Measuring Commercial Damages
In commercial litigation, it’s common for experts to measure damages based on lost profits, diminished business value — or both. Here’s an introduction to these concepts.
Lost Profits vs. Diminished Value
Generally, it’s appropriate to estimate lost profits when a plaintiff suffers an economic loss for a discrete period and then returns to “normal.” Diminished business value is generally reserved for businesses that are completely destroyed or otherwise suffer permanent loss, such as destruction of an entire division or product line.
There may be rare situations in which lost profits fail to adequately capture a plaintiff’s damages. For example, suppose a defendant’s wrongful conduct damages a plaintiff’s reputation, but it doesn’t directly impact the plaintiff’s expected profits. Nevertheless, the defendant’s actions have rendered the plaintiff’s business less marketable and, therefore, less valuable. In this situation, diminished business value may be an appropriate measure of damages, even though the plaintiff’s business lives on.
There are important similarities between how lost profits and diminished business value are measured. Typically, lost profits are a function of lost revenue caused by the defendant’s wrongful conduct and avoided costs that otherwise would have been incurred to generate the revenue. Once lost profits have been estimated, the amount is adjusted to present value.
Alternatively, business value is generally determined using one or more of the cost, market, and income approaches. All three valuation approaches generally boil down to a business’s ability to generate future economic benefits.
For this reason, awarding damages based on both lost profits and diminished business value is derived from the same earnings stream and is usually considered double dipping. A possible exception is the “slow death” scenario: A defendant’s wrongful conduct initially causes the plaintiff’s profits to decline, but the plaintiff continues operating. Eventually, however, the plaintiff succumbs to its injuries and goes out of business. In these cases, it may be appropriate for the plaintiff to recover lost profits for the period following the injury, plus diminished business value as of the “date of death.”
Both metrics calculate the present value of future economic benefits. So, you might expect damages to be identical, regardless of which measure is used. But consider the following differences between the two metrics:
- Business value is usually based on expected cash flow, which can be more or less than expected profits depending on the case facts.
- Lost profits are typically measured on a pretax basis, while business value is generally based on after-tax cash flow.
- Differences in the discount rates that are used to calculate present value of lost profits vs. diminished business value may have a substantial impact on the expert’s conclusion.
- Business value is based on what’s “known or knowable” on the valuation date, while lost profits calculations may consider developments that have occurred up to the time of trial.
In addition, “fair market value” is generally based on the perspective of a hypothetical buyer, while lost profits can consider the specific plaintiff’s perspective. The plaintiff may have a special tax situation, benefit from unique synergies or view the business as less risky than a hypothetical buyer would. Likewise, a business’s value may include adjustments, such as discounts for lack of marketability and key person risks, that may not be considered when estimating lost profits.
Use Management’s Projections With Caution
Experts often rely on management’s projections when estimating lost profits or business value. After all, no one knows the company’s operations better than the managers who control day-to-day functions.
However, internally generated projections may not always be accurate for a variety of reasons. For example, management may be inexperienced in financial matters or biased due to its financial interests in the outcome of the case.
During the COVID-19 pandemic, reliance on management’s projections can be especially risky. Managers may over- or underestimate how the pandemic will affect the company’s earnings stream. And projections prepared simply by applying a reasonable growth rate to historical results may not be realistic.
Given the uncertainty and volatility associated with the current economy, it’s important to ask these types of questions to determine whether management’s projections are reasonable:
- How has the pandemic affected the business’s operations, employees, customers, and supply chains? Has disruption of the business been so extreme as to render historical results irrelevant?
- Will the company’s operations return to normal? If so, when?
- How do management’s projections compare to expectations for the industry and the overall economy? Are its short-term and long-term growth rates reasonable based on these trends and the company’s operating capacity?
- Does the business have sufficient working capital and short-term funding sources to survive until normal operations resume? If not, can the company make changes to extend its life expectancy?
- Has the business put capital expenditures, research and development projects, marketing, and other outlays on hold? If so, will this affect its long-term growth prospects?
The pandemic has impacted each business differently. It’s critical to examine company-specific factors when making this assessment.
Picking the Right Metric
Lost profits and diminished business value are closely related, but they’re not identical. When evaluating a case, it’s critical to understand which measure is appropriate and how it might affect the outcome.