Calculating damages related to an impaired business can be a difficult task. No one has a crystal ball regarding the future. However, the valuation approach allows for a supportable and hopefully reasonable prediction of what would have happened had an impairment not occurred.
The value of an ongoing business to an owner in its most straightforward economic sense is the present value of the future projected earnings (revenue less expenses) of that business that will flow to the owner, adjusted for the risk factors that may foreseeably impact those future projected earnings. The field of business valuation has any number of ways in which a business can be valued, and appropriately requires certain parameters be defined in the valuation process.
Value to Whom
One of the first things to be done in calculating a loss related to business impairment is to clearly define the entity to which the loss is being valued. The value of a business is different for different parties. A business may have a much greater value for a majority owner of a business who is involved in its daily operations and management when compared to a minority owner who has invested money in the business but is otherwise passive in the operations and management of the business. An asset lender of a business may value the business on the market or liquidation value of its encumbered assets only and not in the ongoing operations of a business. And a strategic investor may value a particular business not only based on the money flowing from that business to the investor but also based on profits from other owned businesses that depend on the product or services of the impaired business. Thus, defining the party to which the value of a business is being calculated is a necessary preliminary step in any calculation of lost value of a business.
Interest Being Valued
Another necessary step in calculating a business loss is to define what specifically is being valued. If the injured party is a minority owner of a business who does not participate or have control in management decisions of the business, then the value of the business to that party is likely less than the percentage ownership value of the entire business entity, since risk factors related to lack of control and influence of the business are heightened, subsequently lowering the present value of the future risk-adjusted benefits flowing from that business. Similarly, a business that is publicly traded is more readily marketable than a business that is not as readily marketable, and the former will result in a higher value due to the ability to convert ownership of the business into cash quickly and without the restrictions that the latter may have.
Standard of Value
There are different standards of value that result in significant differences in the ownership interest value of a company. One widely recognized standard of value is fair market value. Unfortunately, this term of art is often used loosely in buy-sell agreements and shareholder agreements and results in misunderstandings between shareholders. Fair market value is defined in United States v. Cartwright, 411 U. S. 546, 93 S. Ct. 1713, 1716-17, 36 L. Ed. 2d 528, 73-1 U.S. Tax Cas. (CCH) ¶ 12,926 (1973), as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. This definition is consistent with IRS Revenue Ruling 59-60, which is sometimes referred to by valuation analysts as the cornerstone of the valuation discipline since it describes a number of factors to be considered in performing a business valuation.
A second standard of value is fair value. Fair value is often defined in the courts or in shareholder and buy-sell agreements, sometimes without enough information, which results in a significant difference in the calculated value of ownership blocks by different parties. Often, a difference between fair value and fair market value is in whether or not adjustments are made to the value calculation for consideration of the business’s marketability or management control. Sometimes, dissenting shareholder actions or minority oppression actions require a fair value calculation, although even within the same jurisdiction, the meaning of fair value is subject to the nuances of the particular instance.
Another standard of value is investment value. Investment value is defined as the specific value of an investment to an investor based on the individual’s investment requirements. This standard of value will consider the potential synergies of the specific investor, risk and rate of return requirements, and perhaps financing costs and tax status. In practice, I seldom see this standard of value being used in a calculation of a business loss.
Premise of Value
The premise of value relates to whether you are valuing the projected cash flows of an ongoing business or whether you are valuing the market value of the assets of the business in an orderly liquidation. This is an important consideration that is often dictated by the particular situation. If it is reasonable to assume the business would have or will be able to continue in the future, then the premise of value should be based on the projected future earnings flowing from the business. However, if the business will not continue to operate, then the adjusted market value of the assets of the business may the appropriate premise. If the business has assets that, taken together, may be attractive to a synergistic buyer, then the premise may be based on a reasonable transaction value of similar businesses in similar situations.
In my experience, the income approach is used most often to calculate a loss associated with business impairment. The income approach projects the future revenues and expenses of the business during the impairment period and discounts them to present value. Risk associated with the projected revenues and expenses can be included in either the projections or in the discount rate. Typically, valuation professionals include the risk factors in the discount based on accepted methods of doing so, although such risks can be factored into the projection assumptions that may be more consistent with the underlying goal of the damages remedy, which is to make the injured party whole, no more or no less. Arguably, the projections should provide the most likely scenario of what would have occurred but for the alleged wrongdoing. A risk-adjusted discount rate may result in an undue reduction to the injured party of its potential loss that occurred only because of the wrongdoing. This is often a point of disagreement between parties.
The asset approach is also used in some situations, sometimes after irreparable harm has been done. For example, a business that was operating because of the work and skill of one particular individual who can no longer perform such work may not be able to continue to operate and earn money. Thus, the value of the assets can become the mitigating value of the potential loss.
The market approach is also used in some situations, particularly in larger companies where reasonable market transactions can be identified. For smaller businesses, this approach is troublesome since comparable transactions are not always readily available and when they are, the situations for those transactions may make them not comparable. Sometimes, small businesses are sold because of personal situations (such as death or retirement of key personnel, personal bankruptcy of an owner, etc.), which results in the transaction information not being a fair indicator of the ongoing, uninterrupted value of the potentially comparable business. In practice, I find this approach to be rarely used in calculating losses associated with business impairment.
Regardless of the valuation approach used, a thorough understanding and analysis of an impaired business and its operational and management strengths and weaknesses, its customers, the industry, competition and the economy are necessary in order to make reasonable and supportable projections of what would have happened in the foreseeable future but for an alleged wrongdoing that impaired a business. Allowing your expert or consultant to gather as much information as is necessary to make reasonable judgments and assumptions that relate to the projected business value that would have likely occurred before the alleged wrongdoing is key to your damage calculation, regardless of whether you are a plaintiff or defendant. •
William E. Harris is a shareholder in ForensicDamages LLC. Harris has 22 years of experience in damage-related disputes. He has taught economic damage-related issues locally, nationally and internationally. He works in his Philadelphia and Haddonfield, N.J., offices and can be reached at email@example.com or 215-720-1570.