Damages Litigation-Diminution of Business
Value
2012 LSU Fraud and Forensic Accounting
Conference
[July 23-24, 2012]
Table of Contents
I.
Diminution of Business Value Methodology
II. Lost Revenue
III. Cost Estimation
IV. Present Value Calculation
V. Other Considerations
VI. Example
Section I - Diminution of Business Value Methodology
Diminution of Business Value Methodology
What is the Diminution of Business Value?1
The difference between:
1. the value before the event in dispute, where the value may be calculated as the present value of the
future cash flow projections; and
2. the value after the event has occurred, where the value may be calculated as the present value of the
future cash flow projections after consideration of the value-impairing event.
Diminution of Business Value Methodology
Diminution of Business Value vs. Lost Profits
Diminution of Business Value
Loss of Profits
• Business value is more holistic in utilizing
• Considers differences in income (comparable to
an income approach in business valuation)
– Income approach
• Like measuring the distance between two points
– Market approach
– Cost/Asset approach
• Like measuring the difference between the areas
of two circles
In either method, future cash flows must be determined in a “but for” scenario.
The divergence occurs by differences in inputs, assumptions, and timing.
Diminution of Business Value Methodology
Determining Future Cash Flows
Future cash flows that would have occurred “but for” the breach or wrongful act must be estimated, as
determined by estimations regarding:
• Lost revenues
• Cost avoidance
Variations in value can occur because of differences in timing of:
• The event date
• The litigation date
• The valuation date
This may require moving cash flows backwards and forwards in time, multiple times.
Section II - Lost Revenue
Lost Revenue
Methodologies
1. Before and After
2. Benchmark
3. Specific Models
Lost Revenue
Before and After
•
•
•
“But for” analysis
But for the defendant’s action, the plaintiff’s revenues would have continued to grow at x%
Based on plaintiff’s historical performance and trends
Revenue (Thousands)
Example: “But for” scenario revenues – 2.5% annual growth based on historical trend
Less: Actual scenario revenues
Lost Revenues
1,200
1,150
1,100
Lost Revenue
1,050
1,000
950
Event Year
900
20X0
20X1
20X2
"But for" scenario
20X3
20X4
Actual scenario
20X5
20X6
Lost Revenue
Before and After
Complications
• New business with no or short history of operations
Lost Revenue
Benchmark
•
•
•
Actual vs. Budget/Projections
Actual performance of similar business
Industry averages
Complications:
• Requires budgets/projections created prior to the event
• Application of similar business or industry benchmarks may be unwise in events with regional or industry
consequences, e.g. April 2010 BP oil spill
• Business is new or unique, e.g. internet or high-tech companies
Lost Revenue
Specific Models
Contract Terms
If litigation is in regards to breach of contract or the plaintiff’s business is contract based, a reasonable estimate
of the “but for” scenario could be made assuming the contract were fulfilled according to the terms of the
contract, including:
• Volume
• Price/cost per unit
Defendant’s Revenues
• Identify revenues associated with the misappropriation of trade secrets
Lost Revenue
Sanity Check
•
Capacity
– Capital resources
– Labor/technological resources
– Consumer demand
Universal Commodities, Inc. v. Weed, 449 S. W. 2d 106 (Tex. Civ. App. 1969)
• Defendant breached contract, but no damages awarded because plaintiff did not have financing
or capital to operate business even if contract were performed
Lost Revenue
Sanity Check
•
Market share
– Is the growth rate reasonable?
Example:
Year
Industry Revenues
Industry Revenue Growth
Plaintiff Market Share
Plaintiff Revenue
Plaintiff Revenue Growth
•
0
100,000,000
0.0%
5.0%
5,000,000
10.0%
1
100,000,000
2
100,000,000
3
100,000,000
4
100,000,000
5
100,000,000
5.5%
5,500,000
6.1%
6,050,000
6.7%
6,655,000
7.3%
7,320,500
8.1%
8,052,550
Industry and other considerations
– Profits attributable to factors other than misappropriation or any harmful act would not have to be
disgorged. This is particularly true in certain cases, such as when using the defendant’s revenue
methodology or valuing a patent that may be used in combination with other value creating features
Section III - Cost Estimates
Cost Estimates
What Are Avoided Costs?
