Title: Critiquing Economic Damage Reports
1CHALLENGING ECONOMIC DAMAGESAn Emphasis on Lost
Value
Presented by Rob Hancock ASA CPA/ABV CVA Oral
Presentation
Centerprise Advisors Litigation Support
ConferenceHouston, TX
____________ Mann
Frankfort Stein
Lipp Advisors, Inc.
2Errors in Business Damage Calculations Are Rooted
In Two Categories
- 1. Experts Damage Methodology the primary
subject of Daubert / Kuhmo Tire challenges - 2. Experts Damage Assumptions the primary
subject of Reasonable Certainty reviews
31. Experts Damage Methodology
- the diminution of a businesss value would be
an acceptable measure of economic loss in cases
where the economic damage to the plaintiff was
ongoing or the business was destroyed by the
defendants actions. - (A Case Study Analysis of the Difference between
Lost Profits Firm Value Business Valuation
Review March 2002, by Gene A. Trevino.)
41. Experts Damage Methodology
5Experts Damage Methodology Defined As
- The quantification and characterization
- of damages based on the experts adopted
- and/or the experts self-developed
- assumptions.
6Experts Damage Assumptions Defined As
- The rationale and bases for the amount
- of revenues and expenses (and other elements
- of cash flow) used in the quantification of
- damages.
- Assumptions also include the rationale and
- bases for the amounts of assets, liabilities
- and equity used to support the quantification
- of damages.
71. Experts Damage Methodology Common
Components Subject to Challenge
- Parties Damaged Who was damaged? Are the
parties with or without standing? Is the damage
calculation linked to the proper party? - Mitigation How did the plaintiff mitigate
damages, if at all? - Damage Date and/or Damage Period When did the
damage occur? Is the damage calculation linked
to the proper damage date or damage period? - Lost Profits vs. Lost Value Was the business
interrupted, partially or fully destroyed or did
a slow death occur? -
Business Interruption Lost Profits Methods -- But
for method -- Yard stick method -- Before and
after method
Business Destruction Lost Value Methods -- Going
concern premise (income and market
approaches) -- Liquidation premise (asset
approach)
Slow Death Lost Profits and Lost Value
8Damage Date Survey
Date Selected Depends on Facts and Circumstances
Source AICPA 2003 Business Valuation Conference
9Correct Slow Death Model Damage chart reflects
lost profits during the period that operations
are impaired. Lost profits (green) stop at the
business destruction date, when the business
ceases operations. This date serves as the
valuation date for calculating lost value (blue).
Damage Date for Business Destruction and Lost
Value
Trial Date
Damage Date for Lost Profits
Lost Profits (green)
Lost Value (blue)
Damage Period
10Double-Dip Slow Death Model If the expert uses
a valuation date prior to the business
destruction date, and continues to calculate lost
profits past the business destruction date,
double-counting (orange) of lost-profits between
the valuation date and the business destruction
date occurs. He will also be including actual
profits (red) in his lost value of the company.
Damage Date for Business Destruction and Lost
Value
Death of Business
Damage Date for Lost Profits
Lost Profits (green)
Double-Dip (orange)
Lost Value (blue)
Actual Profits (red)
Damage Period
11Double-Dip Slow Death Model If the expert uses
a lost profits damage period that extends beyond
the death of the business, which also serves as
the valuation date, then he is double-counting
lost-profits between the business destruction
date and the end of the lost profits damage
period (orange).
Damage Date for Business Destruction
Damage Date for Lost Profits
Double-Dip (orange)
Lost Profits (green)
L.V. (blue)
Damage Period
12The Use and Abuse of Discount Rates
- Personal Injury Risk free rate is the generally
accepted rate. - Lost Profits
- Risk free or risk adjusted discount rate for
business losses? It depends on whether the
discount rate is applied to risk inclusive cash
flows or risk free cash flows. - Pre-tax lost profits factored by an after-tax
discount rate The theory serves to compensate
the plaintiff for income taxes on the damage
awards. - Lost Value
- After-tax lost profits factored by an after-tax
discount rate is generally accepted, but an issue
with pass through entities, such as S
corporations, exists. - Ibbotson Associates certification In response to
increasing challenges on the correct utilization
of Ibbotsons data for computing discount rates,
Ibbotson recently introduced a new certification
service. For a fee, Ibbotson will review an
experts report and issue a letter certifying
that the Ibbotson data was used properly in the
computation of the discount rate.
13Lost Profits Risk Adjusting the Discount Rate or
Cash Flow
Note Damage calculation models usually include
an adjustment for risk by adjusting the lost
profits or the discount rate. Double-counting
risk, or not counting risk at all, will calculate
damages that are too low or too high.
14Survey Use of Discount Rates by Type
- Temporary Impairment Damages
- 79 of participants use a risk-adjusted rate
- 21 of participants use a risk-free rate
- Destroyed Business Damages
- 83 of participants use a risk-adjusted rate
- 17 of participants use a risk-free rate
Source AICPA 2003 Business Valuation Conference
15The Effect and Consideration of Taxes on Damage
Awards
By using pre-tax lost profits with an after-tax
capitalization rate, lost profits calculations
gross-up the award value to compensate the
plaintiff for the tax liability on the damage
award. Typical business valuations do not.
