Once in a while in a life of many businesses a ‘bad actor’ manages to cause enough harm to disrupt business operations and lead to a loss of earnings or even a long-term business damage.
Unsurprisingly, business owners take a dim view of such actions and bring a legal action to redress the injury. One objective of such court cases is to compensate the business owners for their loss. Another is to stop future attempts to do harm. Aggrieved business owners may be filled with righteous rage and seek to exact punitive damages as well to teach the bad actor a lesson in civil behavior.
So far, so good. But the key question is how to measure the extent of damages suffered by the business? Here are some of the common methods that stood the test of time in courts when assessing the economic damages:
- the lost profits measurement
- the reasonable royalty method
- loss of business value.
If the loss a company suffers is relatively short lived, measuring the difference between the resulting profits and an estimate of profits that would have been seen but for the wrongful act gives a defensible measure of economic damages. Simple and to the point.
Suppose the company’s intellectual property (IP) such as valuable trade secrets was stolen. If you can assess a reasonable royalty payment for this or comparable IP, the royalty income thus estimated may be a better way to go especially if the lost profits are difficult to pin down.
Finally, any lasting damage to the business may well depress its value in the long term. Estimating business value before and after the wrongful act gives you a measure of the economic damages sustained by the company.
You have three approaches to choose from when valuing a business: asset, income, and market.
The asset based valuation for economic damages typically uses the asset accumulation method. You make a careful compilation of the company’s assets and liabilities, including those on the books and, importantly, intangible assets developed internally and any contingent liabilities.
Among the income based valuation methods the discounted cash flow method is perhaps best suited for business valuation to estimate economic damages. The method lets you forecast business earnings under the assumptions that reveal the effects of economic harm suffered.
Under the market approach, you have the choice of the guideline publicly traded company comparison as well as the actual prices paid in comparative business sales. If you opt for the guideline public company comparisons, be sure to adjust the valuation multiples you get for lack of marketability and control if the subject company is privately owned and you are considering damages incurred by minority shareholders.