Differentiating between Lost Profits and Lost Business Value by Kathryn Solomon, CPA
Posted on September 18, 2023
by
Scott Bouchner
An economic damages case aims to make the plaintiff “whole” again. There are two methods by which damages may be calculated: an appraisal of the value of the business as of the date of loss and a measure of the plaintiff’s loss of profits. What is the correct measure of damages to use in your case? Could both be applicable? To answer these questions, it is important to remember the purpose of the damages calculation and to acknowledge that each situation has specific facts and circumstances, precedent and case law.
Lost profits are a measure of damages that occur when a business or a segment of a business continues to operate but suffers reduced income for a finite period. The damages measurement is calculated for the period until the business regains the position it would have been in had the alleged damaging act not occurred. During this time, lost profits are measured for the incremental change in revenue directly attributable to the incident. The increase or decrease in expenses related to the incident is also recognized. Lost profits are commonly used in matters involving breach of contract, intellectual property, and general commercial litigation. They are generally calculated before the deduction on income taxes because lost profits awards are taxable upon recovery.
Conversely, lost business value occurs when a company never commences operations, ceases all or part of its operations, or permanently loses a segment of its business. It is used commonly in matters involving shareholder oppression, dissenting shareholders, tax court, family law and business destruction.
There are three generally accepted approaches for determining lost business value; all are performed before and after the date of harm. The asset-based approach, which involves calculating the net equity of the business, is used most often for holding companies. The income method determines the value of the business by applying a capitalization rate or a discount rate to the expected future earnings to arrive at the present value. In both situations, it is essential to apply normalization adjustments so that projected earnings only reflect net income. Finally, the market approach bases a business’s value on transactions of similar companies in the marketplace. The income approach and the market approach are commonly used for operating companies. Business valuations
One of the fundamental differences between lost profits and lost value is the expected duration of the loss. While every case is different, there are situations when business valuation almost always wins out over lost profits. Financial experts perform business valuations to determine the value of an entire company or a specific ownership interest in that business.
Is it possible to have both lost profits and lost business value? The simple answer is yes, but only if the damages are not duplicative – a rare occurrence. One such case would be if a company suffers a “slow death” because of an incident that causes the business to continue operations at a reduced level before ultimately failing. In such a situation, lost profits would be calculated for the period that the company continued operating, and lost value would be measured and applied as of the date the business ceased operations.
While the various methods utilized between valuations and lost profits often produce similar measurements, courts can prefer one approach over another. Therefore, it is advisable to consider measurements under all methodologies before concluding on the approach that best fits the case at hand. Forensic accountants can help determine the best method to use and calculate the appropriate measurement, be it lost profits, lost business value or both.
Kathryn Solomon, CPA, is a manager with the Forensic and Advisory Services Practice of Berkowitz Pollack Brant. She can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com
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