Disputes in businesses often result in legal proceedings in which a claim is made. These claims may vary depending on the nature of the complaint or the breach that necessitates them, but at their core are economic damage quantifications or lost profits that resulted from the dispute.
In providing litigation support to business owners and lawyers, business valuators work to provide the party they are consulting with or serving as an expert witness for with lost-profits determinations, which can be derived from three approaches:
- Before- and-After Approach
- Yardstick (Comparison) Approach
- Sales Projection (“But For”) Approach.
Learn more about each of these approaches to economic damages quantification, a key part of business valuation for litigation support:
Before-and-After Approach
This method requires the business valuator to estimate their client’s “but for” profit during the affected or damage period – or more simply, the gross revenue and profits thereon that would have been earned, if not for the alleged wrongful act committed by the defendant. These are estimated are based on:
- results obtained prior to the alleged damaging acts committed by the defendant; and
- results after the effects of said alleged acts have subsided.
Either one or both of these estimates are compared to those of the plaintiff’s during the damage period set in the case.
A key factor to consider when adopting this approach in business valuation and damage quantification is the valuator’s ability, serving as an expert witness, to establish and prove a plaintiff’s track record, using the pre- and post-damage periods as benchmarks. The expert’s analysis should include various factors such as seasonality affecting the business, which could exacerbate the amount of lost profits. In most cases, only either the “before period” or the “after period” is available for predicting the “but for” results for the plaintiff during the affected period.
Yardstick Approach
The Yardstick Approach is suitable for cases wherein the plaintiff does not have enough time spent or involvement in the business that would define a historical financial track record. As a result, business valuators calculate the plaintiff’s profits during the damage period by comparing these to similar companies or set against industry performance.
Some challenges arise from the use of this approach in providing litigation support through business valuation and damage quantification. For one, it can be difficult to properly identify the similar companies, businesses, or industries to derive substantial comparisons, which can result in a degree of subjectiveness factoring into the lost-profit determination. To mitigate this, valuators must obtain and analyze financial and operating information on companies serving as ‘guidelines’.
Apart from using the financial data of similar businesses, a comparable but unaffected division or branch of the plaintiff’s business can serve as a benchmark, provided that said division or branch has similar characteristics, such as comparable size, demographics, and location, among others. A regression analysis can better support the findings from this approach.
Sales Projections Approach
Adopting this approach requires creating a model for the damaged business derived from assumptions on how the plaintiff’s business would have performed in the market, if not for the adverse effects stemming from the defendant’s alleged damaging acts. In this approach, the plaintiff’s projected profits are estimated during the damage period, “but for” the effects of the defendant’s alleged acts, then compared to the actual profits earned by the plaintiff during the damage period.
Business valuators calculate lost profit as the excess of the projected results set against the actual ones over the damage period, while taking into account the extent of which the value of the business, as a capital asset, suffered from the damage. A small caveat to the resulting calculation is that the total amount of profits lost over the damage period cannot exceed the amount of future profits that the business expected to earn prior to the damage.
The Sales Projection Approach requires a proven historical financial track record that supports the projected profits, along with empirical data and industry publications that forecast industry growth and profitability.