A presentation made by Brent McDade at the 2010 Memphis Bar Association Bench Bar Conference.

1. BUSINESS VALUATION | LITIGATION SUPPORT | TRANSACTION ADVISORY
ADVISORY SERVICES
Understanding and Calculating
Lost Profits Damages
Memphis Bar Association Bench Bar Conference
Sandestin, FL
Brent A. McDade, ASA, CBA, BVAL

2. Do they let just anybody speak at
these things?
• Business appraiser from Decosimo
– The largest regional accounting firm
headquartered in Tennessee
– Offices in Memphis, Nashville, Knoxville,
Chattanooga, Cincinnati, Huntsville, Atlanta,
Dalton, Grand Cayman
– Business appraiser since 1994
– Lost profits damages since 2000

3. Alright, so why should I listen?
• Attorneys don’t do math
• Math people don’t do law
• In damages cases, both are important
– Liability meaningless if no damages
– Damages meaningless if no liability

4. What we’re going to cover
• The very basics of the legal part
• What are lost profits?
• Ways to calculate lost profits
• Ex post vs ex ante calculations

5. The Present Value Equation

6. Part 1: The Legal Part

7. Compensatory Damages
Damages sufficient in amount to indemnify the
injured person for the loss suffered.
--Black’s Law Dictionary, 7 ed. abr.

8. Elements of Lost Profits Damages
Claims
• Causation
– Plaintiff must establish
– Did other causes contribute?

9. Elements of Lost Profits Damages
Claims
• Causation
• Foreseeability
– General damages
– Special or consequential damages
• Reasonable Certainty

10. Elements of Lost Profits Damages
Claims
• Causation
• Foreseeability
• Reasonable Certainty
– No undue speculation
– Sostchin v. Doll Enterprises (FL 2003)
– Higher standard for new businesses

11. Elements of Lost Profits Damages
Claims
• Causation
• Foreseeability
• Reasonable Certainty
• Mitigation

12. Part 2: Lost Profits

13. Definition of Profit
In accounting, profit is the difference between
price and the costs of bringing to market
whatever it is that is accounted as an enterprise
(whether by harvest, extraction, manufacture,
or purchase) in terms of the component costs of
delivered goods and/or services and any
operating or other expenses.
en.wikipedia.org/wiki/Profit_(accounting)

14. Wikipedia
Wikipedia is the best thing
ever. Anyone in the world can
write anything they want
about any subject. So you
know you are getting the best
possible information.
--- Michael Scott – The Office

15. Alternative Definition
1 : a valuable return : gain
2 : the excess of returns over expenditure in a transaction or series of
transactions; especially : the excess of the selling price of goods over
their cost
3 : net income usually for a given period of time
4 : the ratio of profit for a given year to the amount of capital invested
or to the value of sales
5 : the compensation accruing to entrepreneurs for the assumption of
risk in business enterprise as distinguished from wages or rent
"profit." Merriam-Webster Online Dictionary. 2010.
Merriam-Webster Online. 16 April 2010
<http://www.merriam-webster.com/dictionary/profit>

16. Brent’s Lay Definition of Lost Profits
The difference between what you should have
made and what you really made

17. Lost Profits are in the Numerator

18. Five Characteristics of Lost Profits
Lost profits are:
1. Net profits

19. Five Characteristics of Lost Profits
Lost profits are:
1. Net profits
2. Incremental profits

20. Incremental Can Be Problematic
• Not uncommon for experts to make errors in
calculating incremental revenue and costs
• Not uncommon to make errors with fixed
costs
• Show your work!

21. Five Characteristics of Lost Profits
Lost profits are:
1. Net profits
2. Incremental profits
3. But for profits

22. Five Characteristics of Lost Profits
Lost profits are:
1. Net profits
2. Incremental profits
3. But for profits
4. Pretax

23. Five Characteristics of Lost Profits
Lost profits are:
1. Net profits
2. Incremental profits
3. But for profits
4. Pretax
5. Reasonably certain

24. Reasonable Certainty
Damages are not rendered uncertain because
they cannot be calculated with absolute
exactness. It is sufficient if a reasonable basis of
computation is afforded, although the result be
only approximate.
Eastman Kodak Co. v. Southern Photo Materials, 273 U.S. 359
(1927)

25. Part 3: Types of Lost Profits
Calculations
• Before and After
• Sales Projection
• Accounting for Profits
• Yardstick
• Market Share
• Economic Modeling

26. Before and After Calculations
• Based on time series data
• Compares profit before bad act to profit after
bad act
• Typically more suited to stable businesses or
contractual relationships
• Did other things change during that time?

