Damages Litigation-Diminution of Business Value

2012 LSU Fraud and Forensic Accounting Conference

[July 23-24, 2012]

Table of Contents

I. Diminution of Business Value Methodology

II. Lost Revenue

III. Cost Estimation

IV. Present Value Calculation

V. Other Considerations

VI. Example

Section I - Diminution of Business Value Methodology

Diminution of Business Value Methodology

The difference between:

1. the value before the event in dispute, where the value may be calculated as the present value of the future cash flow projections; and

2. the value after the event has occurred, where the value may be calculated as the present value of the future cash flow projections after consideration of the value-impairing event.

What is the Diminution of Business Value?1

Diminution of Business Value Methodology

Diminution of Business Value• Business value is more holistic in utilizing

– Income approach– Market approach– Cost/Asset approach

• Like measuring the difference between the areas of two circles

Loss of Profits• Considers differences in income (comparable to an

income approach in business valuation)• Like measuring the distance between two points

Diminution of Business Value vs. Lost Profits

In either method, future cash flows must be determined in a “but for” scenario.

The divergence occurs by differences in inputs, assumptions, and timing.

Diminution of Business Value Methodology

Future cash flows that would have occurred “but for” the breach or wrongful act must be estimated, as determined by estimations regarding:

• Lost revenues• Cost avoidance

Variations in value can occur because of differences in timing of:• The event date• The litigation date• The valuation dateThis may require moving cash flows backwards and forwards in time, multiple times.

Determining Future Cash Flows

Section II - Lost Revenue

Lost Revenue

1. Before and After2. Benchmark3. Specific Models

Methodologies

Lost Revenue

• “But for” analysis• But for the defendant’s action, the plaintiff’s revenues would have continued to grow at x%• Based on plaintiff’s historical performance and trends

Example: “But for” scenario revenues – 2.5% annual growth based on historical trendLess: Actual scenario revenuesLost Revenues

Before and After

20X0 20X1 20X2 20X3 20X4 20X5 20X6 900,000

950,000

1,000,000

1,050,000

1,100,000

1,150,000

1,200,000

"But for" scenario Actual scenario

Event Year

Lost Revenue

Lost Revenue

Complications• New business with no or short history of operations

Before and After

Lost Revenue

• Actual vs. Budget/Projections• Actual performance of similar business• Industry averages

Complications:• Requires budgets/projections created prior to the event• Application of similar business or industry benchmarks may be unwise in events with regional or industry

consequences, e.g. April 2010 BP oil spill• Business is new or unique, e.g. internet or high-tech companies

Benchmark

Lost Revenue

Contract TermsIf litigation is in regards to breach of contract or the plaintiff’s business is contract based, a reasonable estimate

of the “but for” scenario could be made assuming the contract were fulfilled according to the terms of the contract, including:

• Volume• Price/cost per unit

Defendant’s Revenues• Identify revenues associated with the misappropriation of trade secrets

Specific Models

Lost Revenue

• Capacity– Capital resources– Labor/technological resources– Consumer demand

Universal Commodities, Inc. v. Weed, 449 S. W. 2d 106 (Tex. Civ. App. 1969)• Defendant breached contract, but no damages awarded because plaintiff did not have financing

or capital to operate business even if contract were performed

Sanity Check

Lost Revenue

• Market share– Is the growth rate reasonable?Example:

• Industry and other considerations– Profits attributable to factors other than misappropriation or any harmful act would not have to be

disgorged. This is particularly true in certain cases, such as when using the defendant’s revenue methodology or valuing a patent that may be used in combination with other value creating features

Sanity Check

Year 0 1 2 3 4 5Industry Revenues 100,000,000 100,000,000 100,000,000 100,000,000 100,000,000 100,000,000Industry Revenue Growth 0.0%Plaintiff Market Share 5.0% 5.5% 6.1% 6.7% 7.3% 8.1%Plaintiff Revenue 5,000,000 5,500,000 6,050,000 6,655,000 7,320,500 8,052,550Plaintiff Revenue Growth 10.0%

Section III - Cost Estimates

Cost Estimates

Avoided costs are “costs that would have been incurred in connection with the generation of the lost revenues but were not incurred.”2

Costs incurred by the plaintiff that would not have been incurred except for the actions of the defendant can be offset against avoided costs.

