Black and Blue, Inc.
Impaired businesses need a thorough assessment of economic damages

From breach of contract and patent infringement to outright negligence, commercial torts often give rise to economic damages. In these cases, it’s critical to put a precise dollar amount on how much business the company stands to lose. And many factors go into this assessment.

A formal (but concise) thesis - Most valuators start with a generic “theory of damages” statement. For instance, a basic preliminary statement might be:

But for ABC Manufacturing Co.’s breach of the parties’ exclusive supply contract, XYZ Supply Co. would have sold more widgets.

As the valuator reviews financial information and conducts additional research, he or she refines the theory of damages and fills in the holes.

The conclusion should address specific assumptions and parameters, such as decreased sales volume, incremental profits per unit and duration of the damage period. To illustrate, the previous example might evolve into:

But for ABC’s purchase of 1 million widgets from alternate suppliers, which violated the parties’ exclusive supply contract, XYZ would have sold another 1 million widgets to ABC at an incremental profit of $0.50 each over the 12 months remaining until the contract’s expiration.

A fine-tuned thesis helps the litigants, judge and jury quickly evaluate the validity of the valuator’s final conclusion.

3 popular methods for calculating damages - Arriving at a succinct theory of damages takes time and diligence. Valuators generally use the following three approaches to estimate lost profits or diminished business value:

1. The before-and-after method - This approach assumes that, if it hadn’t been for the tortious act, the company’s operating trends would have continued in pace with past performance. In other words, damages equal the difference between expected and actual performance. A similar approach quantifies damages as the difference between the company’s value before and after the alleged tort occurred.

2. The yardstick method - Under this approach, an appraiser benchmarks a damaged company’s performance to external sources, such as publicly traded comparables or industry guidelines. The presumption is that the company’s performance would have mimicked that of its competitors if not for the tortious act.

3. The sales projection method - Here a valuator relies on subjective estimates of a company’s probable cash flow. Damages involving niche players and startups often call for the sales projection method, because they have limited operating history and few meaningful comparables.

An appraiser considers the specific circumstances of the case to determine the appropriate valuation method (or methods) for that particular situation.

The next step - After they’ve projected lost profits, valuators discount their projections to present value. Some jurisdictions have prescribed discount rates, but, in many instances, appraisers subjectively build up the discount rate based on their professional opinions about risk.

Small differences in the discount rate can generate large differences in valuators’ final conclusions. As a result, the subjective discount rate is often a contentious issue.

Finally, valuators address mitigating factors. What could the damaged party have done to minimize its loss? Most jurisdictions hold plaintiffs at least partially responsible for mitigating their own damages. Similar to discount rates, this subjective adjustment often triggers widely divergent opinions among the parties involved.

A tricky matter - Calculating economic damages is necessary in many different sets of circumstances — but, because of the large number of subjective factors, doing so can be tricky. Valuators use several different methods and consider both financial and nonfinancial factors to ensure their calculations are as sound as possible.

Sidebar: Calculating the whole truth (and nothing but)

The ultimate goal of any economic damages resolution is to make the plaintiff “whole” again. Some key factors need to be considered to ensure this happens and avoid over- or underestimating a damaged business’s loss. Here are three important considerations:

1. Taxation of damages - Most damage awards are taxable. If the plaintiff must pay taxes, an after-tax assessment will be inequitable. Also realize that some parts of a damage award, such as return of capital, may be nontaxable and require an after-tax estimate.

2. Application of a pretax discount rate - Calculating pretax damages requires the use of pretax discount rates. Mismatching after-tax discount rates to pretax cash flows would overstate damages, all else being equal.

3. Assumption that damages will occur over a finite period - Economic damages generally occur over a finite period. That is, they have a beginning and an end. Eventually plaintiffs can overcome the effects of tortious actions. Some financial experts, however, incorrectly assume that damages will continue into perpetuity.

If time and budgets permit, allow your expert an opportunity to review the opposing expert’s analyses. He or she may find that the opposition didn’t take into account one or more of these key factors.