Damages calculations in breach of contract cases represent efforts to determine the amount of money that would make a plaintiff “whole” after suffering some alleged wrongdoing (breach of contract) by another party, usually a defendant. Damages are also estimated when fires or natural disasters disrupt business among other situations. We’ll focus on contractual issues here.
Damages are often measured by the extent of “lost profits” that are the proximate result of an alleged breach of contract. In general, this means calculating the present value of the estimated lost profits of the plaintiff caused by the alleged breach of contract.
The value of Delta Distribution, Inc. (“Delta”), a hypothetical, regional distributor of machine tool products and equipment, can be defined as the value of all expected future benefits, or cash flows, to be derived from the business discounted to the present at a discount rate that is reflective of the risks associated with those cash flows. When business appraisers value a business like Delta, they value all of its expected future cash flows.
In a breach of contract case, a plaintiff may allege that the termination of a contract to sell a particular product resulted in lost profits. For this example, assume that the Delta had a contract with Toolex, Inc. (“Toolex”), a large manufacturer of machine tools. To simplify the discussion, assume that Toolex did terminate the contract, not in accordance with the agreement, in order to implement a direct sales program nationally.
Normally, damages are alleged and the fact of damages must be proven before alleged lost profits can be awarded. For this example, there is no question of the fact of damages. The business appraiser or damages expert must then quantify the extent or magnitude of the damages.
The cash flows associated with the terminated Toolex contract can be thought of as a portion of Delta’s sales, gross profits and earnings. In this case, the appraisal expert would want to do a number of things in order to reasonably estimate the lost profits from the Toolex contract. The analysis might include, among other elements:
- Analysis of the historical financial performance of Delta for the last several years.
- Analysis of the sales, gross profits and other expenses associated with sales of Toolex products. This analysis would include looking at the Toolex line and its relative shares of sales (15%) and gross profits (18%) and other expenses among the other Delta product lines. This analysis is designed to estimate the actual contribution of Toolex products to overall profitability.
- Consideration of the regional economic outlook, as well as the national economic outlook, both of which could impact future sales of Delta’s various lines, including those of Toolex.
- Consideration of alternative product lines that Delta might obtain to take the place of the Toolex line of products and the time it might take to replace the missing Toolex sales. Mitigation is the responsibility of Delta in this case, at least as I understand damages law from a business perspective.
- Consideration of the actual performance of Delta following the contract termination.
With this base of information the business appraiser has the ability to develop a reasonable sales forecast for Delta. “But for” the contract termination, Delta had prospects to sell Toolex products and its other lines, as well. So the appraiser might develop a forecast as if the Toolex contract remained in place.
The next step might be to show the actual performance of Delta absent the Toolex contract in relationship to the forecast just described. The difference in profits between the two forecasts (or actual for a period and then forecasted from there) is a measure of lost profits. Lost profits represent the portion of expected cash flows that are lost as result of the breach of contract.
However, the appraiser cannot reasonably forecast this difference into the indefinite future. In this case, Delta obtained an alternative line from another company and began to develop sales of the substitute through its network. The appraiser might make a reasonable forecast of the growth (and profitability) associated with the new line over a reasonable period of time. As its sales grow and profitability increases, the lost wedge of profits created by the “but for” forecast and the forecast without Toolex is normally diminished over time.
With these tools in hand, the appraiser can then estimate the present value of the diminishing stream of lost profits. The discount rate for this estimation would likely be one reflective of the risks associated with Delta’s overall cash flows (unless there is a compelling reason that the particular cash flows in question are more or less risky than overall cash flows).
Theory of Damages
What we have just described is a theory of damages that says that Delta is damaged by the contract termination by the difference in profitability between what it would likely have earned had the Toolex line remained in place and what it could reasonably expect to earn, inclusive of replacement profits, in the absence of the Toolex line.
This theory of damages would put Delta in approximately the same financial position, with the damages award, as it could have expected to be in but for the termination of the Toolex contract.
The business appraiser has another responsibility in damages matters such as the Delta/Toolex example. The appraiser must “prove” the reasonableness of his or her conclusion of damages. One way to do this is to provide in the context of Delta’s (fair market) value.