Lost Profits Vs Business Valuation Final 091809
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Lost Profits Vs Business Valuation Final 091809

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Presentation to GSCPA Fraud and Forensic Accounting Conference - September 18, 2009

Presentation to GSCPA Fraud and Forensic Accounting Conference - September 18, 2009

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  • 1. Lost Profits vs. Business Valuation Georgia Society of CPAs Fraud & Forensic Accounting Conference September 18, 2009 1
  • 2. Resources/Skills  Important to stay current  Expert witnesses need to know acceptable methodology  Great use of CPA and forensic accounting skills (skills not possessed by pure finance people) 2
  • 3. Two damage claim possibilities, one exception 1. If the business is completely destroyed, the damage equals the market value of business on the date of the loss event. 2. If the business is not completely destroyed, the damage equals the lost profits due to the loss event. 3
  • 4. Two damage claim possibilities, one exception Exception: This may occur if the business isn’t initially completely destroyed and continues to operate for a period of time before closing. In this case, the damage may be equal to lost profits for a certain period of time followed by the value of the business from the date of the shutdown forward. NO DOUBLE DIPPING 4
  • 5. Case Example: Valuation as Sanity Check on Lost Profits  Business struggled but wasn’t shut down  Claimed lost profits were extremely high  Business valuation highlighted the overstated lost profits claim 5
  • 6. Reasoning behind the litigation exception The rules of the game don’t change for litigation  Estimates still must be developed using sufficient competent evidence and methods and techniques accepted by knowledgeable practitioners  Documentation needs may change since the work product is subject to discovery and cross-examination. 6
  • 7. Lost Profits The goal is to put the plaintiff is the same position as it would have been “but-for” the defendant’s actions that gave rise to the alleged damages 7
  • 8. Lost Profits Lost profit damages are typically measured for a specific, limited, time period (and not into perpetuity). 8
  • 9. Lost Profits General Approach The loss is the difference between the profits the business would have earned during the loss period, less what it actually earned during the loss period 9
  • 10. Two ways to perform the calculation  Using all of the company’s expenses in both the “would have” and “did” scenarios (usually only the variable expenses and some other expenses differ; fixed expenses continue under either scenario). 10
  • 11. Two ways to perform the calculation  Using only incremental revenues less avoided costs In either case, the result should be the same – mixing these concepts causes trouble 11
  • 12. Lost Profits  If losses extend into the future, they are present valued at the appropriate discount rate, usually to the date of the trial 12
  • 13. Business Valuation Determine the business’s lost future cash flows into perpetuity (what the business would have produced, using all revenues and expenses) 13
  • 14. Business Valuation Discount lost future cash flows to present value as of shutdown date Question: Enterprise value or equity value? 14
  • 15. Lost Profits  Profits or cash flow?  Does this matter? (In operating businesses, is cash flow usually higher or lower than earnings?)  Do older lost profits court cases contemplate cash flow? 15
  • 16. Lost Profits Considerations related to loss period determination include changes in:  Competition  Technology  Regulation  Economy  Real-world events (9/11) 16
  • 17. Duty to Mitigate A duty to mitigate is imposed on the claimant. This could also apply to business valuation, for example related to salvage value. The Eighth Circuit in 2007 noted: “Calculating the value of an asset at liquidation or disposition is a necessary part of the discounted cash flow analysis.” 17
  • 18. Mitigation issues  Lost Profits  Business Valuation – If a DCF shows a negative “value” is the business worth nothing? 18
  • 19. Case Example: Damages from Failure to Deliver Fixed Assets  Seller estimated the fixed assets that would be included in the sale  Purchaser was only able to find 90% of the income-producing fixed assets that they expected.  Economist hired by the purchaser estimated lost profits of $750 thousand for the next twenty years.  What is wrong with this picture? 19
  • 20. Lost Profits Courts have been reluctant to award lost profits damages over extended periods due to the speculative nature of the underlying projections 20
  • 21. Business Valuation How are the cash flows used in the income approach portion of a business valuation determined? 21
  • 22. Business Valuation Eighth Circuit also noted that “Delaware courts and the financial community have recognized the discounted cash flow model as a preeminent valuation methodology.” Fifth Circuit in 2004 noted that lost asset damages from a breached agreement were “determined by considering what a hypothetical buyer would pay for the chance to earn future profits.” 22
  • 23. Case Example: Acquisition of a Financing Company  Accounting firm advised purchaser of a financing company on the appropriate accounting treatment for the purchase price.  Substantial amount was assigned to goodwill by the accounting firm.  In subsequent years the goodwill was deemed to be unimpaired by DCF analysis performed by the accounting firm even though the Company lost $$$ millions.  What is wrong with this picture? 23
  • 24. Do the Research Understand near term future of subject  Company  Industry  Economy  Other conditions 24
  • 25. Subsequent Events Business Valuation – Generally, a business valuation will not take into account subsequent events unless the facts were known or knowable. Lost Profits – A lost profits analyst must take post-breach events into consideration. 25
  • 26. Estimates at a tipping point Would there be a difference between an estimate of business value with a valuation date of 8/31/08 and an estimate of lost profits from an event occurring on that date? What happened to change the world after that date? 26
  • 27. Income Taxes Lost Profits  Lost profit damages are usually taxable income to the recipient  Avoid double deduction for taxes (once during the calculation and second upon actual payment)  Lost profits computation doesn’t take into account income taxes 27
  • 28. Income Taxes Business Valuation  Lost business value is the price a willing buyer would pay to a willing seller  Hypothetical buyer seeks a cash return on a business investment after payment of all business expenses, including income taxes. 28
  • 29. Case Example: Valuing a Healthcare Practice Pass-through entity being sold to a nonprofit entity IRS and OIG for HHS require that business valuation estimates treat the business as though it was a tax-paying entity. National valuation firm took projected income, applied depreciation expense, and calculated hypothetical tax burden on the balance in order to estimate cash flows. What is wrong with this picture? 29
  • 30. Discount Rate Lost Profits Based on:  Risk-free rate  Risk assessment, or  Plaintiff’s use of funds Business Valuation Based on:  Risk assessment 30
  • 31. Prejudgment and post-judgment interest Lost Profits  Both considered Business Valuation  Both considered 31
  • 32. Thank you for participating James F. Hart Managing Director, Lightfoot Group jhart@lightfootgroup.com Bill Black William H. Black, PC whb@billblackcpa.com 32