16Tax ScenariosDiscount Rates and Cash Flow
The chart below illustrates the percentage of
experts using different discount rate and cash
flow combinations. Only 8 of the respondents
gross-up the damage award for the plaintiffs
tax liability.
Source AICPA 2003 Business Valuation Conference
172. Experts Damage Assumptions Common
Components Subjectto Challenge
- Ideal Scenario for the Plaintiffs Expert The
alleged damaged party serves, on a silver
platter, a full blown, fully researched business
plan (prepared in the pre-damage period)
inclusive of meaningful balance sheets, income
statements and cash flow statements. - Ideally, the expert is also provided the
following information - Market research
- Management bios and resumes
- Prior valuations
- Marketing material
- Fixed asset appraisals
- Organization chart and plan
- Operations plan and description
- Description of competition
- Risk management strategy
- It is a plus if the business plan has been
blessed and/or adopted by others (such as
bankers, investors, bonders, etc.). - If a full, pre-damage period business analysis is
not available, then the expert must supplement
and/or document any existing oral or written
assumptions.
18Experts Assumptions Unreasonable Certainty as
to the Quality of the Business Plan
- Notwithstanding the presence of a completed,
documented business plan, the quality of the plan
raises reasonable certainty issues for example - Adequate Working Capital and Financing?
- Blue Sky Sales Projections?
- Unrealistically Low Production Costs?
- Unbudgeted Spending Required, but not Budgeted,
for Growth? - Unforeseen Regulatory Restrictions on Business
Operations?
19Applications in Non-Judicial Settings
Generally, an experts methodology will sustain a
Daubert challenge if the methodology is accepted
in
- Academic Theory
- Industry Practice
20Errors in Business Damage Calculations Are Rooted
In Two Categories
- Experts Damage Methodology the primary subject
- of Daubert / Kuhmo Tire challenges
- Experts Damage Assumptions the primary subject
- of Reasonable Certainty reviews
21Discount Rates of Emerging Businesses
- Particularly in cases involving start-up
businesses, business valuation discount rates are
widely ranged. The following slides (20-27)
discuss the reasons for the wide range. Examples
of different levels of discount rates are shown
on slide 28.
22Emerging Businesses (a/k/a Start-Ups and New
Businesses) Defined As
companies that are in various early stages of
development, from start-up through initial public
offering. Emerging companies usually have the
common bond of high earnings growth expectations
and little to no history of demonstrable earnings.
23Emerging Businesses Success or Failure
- Approximately 750,000 new businesses start up
every year in the U.S. - Less than 15 percent of these new businesses
survive beyond 5 years - The success rate of new businesses starting from
scratch is 10 to 15, versus buying an existing
business with success rates of 75
24Different Stages of Emerging Businesses
- START-UP STAGE
- Research and development
- Prototype testing
- Test marketing
- Form management team
- Business plan development
- Obtain facilities
- Seed capital needs
25Different Stages of Emerging Businesses (contd)
- DEVELOPMENT STAGE
- Key business and financial milestones have been
met - Good operational indicators
- Full scale operations begin
- Debt/equity needed for working capital and
capital expenditure requirements
26Different Stages of Emerging Businesses (contd)
- GROWTH AND EXPANSION STAGE
- Rapid sales growth
- Acquire additional capital for new products, new
facilities, new markets, etc. - Debt equity more readily available
- BRIDGE STAGE
- Interim financing sought in anticipation of sale
or IPO - EXIT STAGE
- Sale or merger
- Initial public offering
27Key Determinants of Risks For Emerging Businesses
- Business and industry growth prospects
- Type of business and position in industry
- Desirability and marketability for type of
business - Reliance on breakthrough technology
- Evidence of consolidation in the marketplace
- Prospects for inflation
- Competition and barriers to entry in marketplace
- Experience of others in the marketplace
- Return on investment required by investors
- Risk risk
- General health of the public marketplace and
industry
28Key Determinants of Risks For Emerging Businesses
(contd)
- Stability of historical earnings
- Capital structure and availability of capital
- Quality of location and facilities
- Value of assets already in place
- Ability to weather unanticipated delays in
product development and production - Customer relationships and contracts
- Stability of employees
- Supplier relationships and contracts
- Depth, expertise and experience of management
- Market positioning and penetration
29Key Determinants of Risks For Emerging Businesses
(contd)
- Diversification of products, services and
geographical markets - Testing of products, services and geographical
markets - Quality of market research and marketing/advertisi
ng plan - Business plan and forecast with plausible most
probable versus least probable scenarios - Projected integrated financial information
(balance sheets, cash flow statements and income
statements)
30Effect of Risk on Investor Returns -Typical
Discount Rates
- Financial instruments (above inflation rate)
Inflation - Rate Plus
- Treasury bills, money market, CDs 0 -
5 - Risk free long-term bonds (i.e. U.S. Treasury)
2 - 3 - Long-term investment grade corporates
2.5 - 3.5 - Junk bonds 6 - 10
- Common stock of established public companies
7 - 10 - Common stock of speculative and small capital
- public companies, minority
10 - 15 - Equity in private companies, minority interest
25 - 30 - Bridge stage companies
25 - 35 - Growth and expansion stage companies
30 - 50 - Development and expansion stage companies
40 - 60 - Start-up companies 50 - 80