Recovery of Business Damages: Valuation vs. Lost Profit
Eugenia Larmore, MBA, CMA, AVA, CFFA

There is some confusion as to when a lost profit or business valuation methodology should be used to determine the amount of business damages. Though both lost value (business valuation) and lost profit methodologies are used to determine business damages and though they share many economic and financial principles, the two methodologies are not interchangeable and can result in different outcomes. This article describes the two methodologies and provides some basic differences between the uses of these methodologies in business damages cases.

The goal of a damages case is to restore the plaintiff to the financial position he or she would have held “but for” the actions of the defendant. Both the lost profits and business valuation methodologies can accomplish this, though through different calculations and assumptions. Courts have considered and ruled on the issue, including this ruling in the case of Protectors Insurance Service, Inc. v. U.S. Fidelity & Guaranty Co.

"When the loss of business is alleged to be caused by the wrongful acts of another, damages are measured by one of two alternative methods: (1) the going concern value; or (2) lost future profits. The courts allow a plaintiff to recover either the present value of lost future earnings or the present market value of the lost business, but not both." Protectors Insurance Service, Inc. v. U.S. Fidelity & Guaranty Co., 132 F.4d 612 (10th Cir. 1998).

Regarding when each methodology should be used, the ruling from Montage Group, Ltd. v. Athle-Tech Computer Systems, Inc. provides a good rule of thumb.

“If a business is completely destroyed, the proper total measure of damages is the market value of the business on the date of the loss…If the business is not completely destroyed, then it may recover lost profits. A business may not recover both lost profits and the market value of the business.” Montage Group, Ltd. v. Athle-Tech Computer Systems, Inc. 889 So.2d 180, 191 (Fla. App. 2004).

The lost profit methodology requires the expert to estimate the level of profit the plaintiff would have earned had the defendant’s action that caused the damage not occurred. This amount is then adjusted by profits actually received by the business and projected to be received by the business in the future, subsequent to the damaging event. The difference between the “but for” and actual profit is the lost profit in this case, the earnings impairment caused by the actions of the defendant. As much of this lost profit is expected to occur in the future, the lost stream of profits should be discounted by an appropriate rate of return to arrive at a present value.

The lost profit methodology assumes that the earnings impairment is a temporary situation and estimates damages only during the impairment period. The length of the impairment period, as well as projected lost profits during this period, will vary from case to case; requiring the expert to review and weigh all information available. The impairment period usually begins at the date of the damaging action and continues until the plaintiff’s loss has stopped or has been mitigated. The expert must consider all events taking place from the start of the damaging action through the end of the impairment period, including plaintiff’s mitigation efforts.

The business valuation methodology estimates the value of a business or the value of a partial ownership of a business. There are three valuation approaches (1) the asset approach, (2) the market approach, and (3) the income approach. The income approach is the most widely used of the three approaches and is the most similar to the lost profits methodology. Similar to the lost profits calculation, the cash flow generated by the business can be estimated “but for” the defendant’s actions. This cash flow must be adjusted by the appropriate discount rate to arrive at the value of the business lost due to the actions of the defendant. Any profits realized from the liquidation of business assets after business closure must be subtracted from the lost business value.

Unlike the lost profit methodology, a business valuation assumes the business has been irreparably damaged; the resulting lost value is a permanent, rather than a temporary situation. Similar to the lost profit calculation, the business experiences a loss of future cash flows; however, in this case the loss is estimated into perpetuity.

Although each case is unique, lost profit methodology is typically more appropriate in cases of breach of contract and intellectual property infringement. Business valuation is applied almost exclusively in shareholder oppression, dissenting shareholder, family law and tax court matters. In addition, business valuation is appropriate in cases of permanent business value impairment such as merger and acquisition disputes, defamation, slander and intentional business destruction.

This article provides a brief description of the lost profit and business valuation methodologies and the appropriate uses for these methodologies in business damages cases. This discussion is by no means comprehensive nor exhaustive. Additional consideration must be given to tax implications of damage estimates, discount rates, mitigation events, the appropriateness of the use of both methodologies, and more. It is important for the attorney and the expert to meet and discuss the specifics of each case and determine the appropriate methodology for the estimate of business damages.

This article is based on the professional experience of the author and information provided in The Comprehensive Guide to Lost Profits Damages for Experts and Attorneys, Nancy J. Fannon, Editor. 2011 Edition.

As Published in The Writ, April 2012.