The survival of many companies depends on relationships between key customers or vendors (or both). When one of these relationships is disrupted, for whatever the reason, one party may incur financial damage — perhaps even leading to its demise. And business valuation professionals often evaluate this lost value as a source of economic damages.

Going, going, gone . . .

In many cases, valuators will present a company’s alleged damages as lost past and/or future profits. For instance, if a vendor breaches a contract to sell materials at a contracted price, the business may be forced to pay a higher price to the vendor, assuming no immediate alternatives are available.

If it takes six months to secure a new vendor at the originally contracted price, the company will presumably lose money if, to retain its customer base, it doesn’t pass on the cost increase to buyers. The valuator can estimate this type of damage via a lost profits analysis because the business would be able to continue operating and the damage period would be finite. Thus, it would retain a good portion of the value it had before the vendor dispute.

Beyond lost profits

There are unfortunate circumstances, however, when a business interruption is so significant that the company’s value is destroyed and the business itself can no longer operate as a going concern. In such a case, the appropriate measure of damages may be lost business value rather than lost profits.

When this occurs, a valuator will assess the company’s lost value as close to the damaging event as possible. Why? Because the business had a fair market value based on its operating and financial characteristics, and the catastrophe has irrevocably changed these characteristics and, hence, reduced its value.

Lost value estimates

When estimating lost business value, the expert will prepare a dual-dated valuation with the effective dates being just before the damaging event and whatever date management has designated as the point at which the business can no longer continue as a going concern. The difference in value will be the damages sustained by the company because of the event.

In general, estimates of lost profits shouldn’t be combined with estimates of lost value when quantifying economic damages. The reason for this is that, in most cases, calculating damages in such a manner would constitute “double dipping.”

If the business and all of its value have been completely destroyed, the proper measure of damages is its fair market value on the day before the alleged damage. The company that recovers damages equal to the value of the business has, in effect, sold the business. The company’s stockholders shouldn’t also be able to recover future lost profits after the imputed sale.

In Summary

When a disruptive event strikes a company, a valuator can go in one of two directions. If the business can continue as a viable going concern, a lost profits analysis may be the appropriate measure of damages. Alternatively, if the event is so catastrophic that it puts the company out of business, a lost value analysis may be the best indicator of economic loss.

(This is Blog Post #1469)