2012 LSU Fraud and Forensic Accounting Conference [July 23-24, 2012]

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

What is the Diminution of Business Value?

1

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.

Diminution of Business Value vs. Lost Profits

• •

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 In either method, future cash flows must be determined in a “but for” scenario.

The divergence occurs by differences in inputs, assumptions, and timing.

Determining Future Cash Flows

• • 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.

Lost Revenue

Methodologies

1. Before and After 2. Benchmark 3. Specific Models

• • •

Lost Revenue

Before and After

“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 1 200 1 150 1 100 1 050 1 000 950 900 20X0 20X1 20X2 "But for" scenario

Event Year

20X3 20X4 Actual scenario 20X5 Lost Revenue 20X6

Lost Revenue

Before and After

• Complications New business with no or short history of operations

• • •

Lost Revenue

Benchmark

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

Lost Revenue

Specific Models

• •

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

Lost Revenue

Sanity Check

• 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

Lost Revenue

Sanity Check

• Market share – Is the growth rate reasonable?

Example:

Year Industry Revenues Industry Revenue Growth Plaintiff Market Share Plaintiff Revenue Plaintiff Revenue Growth 0

100,000,000 0.0%

5.0%

5,000,000 10.0%

1

100,000,000

5.5%

5,500,000

2

100,000,000

3

100,000,000

4

100,000,000

6.1%

6,050,000

6.7%

6,655,000

7.3%

7,320,500

5

100,000,000

8.1%

8,052,550 • 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

Cost Estimates

What Are Avoided Costs?

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.

Cost Estimates

Plaintiff’s Cost Structure

• • 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

Cost Estimates

Fixed vs. Variable Costs

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

Cost Estimates

Methods of Estimation

• • •

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

Cost Estimates

Sanity Check

• • 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

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.)

Present Value Calculation

Ex Ante/Ex Post Methodologies

• • •

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

Present Value Calculation

Measures of Cash Flow

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

Present Value Calculation

Measures of Cash Flow

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.

Present Value Calculation

Discount Rate

• • • • • 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.

• • • •

Present Value Calculation

Assessment of Risks

• Availability of capital – Was capital invested before the damaging event occurred?

Plaintiff’s experience Experience of others Barriers to entry Economic factors

Present Value Calculation

Failure of the Going Concern

• • 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

Other Consideration

Loss Period

• • 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% 10 year period of cash flows 20 year period of cash flows 40 year period of cash flows 50 year period of cash flows 100 year period of cash flows Perpetuity \$6,145 \$8,514 \$9,779 \$9,915 \$9,999 \$10,000 % of Value Captured 61% 85% 98% 99% 100%

Other Consideration

Taxes

• Damages are generally taxable as ordinary income • Pre-tax or post-tax discount rates?

Other Consideration

Interest

• • • • • 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

Other Consideration

Intellectual Property Methodologies

• 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

Other Consideration

Securities Fraud

• • 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

Example

Stolen Product Line

Revenue Costs Materials Labor Factory costs Direct costs Gross Profit Overhead Pretax Income

Actual

10,000,000

%

4,000,000 40% 3,000,000 1,000,000 8,000,000 2,000,000 20% 1,000,000 1,000,000 10%

New Product

2,000,000

%

400,000 500,000 0 900,000 20% 1,100,000 55% 100,000 1,000,000 50%

“But for”

12,000,000

%

4,400,000 3,500,000 1,000,000 8,900,000 37% 3,100,000 1,000,000 2,100,000 26% 18%

Example

Stolen Product Line

Launch Costs Factory changes Marketing Working capital costs

Actual % New Product

100,000 50,000 300,000

% “But for” %

Discount rate New product line risks Large diversified company Total discount rate 18% 18% 18% 5% -2% 21%

Example

Stolen Product Line Year 0

Pretax income Launch costs Discount factor (21% discount rate) Present value Sum of years 0-5 Sum of yearly cash flows and terminal value 0 450,000 1.000

450,000 2,475,984 5,662,293

1

1,000,000 .826

826,446

2

1,000,000

3

1,000,000

4

1,000,000

5

1,000,000

T

1,000,000 .683

683,013 .564

564,474 .467

466,507 Terminal Year Multiple .386

385,543 10.0x

.319

318,631 3,186,308 Sanity Check: Market Capitalization to EBITDA 5,662,293 1,000,000 = 5.66x