What Are Avoided Costs?

Cost Estimates

• Defendant’s costs are irrelevant• Costs must be examined within the plaintiff’s cost structure

– Analyze historical financial statements and projections

Fixed vs. Variable• Methods of Estimation• Sanity Check

Plaintiff’s Cost Structure

Cost Estimates

Fixed costs are usually not avoidable. Variable costs, those that vary with revenues that would therefore not be incurred “but for” the sale, are usually avoidable.

• Cost of goods sold– Vary with lost revenue

• Inventory accounting methods create differences between plaintiff’s and defendant’s CoGS• Direct costs

– Vary with lost revenue• Overhead costs

– Generally unavoidable, e.g. rent– Can be attributed to revenue in some cases, e.g. marketing/advertising

• Indirect costs– Fixed or variable, sometimes avoided, sometimes not

Fixed vs. Variable Costs

Cost Estimates

Nonstatistical• Account analysis

– Fixed/variable decision left to the subjectivity of the analyst based on review of financial statements• Direct costs

– Specifically identifies the input costs, such as direct labor and materials• Cost accounting allocation

– Allocates indirect costs based on variable measures, such as revenue or units sold

StatisticalQuantitative identification of relationships through:• Regression analysis• Survey data• Attribute samplingRequires understanding of statistical methods and rules

Methods of Estimation

Cost Estimates

Cost estimation can be complicated. For example:• Plaintiff launched new product line without cost history

– Solution: Estimate costs based on similar businesses or industry averages• Product line is entirely new

– Solution: Rigorous identification of direct costs

Sanity Check

Cost Estimates

In determining lost revenues and estimating costs, assumptions must be made considering:• The business plan• Capital resources• Plaintiff’s experience• Industry factors (barriers to entry, etc.) and trends (growing market, etc.)• Economic factors (business cycle, etc.)

General Guidelines for New Businesses

Section IV - Present Value Calculation

Present Value Calculation

Ex Ante• Assumes all lost profits are future lost profits, i.e. valuation is made as of the date of the event or harmful

action by the defendant and all cash flows are discounted to this date• The value is then brought forward to the date of the award• Only knowledge known as of the event date may be considered in the valuation

Ex Post• Assumes some lost profits are historical (occurring prior to the date of the award) and some are future

(occurring following the date of the award• Historical profits may be brought forward to the date of the award, and future profits are discounted to the

date of the award• Neither historical nor future profits are ever discounted to the date of the event• All knowledge known as of the date of the judgment may be considered in the valuation

Ex Ante/Ex Post Methodologies

Present Value Calculation

Lost profits and diminution of business value diverge on the basis of what precisely is to be discounted.Diminution of Business Value MethodsNet Cash Flow to EquityNet Income (after taxes)+ Noncash Charges (e.g.) depreciation, amortization, deferred taxes)– Capital Expenditures (the net changes in fixed and other non current assets)*– Changes in Net Working Capital*+ Net Changes in Long-Term Debt*= Net Cash Flow to EquityNet Cash Flow to Total Invested CapitalNet Income Available to Shareholders (after taxes)+ Noncash Charges– Capital Expenditures*– Changes in Net Working Capital*+ Interest Expense, Net of the Tax Benefit (interest expense x [1 – tax rate])= Net Cash Flow to Total Invested Capital* The amounts are the levels necessary to support projected business

Measures of Cash Flow

Present Value Calculation

The lost profit method does not fully develop the estimates needed to determine net income or cash flows.

Lost Profits Method“But for” Sales– Impaired Sales= Lost Sales– Avoided Costs= Lost Profits

Use of a cash flow based method is better for determining damages when large capital expenditures are required at the outset or occur irregularly over the life of the project.

