Business Damages – What to Look for in a Business Damages Model
By Kathleen E. Suker, Senior Manager, CPA, ABV, CFF, CFE
In lawsuits involving business damages, a plaintiff’s expert prepares a business damages model that details his or her analysis and opinion. There are many components to a business damages model, and understanding them allows for determining if the model has a good foundation.
A business damages model generally includes historical data, assumptions, and projections which, when taken together, yield the valuation expert’s opinion. Damages are usually broken out into four categories:
- Lost past profits,
- Lost future profits,
- Loss of business value, and
- Extra expenses or out-of-pocket costs.
Typically, a plaintiff’s expert will prepare a business damages model that incudes his or her calculation of the damages or lost profits. This model and analysis is then evaluated by the defendant’s expert, who many times will prepare his or her own damages model. The defendant’s expert may also assist defense counsel in preparing the cross-examination of the plaintiff’s expert.
In analyzing business damages, each of the four categories above should be addressed separately because the inputs and assumptions may be based on different data and variables. For example, lost future profits is related to events that have yet to occur and may or may not replicate lost past profits.
The Influence of Variables
The variables considered by the analyst for use in his or her damages model is a key consideration in determining if a model is reliable. Is the damages model based on specific and thorough research, or is it based on non-specific estimates and speculation? Are extra expenses and out-of-pocket costs based on concrete events that have occurred and that the plaintiff has been able to document and substantiate? Accordingly, an expert should consider the quality of the data, the reasonableness of the assumptions, and the reliability of the projections, which all become important factors when evaluating the overall reliability of an expert’s damages model and the resulting opinion.
The assumptions used by the expert must be reasonable and specific to the damages being calculated. The expert must provide a solid foundation for the revenue, expenses, and earnings growth rates used in the projections. Is growth in the future assumed to replicate growth in the past, or does the expert provide a thorough analysis of changes that may occur in the economy, industry, and/or the company? These variables affect a company’s growth and impact the reliability of the expert’s projections.
The expert must also consider the specific components of the company’s cost structure, and not merely rely on average cost, margins and profit percentages. Expenses should be broken out between fixed expenses (expenses that a company would continue to incur despite its level of revenue, such as rent, insurance, administrative salaries, etc.) and variable expenses (expenses that vary with the level of revenue earned, such as direct labor and materials). In addition, some expenses may have both fixed and variable components, such as utilities. An average profit margin also does not take into consideration variable expenses that may not be incurred, which could change the results of an expert’s damages calculation.
In addition to speaking with their own client, did the expert speak with other individuals at the company and/or perform independent research? Sometimes an expert may not obtain an objective opinion from participants who are closely involved in the situation (whether intentional or not). Sound, independent research should also be performed, including speaking with other market participants, if possible.
The Smell Test
Finally, the methods used by the expert should be applied in a sound and reasonable manner, and the results of the analysis should make sense from an overall perspective. For example, is it realistic that the company will grow into perpetuity at an annual rate of 20 percent (as it did in the past three years), or at some point will the company’s sales flatten? Is there an obsolescence factor that should be considered, or do the products or services provided by the company have a limited market shelf-life, thus making a damages model that projects the damage period beyond the likely shelf-life unrealistic?
In the end, a damages expert should step back and determine if his or her calculations and resulting opinion makes sense as a whole (a “smell test”). The expert should also understand the economic factors specific to the damages at hand and apply them in a consistent, accurate, deliberate manor to arrive at a reliable damages calculation.