Quantifying Economic Damages

Business disputes arise every day. For example, a supplier violates a provision of an exclusivity contract ... a publisher infringes on a writer's copyright ... or a competitor steals a trade secret. These wrongdoings typically result in one party losing money. It's up to the legal system to restore order -- and award economic damages.

Here we discuss some approaches to quantifying economic damages, as well as potential pitfalls and contentious issues that may arise.

Start with Causation

A damages calculation starts with a theory that links the actions of the defendant to a loss incurred by the plaintiff. For example, "But for Mr. X's copyright infringement, ABC Company would have earned $x more in pretax profits from 2011 through 2014."

Courts award damages to make the plaintiff "whole" again. Generally, damages are calculated on a pre-tax basis, because plaintiffs typically owe taxes on compensatory damages awards.

Defendants aren't responsible for losses caused by external factors. For example, damages calculations should exclude losses caused by increased competition in the marketplace or by an economic downturn. In today's uncertain economy, it can be tricky to separate losses caused by a defendant's alleged wrongdoing from losses caused by external events.

Use a Recognized Approach

When persuading the courts to accept a damages calculation, a valuator typically uses one (or more) of several generally accepted methods, such as the:

• ‍Yardstick method. Damages under this method are based on how guideline companies performed. Courts perceive industry trends to be an objective indicator of how the plaintiff might have performed if not for the defendant's wrongdoing. But the subject company must be sufficiently similar to comparable (or guideline) companies.‍
• Before-and-after method. Here, damages equal the difference in the plaintiff's actual performance before and after the defendant's wrongdoing. Or an appraiser might quantify a plaintiff's loss by assessing how much the defendant actually benefited from the wrongdoing.‍
• Sales projection method. A valuator may choose to analyze historic trends and forecast how the plaintiff might have fared if not for the defendant's actions.

There's no universally accepted method for quantifying economic damages. Appraisers customize their approach on a case-by-case basis -- and often they use more than one method to support their opinions.

Anticipate Pitfalls and Issues

Damages calculations are a matter of professional opinion. Two competent appraisers employing sound methodology are unlikely to arrive at exactly the same conclusion. Subjective assumptions include:

• ‍Discount rate. The most popular way to estimate damages is to discount projected lost profits (derived using the yardstick, before-and-after or sales projection method) to their net present value. The discount rate generally reflects the risk of achieving the projected profits and the plaintiff's use of funds.‍
• Duration of damages. Usually, damages occur over a finite time period. If a plaintiff is permanently damaged, the valuator may quantify damages as the difference in the company's value before and after the defendant's wrongdoing.‍
• Costs. Lost profits calculations include all related costs -- not just revenues. For example, if a retailer lost $100,000 in sales due to a breach of contract, the valuator would subtract all variable costs associated with the lost revenues.

Courts may not embrace damages calculations that fail to establish causation or to mitigate damages. After a defendant's wrongdoing is revealed, the plaintiff has an obligation to mitigate damages, if possible.

Enlist Outside Expertise

Estimating lost profits is a natural extension of a valuator's skill set. Damages calculations require an understanding of accounting, financial analysis and forecasting, industry and economic trends, and the time value of money. Qualified appraisers also know about relevant legal precedent and how to effectively testify in court.