Lost Business Value or Lost Profits – What is the Difference? by Sharon F. Foote, ASA, CFE
Posted on December 02, 2016 by Scott Bouchner
Financial experts are often utilized by attorneys in commercial litigation cases. The goal is to make the injured party whole; in other words, to return the plaintiff to the financial condition the business would have been in but for the alleged acts of the defendant. Economic damage claims can be calculated by analyzing the affected business from two different perspectives – lost profits or lost business value, depending on the facts and circumstances of each case. The decision of which approach is appropriate should be decided by the damages expert and counsel early in the case, being aware that a business cannot typically recover both lost business value and lost profits.
The amount of damages under both approaches could be similar if all else is held constant. However, in reality, the damages may be significantly different due to the inherent differences in both approaches, which are discussed below.
On June 6, 2014, the Florida Supreme Court approved jury instructions for contract and business litigation that concisely presents the concepts of contract damages. Instruction 504.3, Lost Profits, explains that to recover lost profits, a claimant must prove the defendant caused the claimant’s lost profits and the amount of lost profits must be established “with reasonable certainty.” Instruction 504.4, Damages for Complete Destruction of Business, is only given in the case of a “complete destruction” of the claimant’s business. The jury is instructed that the claimant’s damages are based on the market value of the business; anything less than “complete destruction” would be compensated via the “lost profits” instruction. (Source: In re Standard Jury Instructions – Contract and Business Cases, Instruction 504.3-504.4, 116 So. 3d 284 (Fla. 2013)).
In many valuations (under the fair market value standard), the parties are the hypothetical willing buyer and willing seller as discussed in IRS Revenue Ruling 59-60; in lost profits analyses, the parties are not considered to be either hypothetical or willing. Another of the differences between a compliance-related valuation (i.e., those for tax and financial reporting purposes) and a valuation related to economic damages is that the business value in a compliance-related valuation is as of one specific date in time, whereas in a damage claim for diminution in business value, the value of the business is determined both before and after the causative act as of the dates decided by the court.
In a loss of business value calculation, only the facts known or knowable as of the valuation date are generally considered. The courts in some cases have allowed hindsight, even where there has been a loss of business value, such as when, if hindsight were not allowed, it would result in either a windfall gain or an unfair penalization of the plaintiff.
An early case, frequently cited even today, allowed hindsight and is referred to as the “Book of Wisdom” based on a 1933 U.S. Supreme Court decision in the case of Sinclair Refining Co. v. Jenkins Petroleum Process Co., 289 US 689 (1933). The decision in this case advocated the use of actual results to determine what the value of a patent should have been on the valuation date by proving the “elements of value that were there from the beginning”. The decision in Sinclair Refining effectively allowed for a valuation based on actual results after the valuation date that would supplant market value (based on forecasted data) estimated as of the valuation date since that assessment failed to accurately determine value for the undeveloped patent.
However, in a lost profits calculation, facts and events occurring after the alleged harmful actions of the defendant are considered. If the business lost earnings for a finite period of time, damages can be determined by using a lost profits approach and then adjusted for any mitigation of those damages by the plaintiff.
In the analysis of lost business value under an income approach, the discount rate utilized would typically be either the injured entity’s equity rate of return or its weighted average cost of capital (WACC), calculated using either a build-up method or the capital asset pricing model (CAPM). However, the discount rate utilized in a lost profits calculation could be one of those or others such as the plaintiff’s cost of debt, or its internal rate of return. Another option allowed by some courts is that the projected cash flows can be adjusted to account for the risk associated with them and a risk-free (or risk reduced) rate can be used.
Lost business value calculations consider all costs needed to generate the entity’s revenues and profits as compared to lost profits analyses, which typically place greater emphasis on costs associated with the lost revenues.
As is evident from the discussion above, the calculation of damages under either the lost profits approach or the loss of business value approach is complex and dependent on the facts and circumstances unique to each case, making it very important to utilize experienced, credentialed damage experts that will provide optimum assistance to counsel.
About the Author: Sharon Foote, ASA, CFE, is a member of Berkowitz Pollack Brant’s Forensic and Business Valuation Services practice. She can be reached in the firm’s Miami office at 305-379-7000 or by email at firstname.lastname@example.org.