved risk and uncertainty. In principle, lost profits and lost business value computations may differ in these adjustments because of a disparity of relevant information. For example, the lost profits analysis, which may be based upon ex post information, typically reflects a more certain determination of the lost economic income (either more or less favorable to plaintiff than a projection based only upon ex ante information), whether valuing either past or future damages.”
Other reasons are more nuanced. “Damages amount differences arise, among other potential reasons, because the business valuations may be based upon less information than lost profits damages, some or all risks contemplated in a violation-day business valuation may be resolved by the trier-of-fact, or the discount rate used for the business valuation to reflect an asset transfer price from a willing seller to a willing buyer is greater than the discount rate appropriate for a plaintiff suffering a constructive forced sale of an asset.”[18]
Everett Harry goes on the note, “[Konrad] Bonsack explained and defended ex post damages considering that the objective should be to ‘Restore the plaintiff … for all time’; injury occurs over time and the violation and trial are not simultaneous; a legal violation is not a legitimate asset exchange and may be the constructive passage of title and forced sale; the owner had the rights to both the risks and rewards of the lost asset; the passage of time may bring to light the asset’s intrinsic value; and ‘Hindsight should be used,’ which returns the risks or the rewards of the asset to the plaintiff.”[19]
Conclusion
When being hired for a commercial damages assignment, an expert should, as soon as possible, determine if the economic damages should be valued by lost profits or lost value of the business. Many attorneys will not know the difference between valuing a lost business and lost profits. It may be up to the expert to lead the attorney through the process of “figuring out” what type of damages should be claimed.
An expert with the knowledge of the differences between valuing a lost business and calculating lost profits for an ongoing business can be an asset to an attorney. Once beginning the process of calculating lost profits, the expert must be mindful of the approaches and standards to be used and why they are different from the approach for valuing a lost business.
This article has provided information to allow the expert to explain why experts calculate lost profits one way and value a lost business in another. This will assist the expert in developing his or her approach for estimating lost profits and provide a value added to the attorney.
[1] Lost Profits and Lost Business Value – Differing Damages Measures, Everett Harry, Dunn on Damages Issue 1, Winter 2010, p. 6.
[2] Ibid.
[3] For this discussion, a simple definition has been provided for net cash flow. A more detailed discussion regarding net cash flow would include topics on accrual or cash basis accounting, adjustments related to depreciation, and handling of working capital.
[4] Lost Profits Damages, Principles, Methods, and Applications, Everett Harry, III, Jeffrey Kinrich, Valuation Products and Services, 2022. p. 143.
[5] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd. Ed. Vol 1, Nancy Fannon, Jonathan Dunitz, Business Valuation Resources, 2014, p. 332.
[6] Mood v. Kronos Products, Inc., 245 S.W.3d 8, 13 (Tex. App. 2007).
[7] PSKS, Inc. v. Leegin Creative Leather Products, Inc., 171 Fed. Appx. 464, 468 (5th Cir., 2006).
[8] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd. Ed. Vol 1, p. 333.
[9] Revenue Ruling 59-60, 2.02, Internal Revenue Service.
[10] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd. Ed. Vol 1, p. 331.
[11] Hanover shoe, Inc. v. United Shoe Machinery Corp., 392 U.S. 481, 503 (1968).
[12] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd. Ed. Vol 1, p. 330.
[13] Lost Profits Damages, Principles, Methods, and Applications, pp. 143–144.
[14] Some experts apply an ex ante approach to discounting future lost profits to present value. The difference between the majority used ex post approach and the lesser used ex ante approach will be discussed in this series’ article on discounting future lost profits.
[15] Lost Profits Damages, Principles, Methods, and Applications, p. 143.
[16] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd. Ed. Vol 1, pp. 336–337.
[17] Ibid, pp. 334–335.
[18] Lost Profits and Lost Business Value – Differing Damages Measures, Dunn on Damages Issue 1, p. 6.
[19] Ibid, p. 7.
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 twenty 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 area 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.
