Lost Profits or Lost Business Value
When to Use in Litigation Assignments
In a recent engagement, the author was asked to prepare a lost business analysis for an operating business. In this article, the author discusses when a lost profits vis-à-vis a lost business analysis is best suited.
Recently, I received a call from a new client. That is, I spoke with an attorney with whom I had worked in the past. He wanted to hire me to assess damages in a commercial damages case. The business had been injured by an alleged wrongful act. It was still operating and did not appear to be closing anytime soon. I began to discuss how I would go about estimating the lost profits for this firm. The attorney interrupted and said he did not want a lost profits analysis but a lost business value analysis.
It has been my understanding that if the business continues to operate after an alleged wrongful act, then a lost profits analysis would be appropriate. If the business was forced to close or sell due to an alleged wrongful act, a lost business value appraising the business the day prior to the wrongful act was the appropriate way to assess the loss.
After my conversation with the attorney, I turned to some of our financial and forensic literature to review what it said about this issue. I felt the results of my review might refresh some of our readers, as it did me, or share new insight with others.
Lost Profits vs. Lost Business Value
“A business damages claim may be properly calculated as either the post profits of the business or the lost value of the business. Courts have stated that the general rule permitting the alternate theories of recovery as follows: ‘[I]f a business is completely destroyed, [then] the proper total measure of damages is the market value of the business on the date of loss. If the business is not completely destroyed, then it may recover lost profits. A business may not recover both lost profits and the market value of the business.’[1] Stated another way: Numerous jurisdictions hold the view that when the loss or business is alleged to be caused by the wrongful act of another, damages are measured by one of the two alternative methods: (1) the going concern value; or (2) lost future profits. [T]he courts allow a plaintiff to recover either the present value of lost future earnings or the present 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 the business in question. It measures damages by awarding the difference between the going concern value and the price actually received by the plaintiff upon sale of the business.”[2]
This source noted that the decision to claim lost profits or lost business valuation was an important one that should be made as early as possible in the litigation. The attorney and the expert should consider the nature of the case, the facts, and applicable statutes or court decisions affecting these respective claims.
This source went on to say, “Whether the damages are calculated as lost profits or lost business value, the goal is to put the plaintiff in an economically equivalent position the plaintiff would have been in but for the alleged bad act. … The financial expert needs to be careful, however, in assessing whether the concept of ‘in as good a position’ allows the plaintiff to collect more than the economic equivalent determined using standard damages techniques. … As far as the damage expert is concerned, any damages analysis must be based on sound principles, relevant facts, and reasonable assumptions, applied specifically to each case, yielding a quantification focused on putting the injured party in an economically equivalent position.”[3]
A separate source went into greater detail about the process of choosing which method to use. “[W]e define lost profits as the difference in profits between (a) what the plaintiff would have earned but for the defendant’s actions and (b) the actual profits made by the plaintiff. In this context, lost profits usually refer to lost cash flows, but the practitioner must match the measure to the damage suffered. Lost business value addresses the negative impact of the impaired earnings (cash flows) on the overall business.”[4]
This source goes on to discuss four approaches for calculating lost profits: before and after, sales forecast, yardstick, and market share. It also discusses three approaches for valuing a business: discounted cash flow approach (income), market, and comparable company transaction.
This source also provided an example where lost business value could be used in a situation where a lost profits analysis might be considered. “Damages claims often require multiple valuations of the same business. For example, in a diminution of value claim, the expert values a business before the impairment (but for value) and values it again after the impairment. The difference between the before and after values reflects the loss of value claimed as damages.”[5]
This form of analysis is like a before and after analysis of cash flows which provides for lost profits. So, financial literature confirmed lost business value may be used to calculate the damages to a business that has been wronged but is still ongoing.
Critics complain that valuing a lost business or the injury to a business value does not consider events after the date of injury which may have benefited or harmed the overall profitability of the business claiming damages. Business valuations are calculated following an ex ante approach. This means that the business is valued based on a certain date (e.g., the date of injury) and only information that was known or could have been known on that date is used for assessing the future profitability of the enterprise. Lost profits are calculated using an ex post approach. This means that all information available after the date of injury and up to the date of the calculations may be used to estimate the business’ future cash flow.
“The damages expert should appreciate that the courts do not categorically endorse either the lost profits methodology or the lost business value methodology, but often seem to prefer the lost profits methodology when a choice is available. If for no other reason, triers of fact appear inclined to reach decisions based upon all reasonably available information, including the ex post information, and resist the “blinders” constraint of many business valuations that are based upon ex ante information. While the damages expert should be sensitive to a potential court preference for the use of ex post information and the lost profits methodology, the analyst should select the approach based upon the case facts and the expert’s judgement about which methodology better measures plaintiff’s economic losses.”[6]
This source goes on to note, “A properly determined unimpaired or but for business value as of the legal violation date may be a useful fact and the basis for the judge’s or jury’s determination of damages, particularly when lost profits damages are unavailable to the plaintiff.”[7] This source goes on to cite cases in which lost profits could not be reasonably ascertained or a claim for lost profits was not legally available (e.g., contractually barred from claiming lost profits).
Conclusion
This article has presented a brief review of financial literature to clarify the situations in which it is recommended that lost profits be calculated and those in which lost business value should be calculated. It has not discussed the numerous differences and nuances between the two methodologies. Although much of the same financial information is used to make each calculation, the data may be handled in different ways (e.g. income taxes and expenses). The methodological differences between these two approaches are for another article.
A review of financial literature confirms there are two methodologies commonly available for use by financial experts when calculating financial damages: lost profits and lost business value. Generally, lost profits are calculated when a business has been injured but continues to operate, possibly even at a profit. A lost business value is estimated when the business has been destroyed or severely damaged and the business or its assets were sold.
The review of our literature also shows that there are exceptions to that rule. Multiple valuations may be calculated to show the damage to an ongoing business. The first calculation will show the value of the business prior to the wrongful act and the second calculation, the value of the business, as of a date closer to trial. This second date would be after the impact of the wrongful act has been felt by the business. In this situation, lost profits may not be available due to the inability to make such calculations with reasonable certainty.
Therefore, the literature does support the notion that lost profits should be calculated for a business that continues to operate after being impaired by an alleged defendant. However, there is enough flexibility in court interpretation to allow for the use of a business valuation when the expert and the hiring attorney feel it appropriate.
The attorney called me recently and I left the decision over which method to use open. I told him I would review the case specific data and follow up with my thoughts. Based on my initial review of the case specific data and after reviewing this literature, I am inclined to recommend performing multiple business valuations rather than pursue a lost profits analysis. This case seems to fit into one of those exceptions for using lost business value for an ongoing concern.
[1] Montage Group, Ltd, v. Athle-Tech Computer Systems, Inc., 889 So.2d 180, 191 (Fla. App. 2004) (Internal citations omitted).
[2] The Comprehensive Guide to Lost Profits and Other Commercial Damages; Nancy Fannon, Jonathan Dunitz; BVR, 2014; pp. 323–324.
[3] Ibid., pp. 327–328.
[4] Litigation Services Handbook, 5th Ed., The Role of the Financial Expert; Roman Wiel, Daniel Lentz, David Hoffman; John Wiley & Sons, Inc., 2012; p. 4.16.
[5] Ibid., p. 10.2
[6] Lost Profits Damages: Principles, Methods, and Applications; Everett Harry, Jeffrey Kinrich; VPS, 2022; p. 161.
[7] Ibid.
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.