27. Before and After in a Recession
• Expected Cash Flow
• Risk

28. Sales Projection Method
• Compares actual performance after the bad
act with a forecast of performance before the
bad act
• How reliable was the forecast?

29. Accounting for Profits Method
• Relies on the accounting records of a party
other than the Plaintiff (typically the
Defendant) to establish sales or profits
• Common in cases where the Defendant made
the sales in question
• Would Plaintiff have had the same experience
as Defendant?
• See Johnson v. Welch
No. M2002-00790-COA-R3-CV

30. Yardstick Method
• Compares profits in each period to a yardstick
• Common for processing (and other)
businesses
• Does the yardstick really measure something
relevant?

31. Market Share Method
• Assumes a certain market share would have
been achieved or maintained
• Uses market share information to determine
lost sales
• How reliable is data on the size of the total
market?
• How reasonable is the assumption regarding
Plaintiff’s share?

32. Economic Modeling Method
• Catch all for other ways of determining lost
sales or lost profits
• How reasonable is the model?

33. Timing Considerations
• Damages happen over time
• A dollar tomorrow is worth less than a dollar
today
• A dollar yesterday should have grown to be
more than a dollar today
• Future cash flows are not certain

34. Risk and Time in the Denominator

35. Timing and Lost Profits
• Past lost profits were lost prior to trial
• Future lost profits are expected after the trial
• Making the injured party whole is therefore
complicated by timing issues

36. Definitions
• Interest rate – an amount paid for the use of
money over time
• Rate of return – the benefit of making an
investment
• Discount rate – the rate at which a future cash
flow is discounted to present value
• Required return – the rate of return that
would induce an investor to take a specific
level of risk

37. Ex Ante Calculation
• Damages are calculated as of the date of the
breach
• Expected future damages are based on what
was known or reasonable knowable as of the
date of the bad act
• Damages are discounted to the date of the
bad act

38. Ex Ante Damages Illustration
Damages Discounted Back to Date of Breach
Prejudgment Interest, if applicable
Damages Occurring From Date of Breach into the Future
Date of the Breach Date of Trial

39. Ex Post Damages
• Damages calculated as of a date after the
breach (typically an assumed trial date)
• Damages that occurred between date of
breach and trial informed by intervening
events
• Post trial damages discounted to trial date
• Pretrial damages brought forward at
prejudgment interest or some other rate

40. Ex Post Damages Illustration
Future Damages Discounted Back to Date of Trial
Past Damages Brought forward to date of Trial (???)
Damages Occurring From Date of Breach into the Future
Date of the Breach Date of Trial

41. Book of Wisdom
“… a different situation is presented if years
have gone by before the evidence is offered.
Experience is then available to correct uncertain
prophecy. Here is a book of wisdom that courts
may not neglect. We find no rule of law that sets
a clasp upon its pages and forbids us to look
within.”
-- Sinclair Refining Company v. Jenkins Petroleum,
289 U. S. 689 (1933)

42. More from Sinclair
“An imaginary bid by an imaginary buyer, acting
upon the information available at the moment of
the breach, is not the limit of recovery where the
subject of the bargain is an undeveloped patent.
Information at such a time might be so scanty and
imperfect that the offer would be nominal. The
promisee of the patent has less than fair
compensation if the criterion of value is the price
that he would have received if he had disposed of it
at once, irrespective of the value that would have
been uncovered if he had kept it as his own.”
(citations omitted)

43. Still More from Sinclair
“To correct uncertain prophecies in such
circumstances is not to charge the offender with
elements of value nonexistent at the time of his
offense. It is to bring out and expose to light
the elements of value that were there from the
beginning.” (citations omitted)

44. Lottery Ticket
• Price of the ticket = $1
• Expected Value of the ticket = $0.10
– Potential payout $100,000
– Odds of winning 1 in 1,000,000
• “Pick 3” vs. scratch off

45. Thank you for listening.
I love talking about this stuff.
If you’re ever willing to let me talk about it
more, call me.
423.756.7100
brentmcdade@decosimo.com