Critiquing Economic Damage Reports


1
CHALLENGING 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.
2
Errors 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

3
1. 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.)

4
1. Experts Damage Methodology
5
Experts Damage Methodology Defined As

• The quantification and characterization
• of damages based on the experts adopted
• and/or the experts self-developed
• assumptions.

6
Experts 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.

7
1. 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
8
Damage Date Survey
Date Selected Depends on Facts and Circumstances
Source AICPA 2003 Business Valuation Conference
9
Correct 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
10
Double-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
11
Double-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
12
The 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.

13
Lost 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.
14
Survey 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
15
The 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.
16
Tax 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
17
2. 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.

18
Experts 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

19
Applications in Non-Judicial Settings
Generally an experts methodology will sustain a
Daubert challenge if the methodology is accepted
in

• Academic Theory
• Industry Practice

20
Errors 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

21
Discount Rates of Emerging Businesses

• Particularly in cases involving start-up
  businesses business valuation discount rates are
  widely ranged. The followings (20-27)
  discuss the reasons for the wide range. Examples
  of different levels of discount rates are shown
  on28.

22
Emerging 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.
23
Emerging Businesses Success or Failure

• Approximately 750000 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

24
Different 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

25
Different 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

26
Different 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

27
Key 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

28
Key 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

29
Key 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)

30
Effect 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