Understanding and Calculating Lost Profits Damages
BUSINESS VALUATION | LITIGATION SUPPORT | TRANSACTION ADVISORYADVISORY SERVICES Understanding and Calculating Lost Profits Damages Memphis Bar Association Bench Bar Conference Sandestin, FL Brent A. McDade, ASA, CBA, BVAL
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
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
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
Definition of Profit In accounting, profit is the difference between price and the costs of bringing to marketwhatever 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)
Wikipedia Wikipedia is the best thingever. Anyone in the world can write anything they want about any subject. So youknow you are getting the best possible information.--- Michael Scott – The Office
Alternative Definition1 : a valuable return : gain2 : the excess of returns over expenditure in a transaction or series oftransactions; especially : the excess of the selling price of goods overtheir cost3 : net income usually for a given period of time4 : the ratio of profit for a given year to the amount of capital investedor to the value of sales5 : the compensation accruing to entrepreneurs for the assumption ofrisk 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>
Brent’s Lay Definition of Lost ProfitsThe difference between what you should have made and what you really made
Five Characteristics of Lost ProfitsLost profits are:1. Net profits
Five Characteristics of Lost ProfitsLost profits are:1. Net profits2. Incremental profits
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!
Five Characteristics of Lost ProfitsLost profits are:1. Net profits2. Incremental profits3. But for profits
Five Characteristics of Lost ProfitsLost profits are:1. Net profits2. Incremental profits3. But for profits4. Pretax
Five Characteristics of Lost ProfitsLost profits are:1. Net profits2. Incremental profits3. But for profits4. Pretax5. Reasonably certain
Reasonable Certainty Damages are not rendered uncertain because they cannot be calculated with absoluteexactness. It is sufficient if a reasonable basis ofcomputation is afforded, although the result be only approximate.Eastman Kodak Co. v. Southern Photo Materials, 273 U.S. 359 (1927)
Part 3: Types of Lost Profits Calculations• Before and After• Sales Projection• Accounting for Profits• Yardstick• Market Share• Economic Modeling
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?
Before and After in a Recession• Expected Cash Flow• Risk
Sales Projection Method• Compares actual performance after the bad act with a forecast of performance before the bad act• How reliable was the forecast?
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
Yardstick Method• Compares profits in each period to a yardstick• Common for processing (and other) businesses• Does the yardstick really measure something relevant?
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?
Economic Modeling Method• Catch all for other ways of determining lost sales or lost profits• How reasonable is the model?
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
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
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
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
Ex Ante Damages Illustration Damages Discounted Back to Date of Breach Prejudgment Interest, if applicable Damages Occurring From Date of Breach into the FutureDate of the Breach Date of Trial
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
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 FutureDate of the Breach Date of Trial
Book of Wisdom“… a different situation is presented if yearshave gone by before the evidence is offered.Experience is then available to correct uncertainprophecy. Here is a book of wisdom that courtsmay not neglect. We find no rule of law that setsa clasp upon its pages and forbids us to lookwithin.” -- Sinclair Refining Company v. Jenkins Petroleum, 289 U. S. 689 (1933)
More from Sinclair“An imaginary bid by an imaginary buyer, actingupon the information available at the moment ofthe breach, is not the limit of recovery where thesubject of the bargain is an undeveloped patent.Information at such a time might be so scanty andimperfect that the offer would be nominal. Thepromisee of the patent has less than faircompensation if the criterion of value is the pricethat he would have received if he had disposed of itat once, irrespective of the value that would havebeen uncovered if he had kept it as his own.”(citations omitted)
Still More from Sinclair“To correct uncertain prophecies in suchcircumstances is not to charge the offender withelements of value nonexistent at the time of hisoffense. It is to bring out and expose to lightthe elements of value that were there from thebeginning.” (citations omitted)
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
Thank you for listening.I love talking about this stuff.If you’re ever willing to let me talk about itmore, call firstname.lastname@example.org