In commercial litigation, it’s common for business valuation experts to measure damages based on lost profits or diminished business value — or both. Here’s an introduction to these concepts.

The basics

Generally, it’s appropriate to estimate lost profits when a plaintiff suffers an economic loss for a discrete period and then returns to normal. On the other hand, diminished business value is typically reserved for businesses that are completely destroyed or otherwise suffer a permanent loss, such as destruction of an entire division or product line.

In rare situations, lost profits may 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 affect 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 will survive.

Double dipping

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 following three techniques:

1. The cost (or asset-based) approach,
2. The market approach, and
3. The income approach.

Because value is generally a function of a business’s ability to generate future economic benefits, awarding damages based on both lost profits and diminished business value 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.”

Major differences

Both lost profits and diminished business value involve calculating 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 determined 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 substantially affect the expert’s conclusion.
• Business value is based on what’s “known or knowable” on the valuation date, while lost profits calculations may sometimes 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.

(This is Blog Post #1566)