Lost profits or lost value?
Lost profits and lost business value are common measures of damages in commercial litigation. They’re also a common source of confusion. Here are answers to some frequently asked questions on the subject.
What do they have in common?
Lost profits and lost business value are more alike than they are different. Computing lost profits involves projecting future income streams and converting them to present value using a risk-adjusted discount rate. Damages are generally equal to the difference between the profits a plaintiff would have earned but for the defendant’s wrongful conduct and the actual profits the plaintiff earns — and is expected to earn — after the injury date.
Lost business value is commonly used to measure damages when a business is destroyed, and it often involves essentially the same methodology. When income-based valuation methods are used, determining lost business value is like calculating lost profits, except the business loses all its profits.
Even if a business survives, computing lost value may be appropriate if it suffers a permanent injury, such as the loss of a particular product line or division. In that case, damages might be measured by the difference between the business’s value before and after the injury.
How are they different?
Despite similar methodologies, in most cases there are significant differences between the two measures. Lost profits are usually measured over a specific time period, such as the remaining term of a breached contract or the time it will take the plaintiff to restore “normal” profits. With lost business value, on the other hand, profits are projected into perpetuity.
Also, a business valuation views the business from the perspective of a hypothetical buyer, while a lost profits analysis views it from the plaintiff’s perspective. The differences in perspective can result in very different assessments of risk and, therefore, different damage estimates.
For example, a plaintiff who has developed considerable personal goodwill and industry contacts might view the business as less risky than would an outside buyer. Lost profits may also reflect the plaintiff’s specific tax situation or other factors that result in higher or lower earnings than a hypothetical buyer might experience.
Another important difference is that business value generally is based on facts known or reasonably knowable on the valuation date, regardless of what has actually transpired between that time and the trial date. But it may be appropriate to consider subsequent events in determining the amount of lost profits.
Finally, business value may incorporate discounts for lack of marketability or liquidity.
Can a plaintiff recover both?
Yes, but only with respect to different time periods. If a business suffers lost profits during the period following the defendant’s wrongful conduct but has been permanently injured or destroyed by the time of trial, it may be appropriate to recover lost profits for the initial period and lost business value as of the date the damage becomes permanent.
Keep in mind that an award of both lost profits and lost business value for the same, or overlapping, time periods counts the same income streams twice, resulting in a double recovery. This is true regardless of the valuation approach used. Even if market- or asset-based valuation methods are used, a business’s value is still derived from its capacity to generate profits.
Damage control
A basic understanding of the similarities and differences between lost profits and lost value can help you build a case for business damages or challenge your opponent’s calculations. A valuator can be instrumental in deciding the correct approach.