Adding up the Damage: Lost Profits vs. Business Value
28 July, 2015
Ephraim Stulberg
Canada
When a business is destroyed as a result of wrongdoing, there are two commonly used methods by which the plaintiff’s damages may be measured. One method is to appraise the value of the plaintiff’s business at the date of loss; the loss to the plaintiff is the amount that the plaintiff could have sold the business for at the date of the loss. Another method is to calculate the plaintiff’s annual loss of profits.
Under the business valuation method, the remedy applied is to have the defendant “purchase” the destroyed business from the plaintiff at its “fair market value” at the date of the loss. This value will be equal to the present value of the cash flows that would accrue to the owner of the business over its lifetime. A risk-adjusted discount rate is applied to convert these projected annual cash flows to a single “present value” lump sum. In cases where the business is assumed to have been likely to carry on in perpetuity, the annual discount rate may be converted into a single multiplier – for example, if the appropriate discount rate is 20 per cent, the multiplier would be 1 / 0.2 = 5.
Under the lost-profits method, one forecasts the annual profits for the destroyed business based on the actual economic and industry conditions from the date of the damage to the date of trial and on into the future. As with the business valuation method, under the lost-profits method, the plaintiff’s lost profits should be discounted to reflect the fact that the projected profits were by no means “riskless.”
Unlike claims for personal injury, which are typically discounted to the date of trial, depending on the circumstances the projected profits for each year may need to be discounted to the date of the wrongdoing, in particular when there is considerable uncertainty as to how the plaintiff’s business would have performed absent the wrongdoing. Failure to do so can result in significantly higher damage calculations under the lost-profits method than under the business valuation method, as illustrated in the case of Agribrands Purina Canada Inc. v. Kasamekas ([2010] O.J. No. 84; [2011] O.J. No. 2786).
In Agribrands, the plaintiffs entered into an agreement which called for them to be exclusive distributors of Purina-branded feed in Halton County, Ont. beginning in 1991. The plaintiffs soon discovered that Agribrands was continuing to supply feed to rival distributors. As a result, the plaintiffs suffered and were forced out of business altogether in early 1992.
The plaintiffs’ expert calculated lost profits of between $3.1 million and $4.2 million from the date of breach until the projected retirement of the owners, a period of 28 years. Most of this period fell between the date of the wrongdoing and the date of trial. It appears that the plaintiff’s expert did not apply a discount rate to the past loss of profits, resulting in a large damage calculation. The court ruled that a lost-profits calculation over such a lengthy period was too speculative, particularly for a new business. It instead accepted the business valuation method advocated by the defendants’ expert, and arrived at a significantly lower damage figure based on a multiple of three times the plaintiff’s projected profits.
One key difference between the business valuation methodology and the lost-profits method concerns the issue of hindsight. The business valuation method imagines that the plaintiff would have sold the damaged business immediately prior to the damage occurring; it attempts to estimate the proceeds the plaintiff could have received at that point in time. Such a price would only have been negotiated based on facts known at that date. To the extent that no sale of the business was actually contemplated, a loss calculation based on the value of the business can lead to an amount far different than would have been achieved by the plaintiff but for the loss had they continued to operate the business. In such cases, an analysis of lost profits based on hindsight will prove more realistic.
This issue was addressed in RBC Dominion Securities Inc. v. Merrill Lynch Canada Inc. [2004] B.C.J. No. 2337. The plaintiff filed suit after almost all of the investment advisers at one of its offices joined a competitor in 2000. The plaintiff’s expert estimated the change in the value of the affected branch resulting from the co-ordinated departure; the valuation, being at a point in time, failed to consider the downturn in the financial markets as a result of the bursting of the “tech bubble” shortly following the breach. The court rejected the business valuation method for this reason, noting that to “artificially” ignore these relevant developments in the economy would be to provide a “windfall” for the plaintiff.
Relying solely on the business valuation approach can also be risky if there is any doubt as to the permanency of the loss. In such instances, the preparation of a detailed lost-profits calculation on a year-by-year basis can prove indispensable. Thus, the Ontario Court of Appeal recently overturned the Agribrands damages award, noting that the trial judge was not justified in assuming that, but for the breach, the plaintiff would have continued as a Purina dealer for any longer than the original term of the contract.
The business valuation and lost-profits approaches often yield similar damages calculations. When they do not, it is often due to one of the factors noted above. Courts may also subjectively prefer one approach over the other. Experts are therefore well advised to consider calculations under each methodology and adopt the approach that best fits the facts of the case.
By Ephraim Stulberg. Published in the January 30, 2015 edition of Lawyers Weekly.
The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.
Ephraim Stulberg
B.A, M.A, M.BA, CPA, CA, CBV, CFF, Partner/Senior Vice President
- +1 416.366.4968
- estulberg@mdd.com
- Toronto, ON, Canada
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