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Which Is Appropriate: Lost Profits or Lost Business Value?

Posted by Meaden & Moore on Apr 19, 2019 8:00:00 AM

One Hundred Dollar BillsThe U.S. District Court for the Middle District of Pennsylvania recently awarded damages for various business torts committed against a print shop by two former employees and the competing business they started. A key question was whether lost profits or lost business value was the appropriate measure of damages.

Alleged Wrongdoing

The defendants, a married couple, were two of Mifflinburg Telegraph’s five employees. The wife’s title was “primary designer and printer,” but she essentially ran the business after the owner’s death in 2013. She entered into negotiations with the owner’s estate to purchase the business for $225,000, but the negotiations failed.

In late 2013, the wife started a competing business, Wildcat Publications. Before her departure from Mifflinburg Telegraph in February 2014, she allegedly provided customers with reorder forms that listed Wildcat’s contact information, misappropriated Mifflinburg Telegraph’s proprietary customer list, and deleted the customer list and order histories from Mifflinburg Telegraph’s computers.

Much of Mifflinburg Telegraph’s business came from repeat customers. So, without order histories and customer logos, the company had to start from scratch.

A “Formidable” Task

The court had difficulty determining damages because the plaintiff failed to justify the amount claimed, and there was no opposing counsel. (The case was decided on a motion for default judgment against Wildcat.) In addition, the company’s damages consisted mainly of “intangible damage to its goodwill,” and any decrease in value could be attributed to the recent death of its owner, the loss of key employees or negative market forces in the printing industry.

The plaintiff sought approximately $265,000 in damages, based in part on testimony from the executor of the owner’s estate. The executor valued the company prior to the defendants’ actions at approximately $300,000. The value was based on an industry rule of thumb of four times the average adjusted annual earnings before depreciation, interest and taxes (EBDIT) for the previous five years. The executor also opined that the company had no value at the time of the hearing.

The court opinion references a sworn affidavit from a business valuation professional. He estimated that the value of Mifflinburg Telegraph’s equity in 2013 was between $25,000 and $226,000, using various methods. He estimated that it was worthless by 2015, however.

The court valued the company at $225,000 in 2013, based on “what a ready, willing and able buyer was prepared to pay for it.” But the court couldn’t “in good conscience” award Mifflinburg Telegraph an amount equal to the proposed purchase price.

Although the “duplicitous” actions of the defendants clearly damaged Mifflinburg Telegraph’s goodwill, the business continued to operate. The company retained its assets and accounts receivable, so some value remained. Absent a contract to purchase the company or covenants not to compete, awarding Mifflinburg Telegraph the entire price would make it “more than whole.”

Rather, the court concluded, the award should represent the damage the defendants caused to Mifflinburg Telegraph in the form of lost profits. The court found Mifflinburg’s tax returns for 2008 to 2014 to be “instructive” when qualifying lost profits.

Notably, from 2013 to 2014, just after the defendants began competing with the company, its gross profits plummeted by nearly 70%. So, the court awarded Mifflinburg Telegraph $157,500 – 70% of its $225,000 value.

The court assumed that a 70% drop in gross profits equates with a 70% loss of value. Many financial experts would dispute this assumption, arguing that the court based its damages calculation not on lost profits but on the decrease in the company’s value. While the court admits that the 70% loss in value is an “imperfect calculation,” the judge found that amount “to more closely represent the harm done here” than awarding the plaintiff for the entire value of the business.

Bottom Line

The court’s reasoning in this case seems consistent with the prevailing view: Lost business value is an appropriate damages measure when a business is substantially destroyed, but the lost profits measure makes more sense when a business survives. However, the court ultimately based its damages award on lost business value, even though Mifflinburg Telegraph survived.

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Topics: Investigative and Forensic Accounting

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