Maryland Association of CPAs Forensic Valuation Conference May 16, Rob Schlegel, FASA, MCBA Houlihan Valuation Advisors Indianapolis, Indiana 1

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1 Maryland Association of CPAs Forensic Valuation Conference May 16, 2014 Rob Schlegel, FASA, MCBA Houlihan Valuation Advisors Indianapolis, Indiana 1

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3 Less empirical data available More case-specific More complex Tougher to budget Requires industry expertise 3

based upon the alleged harm suffered by the Plaintiff(s) in business, are calculated as the amount necessary to place the injured party in a position that it

4 based upon the alleged harm suffered by the Plaintiff(s) in business, are calculated as the amount necessary to place the injured party in a position that it would have been had the injury/accident not occurred reflect net profits or Lost Revenues considering Incremental and avoided Costs proven with a reasonable certainty 4

5 Highly subjective Always intended for court presentation Often high-stakes to the owners High-risk because theory is less established than business appraisal s body of knowledge 5

6 Analysis of value or a calculation? If a business is destroyed, the proper measure is the market value ( going concern value ) of the business at the date of loss. Book value? Fair market value? Enterprise value? If a business is only partially destroyed and will recover, it may recover the present value of future lost profits until recovery. Lost profits cannot be greater than the business value. A plaintiff may not recover both lost profits and lost business value (except in slow death, perhaps) Commercial damages move through time and industry trends, with events seen and unforeseen 6

Defamation Tortious interference with contract Theft of trade secrets Breach of

7 Breach of a civil contract requiring: A legal duty owed to another A breach of the duty Proximately caused damage Situations experts see can include: Defamation Tortious interference with contract Theft of trade secrets Breach of fiduciary duty Negligence Conversion Loss of a key man Delay of critical path in production 7

8 Fraud in the inducement Misrepresentation Breach of express or implied warranty Failure to deliver goods Breach of covenant of good faith and fair dealing Violation of non-compete 8

9 REPORTED PROFITS Recession Profits Recovery Recession Industry Growth Years 9

10 Expected Profits Profits Lost Profits Actual Profits Years 10

11 Expected Profits Profits Lost Business Value: All Future Profits Actual Profits Years 11

12 Loss does not allow recovery Expected Profits Profits Lost Profits Lost Business Value Actual Profits Bankruptcy or Sale of Business Assets Years 12

13 Background: Experience, certification, objectivity, typical assignment Financial and industry knowledge Sitting CPA may have best knowledge but be deemed too close Training Programs Maryland Assn. of CPAs; AICPA American Society of Appraisers Forensic Economics Associations Banking, insurance, brokerage Experienced in litigation assignments If use staff, you do the lion s share of analysis 13

14 Attribute Lost Profits Business Valuation Income stream Standard of value Valuation methods Discount rate Incremental stream of avoided costs, typically before income tax Fair Value as may be defined by the Court PV of post trial loss added to pre-trial loss including pre-judgment interest at date of trial Risk assessment, or riskfree, or plaintiff s use of funds Typically after tax net cash flow to equity into perpetuity Fair Market Value as defined by the IRS Discounted net cash flow model (single or multiple period) supported by other methodologies Typically Weighted Average Cost of Capital (WACC) based on risk assessment Use of hindsight Considered (typically) Generally limited to Known, knowable or reasonably foreseeable at date of value 14

15 Economic and industry factors affect damages claim Selection of appropriate methods Understanding of the plaintiff s cost structure (fixed, variable and semi-variable costs related to the harmful act) Proper recognition of actual performance during damage period, and/or future performance period ( foreseeability ) Market share, cost of production Competition reaction, regulations Length of damage period (does it end?) How did similar/competitive businesses do during the damage period: Did the customers flock to competitors? Was the whole industry sector affected by the recession? Were there technological trends that affected the business? Did customer behavior change, affecting market forces? Did business have the capacity to grow and earn? 15

Credible lost profits are natural, proximate, probable, or direct consequence of an act, excluding remote circumstances Plaintiffs must establish lost profits to a reasonable degree of

16 Credible lost profits are natural, proximate, probable, or direct consequence of an act, excluding remote circumstances Plaintiffs must establish lost profits to a reasonable degree of certainty. Experts can t be speculative, vague or contingent and include unknown, unreasonable or unforeseeable factors Conclusions supportable by relevant facts, data, and reasonable assumptions 16

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Account for Profits (Sales Projections): restores profits diverted to the defendant or unattained due to defendant s conduct Profits are normalized to remove the effects of defendant s actions

18 Account for Profits (Sales Projections): restores profits diverted to the defendant or unattained due to defendant s conduct Profits are normalized to remove the effects of defendant s actions Before and after method (historical) Yardstick method (industry trends) Sales projections method Remember Fixed and Variable Expenses! Taxes are tricky! Objective is to make the plaintiff whole. 18

Lost profits reflects REVENUES COSTS = PROFITS Performance Without vs. With alleged actions 2 models showing difference These But-For require projected calculations vs.

