Valuation Corner: Lost Profits v. Lost Business

2/10/2016 - By Zachary Farrington

When calculating economic damages, the objective is to determine the extent of financial injury to the company. This may sound straightforward, but it actually involves many nuances.

Depending on the case, determining economic damages may involve calculating lost profits. Or perhaps calculating a loss or diminution in business value is more appropriate. Sometimes lost profits augment a loss of business value, but not always.

Complete vs. Partial Loss
One of the factors in deciding which type of calculation is warranted is whether the company was so completely injured that it was unable to continue. If so, the valuation analyst would likely use business valuation techniques to calculate the damages, measuring the value of the company before the injury when it was thriving, and after the injury when it may only be worth the liquidation value of its assets.

If the company was partially injured and suffered a slowdown but not complete cessation, the injury could cause either a temporary loss of profits or a permanent downturn in business value. Say a fire puts the business out of commission for a number of months. This temporary injury would generally dictate a lost profits calculation, which measures loss over a specific period of time.

However, in the case of a permanent injury from which the company will never recover, the damages could be either lost profits or lost business value. Say, for example, that the actions of a vendor caused a company to permanently lose its biggest client. The company would certainly experience lost profits, but it might also suffer a permanent loss of value due to permanent impairment in future cash flows.

In this case, the valuation analyst must determine if the injury is truly permanent. If so, business valuation techniques may be used instead of lost profit calculation techniques.

Double Dipping
Does an injury to a business ever call for a lost profits calculation and a business valuation? Experts disagree.

Although the law does not allow duplicative damages or “double dipping,” there may be cases involving the “slow death” of a company that would perhaps indicate that both types of measurement would be appropriate. For example, it may be that a company lost profits for a substantial “interim” period of time when the owner was trying to mitigate the damage before the company ultimately failed.

In such a case, the facts may indicate that the interim period justifies a lost profits calculation. Then a business valuation would reflect the damages once the company stopped being a viable operation.

Facts and Circumstances
Whether lost profits or lost business value, temporary or permanent, the analyst must show that the damages were substantially caused by the injury in question, and that the damages calculated are reasonable.

All valuation analysts agree that their approach to each case depends on its specific facts and circumstances. That’s why it is crucial to work with an experienced, credentialed valuation analyst who can support his or her assumptions in court.