Understanding and Calculating Lost Profits Damages
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This document summarizes a presentation on understanding and calculating lost profits damages. It begins with an introduction of the speaker and his qualifications in business appraisal and calculating lost profits damages. It then outlines the presentation topics which include the basics of the legal framework for lost profits, definitions of profits and lost profits, and methods for calculating lost profits such as before and after, sales projection, accounting for profits, yardstick, and economic modeling. The presentation discusses challenges with various calculation methods and concepts like mitigation, causation, foreseeability, reasonable certainty, and discounting future damages to present value. It provides examples of ex ante and ex post calculations of damages and discusses the "book of wisdom" concept of incorporating knowledge gained after the breach
Understanding and Calculating Lost Profits Damages
- 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