Attorneys involved in commercial litigation need to understand the relationship between prospective lost profits and lost business value derived from income properties. These two measures of damages have a lot in common, but their differences — which can be subtle — are a frequent source of confusion. Familiarity with the underlying concepts can help ensure that damages are accurate and not double counted.
More alike than different
Lost profits and lost business value often involve similar methodologies, particularly when a business is appraised using the income method.
To calculate future lost profits, experts project future income streams and discount them to present value. In doing so, they apply a discount rate that reflects both the time value of money and the risk associated with uncertain future income. Damages are measured by the difference between the plaintiff’s expected profits during the future damage period with and without the defendant’s alleged wrongful conduct.
When using the income method to estimate lost business value, the valuator assumes a future income stream based on historical results or actually projects future income and discounts it to present value. The primary difference between lost profits and lost business value then is that the former measures lost income over a discrete damages period, while the latter measures it over the life of the business or into perpetuity.
You might even characterize lost profits as a form of valuation that applies to a portion of a business rather than the enterprise as a whole. Thus, lost profits typically are used to measure damages when a business suffers an interruption or temporary loss, while lost business value usually is applied when a business is destroyed.
Even if a company continues to operate, however, lost business value may be an appropriate measure of damages. For example, a defendant’s conduct might cause permanent damage to a portion — such as a division or product line — of a business.
Matter of perspective
Despite the similarities between future lost profits and lost business value, there are some differences worth noting. For one thing, although the income method is weighted more heavily, business value generally is determined by combining the income, market and asset methods. Also, unlike lost profits, business value may be calculated by incorporating marketability discounts or control premiums.
But perhaps the most important difference is one of perspective. Fair market value commonly is defined as the price at which an asset would change hands between a hypothetical buyer and seller when neither is compelled to buy or sell and both parties have reasonable knowledge of the relevant facts. Lost profits, on the other hand, are viewed from the plaintiff’s perspective. An expert measuring lost profits, for example, might consider factors — such as the reputation of a plaintiff owner — that could enable the plaintiff to generate more profits than a hypothetical outside buyer.
Similarly, the risk associated with future income may be viewed differently depending on whether the plaintiff will continue to operate the business or a hypothetical buyer will take over.
20/20 vision
Another potential difference is the role hindsight plays. Lost business value is the difference between the plaintiff’s value immediately before and after the defendant’s wrongful conduct. Lost profits, on the other hand, is the difference between the present values of projected pre-injury and post-injury profits. When measuring business value, experts generally are limited to considering facts that are known or reasonably knowable by hypothetical buyers and sellers as of the valuation date. Events that occur after that date, but before trial, usually aren’t considered. When measuring lost profits, on the other hand, it may be appropriate to consider the effect of subsequent events. Theoretically, lost business value and lost profits should be roughly the same, but this difference in perspective can cause the two to diverge.
Given the differences between lost profits and lost value, a plaintiff — at least in theory — could win lost profits damages that exceed the value of the business. For example, lost profits might be based on a lower discount rate than a business valuation, under the assumption that the plaintiff’s continued operation of the business reduces the risk.
Be prepared
Whether you represent the plaintiff or defendant in commercial litigation, it’s important to have a basic understanding of lost profits and lost business value. Knowing how they differ and where they overlap will help you support your own damages theory or rebut your opponent’s position.
SIDEBAR
How to avoid double dipping
Can lost profits and lost business value be recovered in the same case? The answer, as in many legal matters, is “it depends.” Both types of damages may be appropriate provided they relate to different time periods. In “slow death” cases, for example, a business that suffers reduced profits for a period of time and eventually goes out of business might recover lost profits for the initial period and lost business value as of the “date of death.”
Recovery of lost profits and lost business value for the same time period, however, generally involves counting the same lost income twice, or “double dipping.” A common misconception — even among many judges — is that double dipping is a concern only when the income method of valuation is used. But even if an expert uses the market or asset method, value is derived from the business’s potential to generate income in the future. In most cases, it’s inappropriate to apply both measures of damages to the same time period.
Case in Point - Issue 4