Once in a while in a life of many businesses a ‘bad actor’ manages to cause harm. Enough 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. In other words, business owners pursue court cases to get compensation for their loss. Moreover, they will probably want to stop future attempts to do harm. Aggrieved business owners may be filled with righteous rage. They often seek to exact punitive damages as well in order to teach the bad actor a lesson in civil behavior.
So far, so good. But here is the question: how to measure the extent of damages suffered by the business? Consider these common methods that stood the test of time in court cases over economic damages:
- the lost profits measurement
- the reasonable royalty method
- loss of business value.
How lasting are the damages?
Let’s say the loss a company suffers is relatively short lived. Then you can measure the difference between the resulting profits and an estimate of profits that would have been seen but for the wrongful act. This gives you 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. Can you assess a reasonable royalty payment for this or comparable IP? Then you may opt for the royalty income thus estimated as a better way to go. This can work well especially if you can’t pin down the lost profits.
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.
Don’t forget the off-balance sheet assets!
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. This includes 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.