By Zach Reichenbach
Have you ever been involved in litigation where lost profits was the remedy of damages, but the experts’ lost profits calculations did not line up? For many of these cases, you probably remember the analyses differing so drastically that there was no way to reconcile the amounts. These types of cases can be highly contested, and the legal and expert fees are often high, since each damages expert can have dramatically different opinions. Your job as the litigator is to make sure your expert has the appropriate information to make their calculations with supportable data.
There are common battleground issues to be aware of in cases where the remedy of damages is lost profits. Two of the more common issues are the variable versus fixed cost determination, and the income and expense projections.
The calculation of lost profits is revenue minus variable costs, where fixed costs are not subtracted from revenue in the calculation. Experts are aware of the differences between variable and fixed costs, and also understand that this difference can have a significant impact on the lost profits calculation. As an example, one expert could determine variable costs to be $4,000,000, including salaries and benefit expenses, while the other expert does not include salary and benefit expenses and determines the variable costs to be $2,000,000. There is now a $2,000,000 difference between the two experts’ calculations because they differ on how to classify salaries and benefits expense. The determination of who is right and who is wrong usually depends on whose analysis is more fully supported by data and research.
There are many sources of information that an expert can rely on when researching information on lost profits. One expert might rely on a certain set of financials, whereas another expert may have access to the company’s controller, and be able to fully understand the differences in expenses. Having a mix of both of these sources, in addition to the experts’ own experience and analysis, usually results in a supported opinion. But this scenario takes place in a perfect world, and having everything available in the record is usually not the case. This is why it is critical for counsel to work with the expert to get them the necessary documentation, sometimes obtaining documentation through subpoena or deposition. Ultimately, counsel should communicate with the expert during the analysis and report writing stage to understand which areas of the expert’s analysis are not fully supported, and what ways counsel can help to provide the necessary documentation.
The other common issue when the remedy of damages is lost profits, is determining the revenue and variable cost projections in the analysis. Companies that suffer lost profits may continue to lose profits well after the trial date, so it is important for the expert to consider future lost profits that the damaged company may incur. Each expert will have a different opinion on the projected revenue and variable costs, and this results in damage opinions that are very different from expert to expert. For instance, one specialist may project revenue to be $15,000,000 a year, while another projects revenue at $7,000,000 a year. The difference in revenue is significant, and most likely will result in a damage amount that varies to some degree.
These differences in expert opinions can be the result of a variety of factors, but a common one is the documentation used to support the opinions. The typical documentation used to support these opinions may include projections prepared by the company, discussions with the company’s controller/CFO, historical financial performance, market and economic trends and the financial performance of competitors.
There can be many battleground issues in litigation cases where lost profits is the remedy of damages. Each case will be different, but the variable versus fixed cost issue and the revenue and expense projection issue are two of the most common. The bottom line is that the expert opinions need to be supported with facts and reasonable assumptions. These cases are commonly lost because one expert does not have the necessary facts to support their opinions. With millions of dollars potentially at stake, knowing what to do ahead of time can make a dramatic difference.
As a principal in Ellin & Tucker’s Forensic and Valuation Services Group, and member of the firm since 2008, Zach Reichenbach, CFA, CPA / ABV has extensive experience providing expert testimony in federal court and providing litigation services for domestic and international commercial damage and valuation engagements. He specializes in complex commercial damages, valuation, intellectual property, and forensic accounting assignments.