Avoided costs are “costs that would have been incurred in connection with the generation of the lost revenues
but were not incurred.”2
Costs incurred by the plaintiff that would not have been incurred except for the actions of the defendant can be
offset against avoided costs.
Cost Estimates
Plaintiff’s Cost Structure
•
•
Defendant’s costs are irrelevant
Costs must be examined within the plaintiff’s cost structure
– Analyze historical financial statements and projections
Fixed vs. Variable
• Methods of Estimation
• Sanity Check
Cost Estimates
Fixed vs. Variable Costs
Fixed costs are usually not avoidable. Variable costs, those that vary with revenues that would therefore not be
incurred “but for” the sale, are usually avoidable.
•
•
•
•
Cost of goods sold
– Vary with lost revenue
• Inventory accounting methods create differences between plaintiff’s and defendant’s CoGS
Direct costs
– Vary with lost revenue
Overhead costs
– Generally unavoidable, e.g. rent
– Can be attributed to revenue in some cases, e.g. marketing/advertising
Indirect costs
– Fixed or variable, sometimes avoided, sometimes not
Cost Estimates
Methods of Estimation
Nonstatistical
• Account analysis
– Fixed/variable decision left to the subjectivity of the analyst based on review of financial statements
• Direct costs
– Specifically identifies the input costs, such as direct labor and materials
• Cost accounting allocation
– Allocates indirect costs based on variable measures, such as revenue or units sold
Statistical
Quantitative identification of relationships through:
• Regression analysis
• Survey data
• Attribute sampling
Requires understanding of statistical methods and rules
Cost Estimates
Sanity Check
Cost estimation can be complicated. For example:
• Plaintiff launched new product line without cost history
– Solution: Estimate costs based on similar businesses or industry averages
• Product line is entirely new
– Solution: Rigorous identification of direct costs
Cost Estimates
General Guidelines for New Businesses
In determining lost revenues and estimating costs, assumptions must be made considering:
• The business plan
• Capital resources
• Plaintiff’s experience
• Industry factors (barriers to entry, etc.) and trends (growing market, etc.)
• Economic factors (business cycle, etc.)
Section IV - Present Value Calculation
Present Value Calculation
Ex Ante/Ex Post Methodologies
Ex Ante
• Assumes all lost profits are future lost profits, i.e. valuation is made as of the date of the event or harmful
action by the defendant and all cash flows are discounted to this date
• The value is then brought forward to the date of the award
• Only knowledge known as of the event date may be considered in the valuation
Ex Post
• Assumes some lost profits are historical (occurring prior to the date of the award) and some are future
(occurring following the date of the award
• Historical profits may be brought forward to the date of the award, and future profits are discounted to the
date of the award
• Neither historical nor future profits are ever discounted to the date of the event
• All knowledge known as of the date of the judgment may be considered in the valuation
Present Value Calculation
Measures of Cash Flow
Lost profits and diminution of business value diverge on the basis of what precisely is to be discounted.
Diminution of Business Value Methods
Net Cash Flow to Equity
Net Income (after taxes)
+ Noncash Charges (e.g.) depreciation, amortization, deferred taxes)
– Capital Expenditures (the net changes in fixed and other non current assets)*
– Changes in Net Working Capital*
+ Net Changes in Long-Term Debt*
= Net Cash Flow to Equity
Net Cash Flow to Total Invested Capital
Net Income Available to Shareholders (after taxes)
+ Noncash Charges
– Capital Expenditures*
– Changes in Net Working Capital*
+ Interest Expense, Net of the Tax Benefit (interest expense x [1 – tax rate])
= Net Cash Flow to Total Invested Capital
* The amounts are the levels necessary to support projected business
Present Value Calculation
Measures of Cash Flow
The lost profit method does not fully develop the estimates needed to determine net income or cash flows.
Lost Profits Method
“But for” Sales
– Impaired Sales
= Lost Sales
– Avoided Costs
= Lost Profits
Use of a cash flow based method is better for determining damages when large capital expenditures are
required at the outset or occur irregularly over the life of the project.
Present Value Calculation
Discount Rate
As always, the discount rate must match the cost of generating the profits to be discounted.
