Damages Litigation-Diminution of Business Value 2012 LSU Fraud and Forensic Accounting Conference [July 23-24, 2012]

Table of Contents I.Diminution of Business Value Methodology II.Lost Revenue III.Cost Estimation IV.Present Value Calculation V.Other Considerations VI.Example

Section I - Diminution of Business Value Methodology

Diminution of Business Value Methodology The difference between : 1.the value before the event in dispute, where the value may be calculated as the present value of the future cash flow projections; and 2. the value after the event has occurred, where the value may be calculated as the present value of the future cash flow projections after consideration of the value-impairing event. What is the Diminution of Business Value? 1

Diminution of Business Value Methodology Diminution of Business Value Business value is more holistic in utilizing –Income approach –Market approach –Cost/Asset approach Like measuring the difference between the areas of two circles Loss of Profits Considers differences in income (comparable to an income approach in business valuation) Like measuring the distance between two points Diminution of Business Value vs. Lost Profits In either method, future cash flows must be determined in a “but for” scenario. The divergence occurs by differences in inputs, assumptions, and timing.

Diminution of Business Value Methodology Future cash flows that would have occurred “but for” the breach or wrongful act must be estimated, as determined by estimations regarding: Lost revenues Cost avoidance Variations in value can occur because of differences in timing of: The event date The litigation date The valuation date This may require moving cash flows backwards and forwards in time, multiple times. Determining Future Cash Flows

Section II - Lost Revenue

Lost Revenue 1.Before and After 2.Benchmark 3.Specific Models Methodologies

Lost Revenue “But for” analysis But for the defendant’s action, the plaintiff’s revenues would have continued to grow at x% Based on plaintiff’s historical performance and trends Example: “But for” scenario revenues – 2.5% annual growth based on historical trend Less: Actual scenario revenues Lost Revenues Before and After Lost Revenue

Complications New business with no or short history of operations Before and After

Lost Revenue Actual vs. Budget/Projections Actual performance of similar business Industry averages Complications: Requires budgets/projections created prior to the event Application of similar business or industry benchmarks may be unwise in events with regional or industry consequences, e.g. April 2010 BP oil spill Business is new or unique, e.g. internet or high-tech companies Benchmark

Lost Revenue Contract Terms If litigation is in regards to breach of contract or the plaintiff’s business is contract based, a reasonable estimate of the “but for” scenario could be made assuming the contract were fulfilled according to the terms of the contract, including: Volume Price/cost per unit Defendant’s Revenues Identify revenues associated with the misappropriation of trade secrets Specific Models

Lost Revenue Capacity –Capital resources –Labor/technological resources –Consumer demand Universal Commodities, Inc. v. Weed, 449 S. W. 2d 106 (Tex. Civ. App. 1969) Defendant breached contract, but no damages awarded because plaintiff did not have financing or capital to operate business even if contract were performed Sanity Check

Lost Revenue Market share –Is the growth rate reasonable? Example: Industry and other considerations –Profits attributable to factors other than misappropriation or any harmful act would not have to be disgorged. This is particularly true in certain cases, such as when using the defendant’s revenue methodology or valuing a patent that may be used in combination with other value creating features Sanity Check

Section III - Cost Estimates

Cost Estimates Avoided costs are “costs that would have been incurred in connection with the generation of the lost revenues but were not incurred.” 2 Costs incurred by the plaintiff that would not have been incurred except for the actions of the defendant can be offset against avoided costs. What Are Avoided Costs?

Cost Estimates Defendant’s costs are irrelevant Costs must be examined within the plaintiff’s cost structure –Analyze historical financial statements and projections Fixed vs. Variable Methods of Estimation Sanity Check Plaintiff’s Cost Structure

Cost Estimates Fixed costs are usually not avoidable. Variable costs, those that vary with revenues that would therefore not be incurred “but for” the sale, are usually avoidable. Cost of goods sold –Vary with lost revenue Inventory accounting methods create differences between plaintiff’s and defendant’s CoGS Direct costs –Vary with lost revenue Overhead costs –Generally unavoidable, e.g. rent –Can be attributed to revenue in some cases, e.g. marketing/advertising Indirect costs –Fixed or variable, sometimes avoided, sometimes not Fixed vs. Variable Costs

Cost Estimates Nonstatistical Account analysis –Fixed/variable decision left to the subjectivity of the analyst based on review of financial statements Direct costs –Specifically identifies the input costs, such as direct labor and materials Cost accounting allocation –Allocates indirect costs based on variable measures, such as revenue or units sold Statistical Quantitative identification of relationships through: Regression analysis Survey data Attribute sampling Requires understanding of statistical methods and rules Methods of Estimation

Cost Estimates Cost estimation can be complicated. For example: Plaintiff launched new product line without cost history –Solution: Estimate costs based on similar businesses or industry averages Product line is entirely new –Solution: Rigorous identification of direct costs Sanity Check

Cost Estimates In determining lost revenues and estimating costs, assumptions must be made considering: The business plan Capital resources Plaintiff’s experience Industry factors (barriers to entry, etc.) and trends (growing market, etc.) Economic factors (business cycle, etc.) General Guidelines for New Businesses