19 Lost profits reflects REVENUES COSTS = PROFITS Performance Without vs. With alleged actions 2 models showing difference These But-For require projected calculations vs. actual/projected calculations Sales projections derived from client management? Expert has duty to independently verify Business plans may be perfunctory, and consistently optimistic Yardstick measures (industry & guidelines) compares the subject to an industry cohort to make predictions absent the injury Comparability is key Before and after (historical) profits earned pre-incident to profits earned post-incident 19

20 Lost profits likely to be incurred from date of trial to date in the future Time value of money Key factors are estimates of loss and selection of a discount rate 20

21 Start of Damage Make Whole or $717,000 (rounded) May bring this forward to trial date 21

22 Simple cost accounting separates fixed and variable costs Some costs, such as Cost of Goods Sold may vary directly with Revenues. Some, however, may not be entirely avoided. Rent is normally fixed has defendant mitigated if possible? Be aware of terminology: Direct costs Overhead costs Indirect costs Short-term and long-term costs 22

23 General office expense General supervision or management Depreciation (subject to caveat) Rent & utilities Insurance Taxes Technology & long-term leases Long-term debt 23

24 Can depend on industry, but some costs are fixed for all businesses Consider salary savings variable costs warehouse and storage space non-fixed overhead expenses 24

Prejudgment interest compensates plaintiff for interest not earned (loss of funds) on lost profits from date of incident to date of trial Courts may have considerable discretion: Statutory rates

25 Prejudgment interest compensates plaintiff for interest not earned (loss of funds) on lost profits from date of incident to date of trial Courts may have considerable discretion: Statutory rates Risk-free interest rate Applicable Federal Rate Prime rate T-Bill or Bond rate Defendant s after-tax borrowing rate (defendant s lower cost of borrowing may yield a higher benefit) Plaintiff s cost of capital 25

Ex Post methodology: Relies on all information known or knowable up to the date of trial No discounting of historical lost profits incurred between date of incident and date of

26 Ex Post methodology: Relies on all information known or knowable up to the date of trial No discounting of historical lost profits incurred between date of incident and date of trial Prejudgment interest applied to historical lost profits based on timing of lost profits Future lost profits beyond date of trial would be discounted back to date of trial 26

known or knowable at the date of the incident Once present value is calculated,

27 Ex Ante methodology: Assumes all lost profits are future lost profits and must be discounted back to date of incident (no historical component) Relies on all information known or knowable at the date of the incident Once present value is calculated, resulting damage amount is brought forward to date of the award by applying prejudgment interest 27

28 1. Temporary impairment with recovery 2. Immediate destruction of business 3. Slow death of the business WRINKLES: Startup/Emerging business scenario is high risk Damage, coupled with recession during , doomed the business Mitigation of the damage amount or period Cost avoidance during the damages period relating to lost revenues and related expenses 28

29 Factual dependent Industry specific Damages may diminish in magnitude over the damages period Mitigation opportunities may change over the damages period 29

30 Can vary based on underlying causes Begins on date of harmful act Ends when plaintiff returns to original position it would have originally occupied had alleged damage not occurred Trial date may not provide an end date for the loss Future damages are more speculative, and must be discounted to present value 30

31 Expected Profits Profits Lost Profits Actual Profits Date of Trial Years 31

Link between alleged wrongful act and damages sustained ( proximate cause ) Factual basis for the claim Rigorous estimation of: Lost revenues Incremental costs,

32 Link between alleged wrongful act and damages sustained ( proximate cause ) Factual basis for the claim Rigorous estimation of: Lost revenues Incremental costs, including those avoided/saved Cost drivers associated with lost revenue dollar Competence of your expert Know the procedures undertaken Recognize unique issues 32

Variety of methods, financial and economic principles Estimation of commercial damages Must clearly define facts and assumptions underlying calculations Helpful to trier of fact Methods and

33 Variety of methods, financial and economic principles Estimation of commercial damages Must clearly define facts and assumptions underlying calculations Helpful to trier of fact Methods and procedures must relate to the specific issues in dispute Calculations not tied to the underlying cause of damages may be deemed irrelevant or unreliable Attorneys will expect good work Verify post events, competitive operations, and trends 33

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