lost profits vs business valuation final 091809

Lost Profits vs. Business

Valuation

Georgia Society of CPAs

Fraud & Forensic Accounting Conference

September 18, 2009

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Resources/Skills

Important to stay current

Expert witnesses need to know acceptable methodology

Great use of CPA and forensic accounting skills (skills not possessed by pure finance people)

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Two damage claim possibilities, one

exception

1. If the business is completely destroyed, the damage equals the market value of business on the date of the loss event.

2. If the business is not completely destroyed, the damage equals the lost profits due to the loss event.

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Two damage claim possibilities, one

exception

Exception:

This may occur if the business isn’t initially completely destroyed and continues to operate for a period of time before closing.

In this case, the damage may be equal to lost profits for a certain period of time followed by the value of the business from the date of the shutdown forward.

NO DOUBLE DIPPING

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Case Example: Valuation as Sanity

Check on Lost Profits

Business struggled but wasn’t shut down

Claimed lost profits were extremely high

Business valuation highlighted the overstated lost profits claim

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Reasoning behind the

litigation exception

The rules of the game don’t change for litigation

Estimates still must be developed using sufficient competent evidence and methods and techniques accepted by knowledgeable practitioners

Documentation needs may change since the work product is subject to discovery and cross-examination.

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Lost Profits

The goal is to put the plaintiff is the same position as it would have been “but-for” the defendant’s actions that gave rise to the alleged damages

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Lost Profits

Lost profit damages are typically measured for a specific, limited, time period (and not into perpetuity).

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Lost Profits

General Approach

The loss is the difference between the profits the business would have earned during the loss period, less what it actually earned during the loss period

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Two ways to perform the calculation

Using all of the company’s expenses in both the “would have” and “did” scenarios (usually only the variable expenses and some other expenses differ; fixed expenses continue under either scenario).

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Two ways to perform the calculation

Using only incremental revenues less avoided costs

In either case, the result should be the same – mixing these concepts causes trouble

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Lost Profits

If losses extend into the future, they are present valued at the appropriate discount rate, usually to the date of the trial

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Business Valuation

Determine the business’s lost future cash flows into perpetuity (what the business would have produced, using all revenues and expenses)

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Business Valuation

Discount lost future cash flows to present value as of shutdown date

Question: Enterprise value or equity value?

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Lost Profits

Profits or cash flow?

Does this matter? (In operating businesses, is cash flow usually higher or lower than earnings?)

Do older lost profits court cases contemplate cash flow?

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Lost Profits

Considerations related to loss period determination include changes in:

Competition

Technology

Regulation

Economy

Real-world events (9/11)

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Duty to Mitigate

A duty to mitigate is imposed on the claimant. This could also apply to business valuation, for example related to salvage value.

The Eighth Circuit in 2007 noted: “Calculating the value of an asset at liquidation or disposition is a necessary part of the discounted cash flow analysis.”

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Mitigation issues

Lost Profits

Business Valuation – If a DCF shows a negative “value” is the business worth nothing?

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Case Example: Damages from

Failure to Deliver Fixed Assets

Seller estimated the fixed assets that would be included in the sale

Purchaser was only able to find 90% of the income-producing fixed assets that they expected.

Economist hired by the purchaser estimated lost profits of $750 thousand for the next twenty years.

What is wrong with this picture?

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Lost Profits

Courts have been reluctant to award lost profits damages over extended periods due to the speculative nature of the underlying projections

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Business Valuation

How are the cash flows used in the income approach portion of a business valuation determined?

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Business Valuation

Eighth Circuit also noted that “Delaware courts and the financial community have recognized the discounted cash flow model as a preeminent valuation methodology.”

Fifth Circuit in 2004 noted that lost asset damages from a breached agreement were “determined by considering what a hypothetical buyer would pay for the chance to earn future profits.”

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Case Example: Acquisition of a

Financing Company

Accounting firm advised purchaser of a financing company on the appropriate accounting treatment for the purchase price.

Substantial amount was assigned to goodwill by the accounting firm.

In subsequent years the goodwill was deemed to be unimpaired by DCF analysis performed by the accounting firm even though the Company lost $$$ millions.

What is wrong with this picture?

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Do the Research

Understand near term future of subject

Company

Industry

Economy

Other conditions

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Subsequent Events

Business Valuation – Generally, a business valuation will not take into account subsequent events unless the facts were known or knowable.

Lost Profits – A lost profits analyst must take post-breach events into consideration.

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Estimates at a tipping point

Would there be a difference between an estimate of business value with a valuation date of 8/31/08 and an estimate of lost profits from an event occurring on that date?

What happened to change the world after that date?

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Income Taxes

Lost Profits

Lost profit damages are usually taxable income to the recipient

Avoid double deduction for taxes (once during the calculation and second upon actual payment)

Lost profits computation doesn’t take into account income taxes

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Income Taxes

Business Valuation

Lost business value is the price a willing buyer would pay to a willing seller

Hypothetical buyer seeks a cash return on a business investment after payment of all business expenses, including income taxes.

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Case Example: Valuing a

Healthcare Practice

Pass-through entity being sold to a nonprofit entity

IRS and OIG for HHS require that business valuation estimates treat the business as though it was a tax-paying entity.

National valuation firm took projected income, applied depreciation expense, and calculated hypothetical tax burden on the balance in order to estimate cash flows.

What is wrong with this picture?

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Discount Rate

Lost Profits

Based on:

Risk-free rate

Risk assessment, or

Plaintiff’s use of funds

Business Valuation

Based on:

Risk assessment

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Prejudgment and post-judgment

interest

Lost Profits

Both considered

Business Valuation

Both considered

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Thank you for participating

James F. Hart

Managing Director, Lightfoot Group

jhart@lightfootgroup.com

Bill Black

William H. Black, PC

whb@billblackcpa.com

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