Measures of Cash Flow

Present Value Calculation

As always, the discount rate must match the cost of generating the profits to be discounted.• Risk-free rate• Plaintiff’s cost of debt• Plaintiff’s cost of equity• Plaintiff’s weighted average cost of capital• Rate of return on a similar investment

Selection of an appropriate rate depends on unique circumstances such as:• Were the lost profits generated from a business line that is inherently riskier than what is reflected in its

WACC?• Is the company still a going concern following the event or harmful act?• What are the company specific risks?

The courts have provided little guidance on the issue of selecting an appropriate discount rate.

Discount Rate

Present Value Calculation

• Availability of capital– Was capital invested before the damaging event occurred?

• Plaintiff’s experience• Experience of others• Barriers to entry• Economic factors

Assessment of Risks

Present Value Calculation

If the event or harmful act causes the business to fail, the market value of the business can be awarded as damages.

• Costs incurred in winding up and liquidating the business should be included in the valuation• Damages from a “slow death” in which the company fails a number of periods after the event can include

the diminution of business value and lost profits in the period between the event and the failure of the business

Failure of the Going Concern

Section V - Other Considerations

Other Consideration

• Diminution of business value typically presumes valuation of cash flows into perpetuity• Limitations on how many years of loss can be recovered means the terminal value cannot grow into

perpetuity– E.g. contract limitations, intellectual property

Consider the declining value of cash flows over long periods of time.Example: $1,000 annual cash flow in perpetuity, discounted at 10%

Loss Period

% of Value Captured10 year period of cash flows $6,145 61%20 year period of cash flows $8,514 85%40 year period of cash flows $9,779 98%50 year period of cash flows $9,915 99%100 year period of cash flows $9,999 100%Perpetuity $10,000

Other Consideration

• Damages are generally taxable as ordinary income

• Pre-tax or post-tax discount rates?

Taxes

Other Consideration

Historical cash flows may need to be moved forward. Courts have considerable discretion in determining the interest rate on pre-judgment damages. Interest rate selection and application varies across jurisdiction.

• Statutory rates• Risk-free rates• Plaintiff’s cost of capital• Defendant’s cost of debt• Simple interest or compound interest

Interest

Other Consideration

Patents:• Damages cannot be less than the amount of a reasonable royalty

Copyrights and Trademarks:• Lost profits method, royalty rates, decline in market value of copyrighted material

Intellectual Property Methodologies

Other Consideration

Plaintiffs’ seek damages resulting from failure to disclose adverse information.• Reversal of scenarios: Diminution of business value is the difference between the price paid for the

securities (the actual scenario) and the value of the securities had the information been known at the time of purchase (the “but for” scenario)

• Must account for more factors than only the decline in price when the information did become available

Securities Fraud

Section VI - Example

ExampleStolen Product Line

Actual % New Product % “But for” %

Revenue 10,000,000 2,000,000 12,000,000

Costs Materials 4,000,000 40% 400,000 20% 4,400,000 37%

Labor 3,000,000 500,000 3,500,000

Factory costs 1,000,000 0 1,000,000Direct costs 8,000,000 900,000 8,900,000

Gross Profit 2,000,000 20% 1,100,000 55% 3,100,000 26%

Overhead 1,000,000 100,000 1,000,000

Pretax Income 1,000,000 10% 1,000,000 50% 2,100,000 18%

ExampleStolen Product Line

Actual % New Product % “But for” %

Launch Costs

Factory changes 100,000Marketing 50,000

Working capital costs 300,000

Discount rate 18% 18%

New product line risks 5%Large diversified company -2%

Total discount rate 18% 21%

ExampleStolen Product Line

Year 0 1 2 3 4 5 T

Pretax income 0 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

Launch costs 450,000Discount factor (21% discount rate)

1.000 .826 .683 .564 .467 .386 .319

Present value 450,000 826,446 683,013 564,474 466,507 385,543 318,631

Sum of years 0-5 2,475,984 Terminal Year Multiple 10.0x 3,186,308

Sum of yearly cash flows and terminal value

5,662,293

Sanity Check: Market Capitalization to EBITDA

5,662,293 = 5.66x1,000,000

Contact

Chaffe & Associates, Inc.201 St. Charles Avenue, Suite 1410

New Orleans, LA 70170-1410504.524.1801

A copy of this presentation and other resources are available atwww.chaffe-associates.com