Section IV - Present Value Calculation

Present Value Calculation Ex Ante Assumes all lost profits are future lost profits, i.e. valuation is made as of the date of the event or harmful action by the defendant and all cash flows are discounted to this date The value is then brought forward to the date of the award Only knowledge known as of the event date may be considered in the valuation Ex Post Assumes some lost profits are historical (occurring prior to the date of the award) and some are future (occurring following the date of the award Historical profits may be brought forward to the date of the award, and future profits are discounted to the date of the award Neither historical nor future profits are ever discounted to the date of the event All knowledge known as of the date of the judgment may be considered in the valuation Ex Ante/Ex Post Methodologies

Present Value Calculation Lost profits and diminution of business value diverge on the basis of what precisely is to be discounted. Diminution of Business Value Methods Net Cash Flow to Equity Net Income (after taxes) + Noncash Charges (e.g.) depreciation, amortization, deferred taxes) – Capital Expenditures (the net changes in fixed and other non current assets)* – Changes in Net Working Capital* + Net Changes in Long-Term Debt* = Net Cash Flow to Equity Net Cash Flow to Total Invested Capital Net Income Available to Shareholders (after taxes) + Noncash Charges – Capital Expenditures* – Changes in Net Working Capital* + Interest Expense, Net of the Tax Benefit (interest expense x [1 – tax rate]) = Net Cash Flow to Total Invested Capital * The amounts are the levels necessary to support projected business Measures of Cash Flow

Present Value Calculation The lost profit method does not fully develop the estimates needed to determine net income or cash flows. Lost Profits Method “But for” Sales – Impaired Sales = Lost Sales – Avoided Costs = Lost Profits Use of a cash flow based method is better for determining damages when large capital expenditures are required at the outset or occur irregularly over the life of the project. Measures of Cash Flow

Present Value Calculation As always, the discount rate must match the cost of generating the profits to be discounted. Risk-free rate Plaintiff’s cost of debt Plaintiff’s cost of equity Plaintiff’s weighted average cost of capital Rate of return on a similar investment Selection of an appropriate rate depends on unique circumstances such as: Were the lost profits generated from a business line that is inherently riskier than what is reflected in its WACC? Is the company still a going concern following the event or harmful act? What are the company specific risks? The courts have provided little guidance on the issue of selecting an appropriate discount rate. Discount Rate

Present Value Calculation Availability of capital –Was capital invested before the damaging event occurred? Plaintiff’s experience Experience of others Barriers to entry Economic factors Assessment of Risks

Present Value Calculation If the event or harmful act causes the business to fail, the market value of the business can be awarded as damages. Costs incurred in winding up and liquidating the business should be included in the valuation Damages from a “slow death” in which the company fails a number of periods after the event can include the diminution of business value and lost profits in the period between the event and the failure of the business Failure of the Going Concern

Section V - Other Considerations

Other Consideration Diminution of business value typically presumes valuation of cash flows into perpetuity Limitations on how many years of loss can be recovered means the terminal value cannot grow into perpetuity –E.g. contract limitations, intellectual property Consider the declining value of cash flows over long periods of time. Example: $1,000 annual cash flow in perpetuity, discounted at 10% Loss Period

Other Consideration Damages are generally taxable as ordinary income Pre-tax or post-tax discount rates? Taxes

Other Consideration Historical cash flows may need to be moved forward. Courts have considerable discretion in determining the interest rate on pre-judgment damages. Interest rate selection and application varies across jurisdiction. Statutory rates Risk-free rates Plaintiff’s cost of capital Defendant’s cost of debt Simple interest or compound interest Interest

Other Consideration Patents: Damages cannot be less than the amount of a reasonable royalty Copyrights and Trademarks: Lost profits method, royalty rates, decline in market value of copyrighted material Intellectual Property Methodologies

Other Consideration Plaintiffs’ seek damages resulting from failure to disclose adverse information. Reversal of scenarios: Diminution of business value is the difference between the price paid for the securities (the actual scenario) and the value of the securities had the information been known at the time of purchase (the “but for” scenario) Must account for more factors than only the decline in price when the information did become available Securities Fraud

Section VI - Example

Example Stolen Product Line Actual%New Product%“But for”% Revenue10,000,0002,000,00012,000,000 Costs Materials4,000,00040%400,00020%4,400,00037% Labor3,000,000500,0003,500,000 Factory costs1,000,0000 Direct costs8,000,000900,0008,900,000 Gross Profit2,000,00020%1,100,00055%3,100,00026% Overhead1,000,000100,0001,000,000 Pretax Income1,000,00010%1,000,00050%2,100,00018%

Example Stolen Product Line Actual%New Product%“But for”% Launch Costs Factory changes100,000 Marketing50,000 Working capital costs300,000 Discount rate18% New product line risks5% Large diversified company-2% Total discount rate18%21%

Example Stolen Product Line Year012345T Pretax income01,000,000 Launch costs450,000 Discount factor (21% discount rate) Present value450,000826,446683,013564,474466,507385,543318,631 Sum of years 0-52,475,984Terminal Year Multiple10.0x3,186,308 Sum of yearly cash flows and terminal value 5,662,293 Sanity Check: Market Capitalization to EBITDA 5,662,293 = 5.66x 1,000,000

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