• Risk-free rate
• Plaintiff’s cost of debt
• Plaintiff’s cost of equity
• Plaintiff’s weighted average cost of capital
• Rate of return on a similar investment
Selection of an appropriate rate depends on unique circumstances such as:
• Were the lost profits generated from a business line that is inherently riskier than what is reflected in its
WACC?
• Is the company still a going concern following the event or harmful act?
• What are the company specific risks?
The courts have provided little guidance on the issue of selecting an appropriate discount rate.
Present Value Calculation
Assessment of Risks
•
•
•
•
•
Availability of capital
– Was capital invested before the damaging event occurred?
Plaintiff’s experience
Experience of others
Barriers to entry
Economic factors
Present Value Calculation
Failure of the Going Concern
If the event or harmful act causes the business to fail, the market value of the business can be awarded as
damages.
• Costs incurred in winding up and liquidating the business should be included in the valuation
• Damages from a “slow death” in which the company fails a number of periods after the event can include
the diminution of business value and lost profits in the period between the event and the failure of the
business
Section V - Other Considerations
Other Consideration
Loss Period
•
•
Diminution of business value typically presumes valuation of cash flows into perpetuity
Limitations on how many years of loss can be recovered means the terminal value cannot grow into
perpetuity
– E.g. contract limitations, intellectual property
Consider the declining value of cash flows over long periods of time.
Example: $1,000 annual cash flow in perpetuity, discounted at 10%
10 year period of cash flows
20 year period of cash flows
40 year period of cash flows
50 year period of cash flows
100 year period of cash flows
Perpetuity
$6,145
$8,514
$9,779
$9,915
$9,999
$10,000
% of Value Captured
61%
85%
98%
99%
100%
Other Consideration
Taxes
•
Damages are generally taxable as ordinary income
•
Pre-tax or post-tax discount rates?
Other Consideration
Interest
Historical cash flows may need to be moved forward. Courts have considerable discretion in determining the
interest rate on pre-judgment damages. Interest rate selection and application varies across jurisdiction.
• Statutory rates
• Risk-free rates
• Plaintiff’s cost of capital
• Defendant’s cost of debt
• Simple interest or compound interest
Other Consideration
Intellectual Property Methodologies
Patents:
• Damages cannot be less than the amount of a reasonable royalty
Copyrights and Trademarks:
• Lost profits method, royalty rates, decline in market value of copyrighted material
Other Consideration
Securities Fraud
Plaintiffs’ seek damages resulting from failure to disclose adverse information.
• Reversal of scenarios: Diminution of business value is the difference between the price paid for the
securities (the actual scenario) and the value of the securities had the information been known at the time
of purchase (the “but for” scenario)
• Must account for more factors than only the decline in price when the information did become available
Section VI - Example
Example
Stolen Product Line
Actual
Revenue
%
10,000,000
New Product
%
2,000,000
“But for”
%
12,000,000
Costs
Materials
4,000,000 40%
400,000
Labor
3,000,000
500,000
3,500,000
Factory costs
1,000,000
0
1,000,000
Direct costs
8,000,000
900,000
8,900,000
Gross Profit
2,000,000 20%
Overhead
1,000,000
Pretax Income
1,000,000 10%
1,100,000
20%
55%
100,000
1,000,000
4,400,000
3,100,000
37%
26%
1,000,000
50%
2,100,000
18%
Example
Stolen Product Line
Actual
%
New Product
%
Launch Costs
Factory changes
100,000
Marketing
50,000
Working capital costs
Discount rate
300,000
18%
18%
New product line risks
5%
Large diversified company
-2%
Total discount rate
18%
21%
“But for”
%
Example
Stolen Product Line
Year
0
1
2
3
4
5
T
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1.000
.826
.683
.564
.467
.386
.319
450,000
826,446
683,013
564,474
466,507
385,543
318,631
Terminal Year Multiple
10.0x
3,186,308
Pretax income
Launch costs
0
450,000
Discount factor (21%
discount rate)
Present value
Sum of years 0-5
2,475,984
Sum of yearly cash flows
and terminal value
5,662,293
Sanity Check: Market Capitalization to EBITDA
5,662,293
1,000,000
=
5.66x
Contact
Chaffe & Associates, Inc.
201 St. Charles Avenue, Suite 1410
New Orleans, LA 70170-1410
504.524.1801
A copy of this presentation and other resources are available at
www.chaffe-associates.com