Disputes in Mergers & Acquisitions – Lost Profits vs. Lost Business Value
M&A is a tough, high-stakes business. In a 2012 Robert Sher article appearing in Forbes, the columnist cited research indicating that M&A activity has about a 50% chance of success. Nothing more than a coin flip. So, what happens when an M&A deal goes bad? Well, when the buyer of a company feels he was fleeced into buying a bad company at an unreasonably rich price, litigation often ensues. Our firm is often engaged by attorneys to assist in measuring damages associated with the claims of one party against the other in the given transaction. Economic damages can be measured in a variety of ways in cases involving post-transaction litigation. The most appropriate method(s), however, is dependent upon the specific facts and circumstances of the case.
One option for the financial expert is to measure damages in terms of lost profits. In a case where the expert measures lost profits, he will compare the actual profits realized during a period of time (“the damages period”) to the profits that would have been realized had the harmful event (e.g., breach of contract, misrepresentation, etc.) not occurred. The latter profits figure, often called “but for” profits, represents the level of earnings the business would have earned “but for” the defendant’s conduct. For example, in a case where a non-compete agreement was signed by the seller and then subsequently breached, the financial expert determines profits under two separate assumptions: 1) profits of the business without seller competition and 2) profits of the business with seller competition. The difference between these two levels of profit would be considered the damages suffered by the buyer due to the seller’s breach of the non-compete agreement.
Lost Business Value
The financial expert may also measure damages by valuing the business under two sets of assumptions. Once again, the “but for” concept is critical in this approach to measuring damages. First, the financial expert will determine the value of the business as if the harmful act never occurred. In many M&A disputes, the purchase price contemplated in the transaction is instructive in valuing the business for damages purposes.
In other words, the purchase price paid is indicative of the value of the business in a scenario where no harmful act occurred (i.e., this is what the business would be worth “but for” the defendant’s conduct). Nonetheless, the expert may perform his own valuation analysis to independently determine the value of the business or to confirm the reasonableness of the purchase price. The discounted cash flow method, the private company transaction method and the guideline public company method can all be employed to help the expert arrive at a reasonable value of the business. It is important to reiterate, however, that a value of the business is determined under the assumption that no harmful act had ever occurred.
This value is then compared to the value of the company taking into account the impact of the harmful act. For example, the defendant may have overstated earnings to the buyer during the due diligence process as a result of misrepresentations. This may have convinced the buyer to “overpay” for the business. Therefore, the expert will value the business assuming this more appropriate level of earnings and, presumably, arrive at a lower value of the business. The difference between these two scenarios (the value assuming the harmful act never occurred vs. the subsequent value as a result of the harmful act) is considered an indication of damages.
The measurement of lost business value is most commonly applied in cases where there is permanent deterioration of value (e.g., a material segment of the business or the business as a whole has been destroyed). Because the process of valuing a business contemplates the future expected cash flows of the business into perpetuity (as opposed to a finite damages period contemplated in a lost profits approach), a measurement of lost business value assumes a permanent loss. In certain cases, the facts will support this approach while in other cases a lost profits approach using a finite damages period may be more appropriate.
Finally, in certain situations, the use of the both approaches may be applied. The expert must be careful not to perform computations that result in a duplication of recovery, however. Once again, it is critical for the expert to understand the specific facts and circumstances of the case in order to employ the best approach (or approaches) for the case at hand.
For more information on valuation in relation to buying or selling your business or our Valuation and Litigation Advisory Services.