EVALUATING BUSINESS DAMAGES
VALUATION of a small business to determine business damages in litigation is often difficult. Particularly if the business shows a loss on its income taxes. Our experience is that the majority of clients who run small businesses overestimate the value of their businesses, and–consequently–overestimate their losses.
The courts are crowded with people arguing over valuing everything from the income-stream of a mom-and-pop corner store to a market advantage in the sale of complicated technology. This article is limited to an overview of issues that affect the valuation of small businesses with limited fixed assets and debt financing. Here are some of the basic questions our firm asks when looking at a small business damages claim.
QUESTION 1: Lost profits or increased expenses? When looking at a profitable business, it is easy to quantify how much money the business was making before and after the event giving rise to the lawsuit. Subtract, and you have a defensible business loss as business damages.
However, if the business is not profitable, or not very profitable, looking at profits can undervalue the loss. Just because a business is not profitable does not mean that there was no business loss. There are three ways our firm thinks about capturing increased business expenses as business damages when there are no lost profits.
(1) Increased demise of the business. Sometimes the breach of a major contract, a competitor’s unfair business practice, the misappropriation of trade secrets, a personal injury to a key employee, or other “wrong” giving rise to a lawsuit is the last nail in the coffin of a struggling business. The rapid demise of a business can create its own additional losses. There is a significant difference between the timely dissolution and sale of an ongoing business concern versus a “fire sale” price precipitated by an unexpected unfair business practice, failure to pay on a major contract, or unexpected injury to a business owner. A look at cash flow can uncover the difference. If a business had revenues of $300,000, against expenses of $450,000, it is losing $150,000 a year. But, when the injury or business wrong occurs, the revenues can fall much further, while many fixed expenses stay the same. If the business is a type that is regularly bought and sold (e.g., restaurants, bars, brokerage companies), there are experts who can assist in valuing the difference between the value of an ongoing business and one that has ceased (or nearly ceased) operations and needs to be liquidated at a fire sale.
(2) Unavoidable fixed costs and unrealized expenses. Even if a business can be shuttered easily, that does not mean that the expenses of the business can be avoided. For example, lease obligations and equipment rentals that cannot be avoided become a business loss. It is worth looking at pre-injury business investments into projects that were abandoned because of the incident being sued over. For example, investments in leases, insurance, licenses, remodels and the like are all investments that the business may have anticipated recouping, and which can justify a business damages award.
(3) Key-employee replacement costs. In the case of a business owner whose suffered a personal injury, there are additional staffing costs and increased hours by existing employees while the business owner is unable to work. In addition, sometimes we can look at the average wage for what the business owner did and argue that the benefit to the business of their work was at least what they would have been able to receive on the open market.
QUESTION 2: Is the income in cash? A surprising number of businesses are profitable even though they do not generate significant (or any) cash for their owners. The rental business is one example. Many landlords are in the business as part of a long-term strategy to acquire property, even if there is no income coming out of the business. Other businesses are carefully set up to generate tax losses through–for example–depreciation of fixed assets or amortization of intangibles like patents or goodwill, and thereby offsetting other business income.
QUESTION 3: When does the money come in, and what part is from future repeat business? The easiest business to look at are those–like retail stores–that make money on each transaction at the time of the transaction. However, it is often the case that income is spread over many years and may come in long after the business owner’s work is done. For example, insurance brokers often earn a percentage of the premium paid every year the insured buys the insurance. Because many people do not change their insurance from year to year, a sale by a broker in Year 1 often means income in Years 2, 3, 4 and 5. The same is true for many professionals (doctors, dentists, lawyers, accountants) who expect income from future follow-ups. What this means is that an interruption in the business in Year 1 can cost our clients in Years 2, 3, 4 and 5. One way to inquire into this is to ask, how much of the business income is passive, and how much of it is repeat customers?
QUESTION 4: Do the tax returns reflect reality? Businesses are permitted to keep two sets of books: one for the purpose of taxes (cash accounting) and the other for their investors (accrual accounting under Generally Accepted Accounting Principles – GAAP) Plenty of tax preparers have creatively found ways of making all or nearly all of their client’s income disappear from the tax returns. It can be hard to explain to a judge or jury that, even though the business owner told the IRS that they were not profitable, the business in fact had significant income that justifies an award of business damages. The way we lawyers get around this to look, in detail, at what business expenses (tax deductions) are unavoidable when the business is not operating or operating in a limited manner, and argue that those expenses were a legitimate business expense before the incident or injury and will be a legitimate expense going forward, justifying a business damages award.
CONCLUSION: The lesson is simple: small business people are often too busy running their businesses to understand the value of their businesses. So when representing small business owners in business injury litigation– whether it be unfair competition, breach of contract, theft of trade secrets, or personal injury to the business owner–smart lawyers dig into the business books to understand the dynamics of the business. Otherwise, we may either undervalue the losses or mistakenly overestimate them when calculating the amount of business damages.
If you or your business has suffered a loss or injury for which you deserve compensation, feel free to contact us at Shenfield & Associates.
Christopher Shenfield, at Burlingame, February 15, 2016