Lost Profits v. Lost Business Value: Which is More Appropriate When Determining Economic Damages?
By Kathleen Suker, CPA, ABV, CFF, CFE, Senior Manager, Advisory Services
Imagine you find yourself in the unenviable position of being a plaintiff in a business litigation, which may include a breach of fiduciary duty, breach of contract, or a tort claim. Your claim includes an allegation that the defendant’s actions or inactions resulted in a diminution of your business’ earning power. As a result of the defendant’s alleged wrongful conduct, you are now seeking economic damages related to your loss. How is your loss determined? How is your economic damage measured? Do you have a claim for lost business profits, or should your claim be for a diminution of business value? The answer, as in most business litigations, is that it all depends on the facts and circumstances of your loss.
Overall Purpose of the Analysis
The purpose of a damages remedy is to restore the plaintiff to the same economic position after the damaging act as if the damaging act had not occurred at all (i.e., to make the plaintiff whole).
In Goodstein Construction Corp. v. City of New York, 80 N.Y.2d 366, 373, 590 N.Y.S.2d 425, 604 N.E.2d 1356 (1992), the court stated that “[d]amages are intended to return the parties to the point at which the breach arose and to place the nonbreaching party in as good a position as it would have been had the contract been performed.”
Lost Profits vs. Lost Business Value
In commercial litigation, economic damages are measured in terms of lost profits or lost business value. Generally, the courts have found that if a business continues to operate but at a lesser profitability), the proper measure of damage is determining the business’ lost profits. A lost profits approach is appropriate when the harm to the business is for a determinate period of time and can be linked to separately identifiable cash flows. Alternatively, if a business ceases to operate, or if its value is permanently diminished, the proper measure of damage is determining the diminution in business value, through a business valuation comparing the value of the entity before and after the damaging act.
In other words, a claim for lost profits is generally considered when the loss period is finite. Thus, the financial expert is tasked with determining, to a reasonable degree of professional certainty, when the business will return to the level of profitability it achieved prior to the damaging act.
A claim for lost business value is generally made when the loss period is determined to be indefinite; the business will never fully recover prior profitability or the business has ceased to operate altogether.
Which Approach to Use
Whether to pursue a claim for lost profits or diminution of business value is an important decision that may rest on legal precedent and, accordingly, should be discussed at the outset of the claim with both the plaintiff’s attorney and financial expert. The facts and circumstances attributable to the loss should be evaluated in order to determine which approach is most appropriate. In addition, applicable case law should be discussed in order to determine if the selected approach is applicable in the jurisdiction in which the case is being tried.
The financial expert must have a credible basis for applying his or her chosen methodology in order to provide the trier of fact with a reasonable (not speculative) damages calculation. If the financial expert’s basis for selecting the approach is determined to be unsound in theory and application, the damage estimate could be reduced or even excluded by the court.
As discussed above, one of the primary considerations the financial expert must consider in his or her selection of approach is which approach will result in making the plaintiff whole without over-or-under compensating the plaintiff for the wrongful act. This consideration should guide the financial expert in determining their calculation of economic damages.
Similarities and Differences
The lost profits and business valuation approaches share many similar economic and financial principles; however, there are a several differences that may lead to divergent outcomes when determining a plaintiff’s economic loss. An in-depth discussion of these differences is outside the scope of this article; however, the treatment of taxes and discount rates are two of the key variables that can lead to disparate conclusions. In addition, the consideration of expenses and measurement dates can also vary between a lost profits analysis and a business valuation.
There may also be other factors, not having to do with the damaging act that limits the loss period, such as contract restrictions or anticipated obsolescence (technical, marketing, or otherwise) of a product or service. The financial expert must also consider these factors when calculating damages or lost business value.
Can a Plaintiff Claim both Lost Profits and Lost Business Value?
If a plaintiff’s business continues to operate, albeit at a lesser level of profitability, it is during that time period that a claim for lost profits may be determined. If, subsequently, the plaintiff’s business ceases to operate, the plaintiff may then claim a loss of business value. The terms under which either loss can be claimed run consecutively, not concurrently, as the financial expert must make sure he or she is not “double dipping” in calculating the plaintiff’s loss. The financial expert must employ an approach that puts the plaintiff in the same financial position had it not been for the damaging act and does not provide an economic windfall to the plaintiff.
There are many similarities (and differences) between a lost profits damage calculation and a business valuation. The financial expert tasked with quantifying the economic loss must take into consideration the most appropriate approach in order to make the plaintiff whole and restore their financial position, had the damaging act not occurred. The approach chosen must take into account the facts and circumstances of the case and applicable case law in order to provide a reliable loss calculation that can be relied upon by a trier of fact.