Damage Calculations

#1: Lost Income, Damages, Business Valuation, Forensic Accounting, Settled
#2: Forensic Accounting, Damage Calculations, Expert Testimony
#3: Elder Abuse, Fraud, Forensic Accounting, Expert Testimony
#4: Loan Agreement and Conversion to Equity – Fraud and Business Valuation
#5: Restaurant Economic Damages Litigation
#6: Bad Faith – Damages for Fire and Business Failure
#7: Lost Income via Facilities Management Company
#8: Impact of Tainted Food Product – Lost Profits
#9: Wildfires
#10: Risky Business: When Lost Value Damages Do Not Involve Lost Income

#1:  Lost Income, Damages, Business Valuation, Forensic Accounting, Settled

Several years ago, several fires raced through Southern California pushed to the ocean by fierce Santa Ana winds.  In the path of the fire storm were hundreds of homes and businesses.  Some of the fires were either started or fed by the alleged negligence of various parties.  The result was claims filed against the negligent parties and Chris Hamilton Forensics was contacted by the law firms handling the plaintiff’s litigation.  Chris Hamilton Forensics was retained to calculate lost income damages and, for completely destroyed businesses, valuations of the business immediately prior to the destruction of the business.

Each of the cases was settled successfully without requiring lengthy litigation.  Chris Hamilton Forensics, by preparing accurate, complete, and reasonable damage calculations assisted the parties in resolving the dispute.

#2:  Forensic Accounting, Damage Calculations, Expert Testimony

Chris Hamilton Forensics was retained to provide forensic accounting and damage calculation analysis in a breach of contract matter and a shareholder dispute involving several companies.  After analysis of accounting and financial records Chris Hamilton Forensics proposed a theory of damages and evidence presentation.  The client and counsel agreed to the approach.

After the damage analysis was done, extensive testimony was provided at deposition and trial.  The result was a verdict in favor of the client.  The court noted in the decision the following regarding the work of Chris Hamilton Forensics: “It should be said that Mr. Hamilton, especially under cross-examination, exhibited good knowledge of the companies in the dispute…”

#3:  Elder Abuse, Fraud, Forensic Accounting, Expert Testimony

Plaintiff’s counsel contacted Chris Hamilton Forensics for assistance in an elder abuse case.  Over the period of several years several real properties and cash had been stolen and re-titled.  Chris Hamilton Forensics was retained to recreate the accounting for several years, quantify the loss, and provide testimony in support of the conclusions and opinions reached as a result of our work.  Trial was held in Superior Court and the testimony from Chris Hamilton Forensics was a central element of the case that was presented in a bench trial.

The court ruled in favor of the elderly couple and ordered a return of the stolen assets.

#4: Loan Agreement and Conversion to Equity – Fraud and Business Valuation

Summary of issue: Chris Hamilton Forensics was hired by defendant in a case alleging fraud and related claims.  The case revolved around a loan agreement that provided for a conversion to equity under certain conditions.  Our client loaned the money and, eventually, all of those conditions were met and our client exercised the conversion provision of the agreement.  Plaintiffs (borrower) immediately sued for fraud and other claims surrounding related to the formation of the original agreement. Defendant counter-sued for damages associated with being “locked out’ of the business and not participating in dividend distributions.

Money involved:  The business was valued at several million dollars.  Alleged damages against our client was the value of the business as well as additional tort damage claims.

Chris Hamilton Forensics work:

Discovery – Plaintiffs refused to provide most of the financial discovery making the case highly forensic, meaning that there were very few records available that would normally be relied upon to express a value.

Valuation – The valuation work was based entirely on tax returns and other random information intentionally and inadvertently provided by Plaintiff.  Opinion of value was based on distributions from the business (S- corporation) to the plaintiffs adjusted for reasonable compensation, taxes, and estimated capital investment required in the business.  The result was a value that was likely conservative due to the inability to adjust draws for personal expenses paid through the business since that information was not available.

Testimony – A bench trial was held involving expert testimony of several hours.

Result:   The court ruled in favor of the defendant and on the issues and deferred ruling on the damages.  This allowed the parties to settle the remaining issues.

#5: Restaurant Economic Damages Litigation

Issue: Civil litigation was initiated in a property dispute between the owners of a restaurant and the owners of a neighboring piece of real estate. Chris Hamilton Forensics was hired to quantify the financial impact of a parking injunction on the value of a restaurant. The injunction would prevent the restaurant from using a driveway that provided access to a parking lot at the rear of the restaurant. There was no other access to the parking lot and loss of that access would require the restaurant to initiate a parking valet service. This service would require additional cost to patrons and would necessarily limit the restaurant hours to dinner only since surrounding parking lots were fully utilized during daytime business hours. Breakfast and lunch business represented 40% of the profits of the business and would be impossible.

Chris Hamilton Forensics work: Two business valuations were prepared: A business valuation was prepared as-if the injunction did not happen and a second appraisal was prepared reflecting the permanent diminution in value had the injunction been made permanent. Because of the type of litigation, Chris Hamilton Forensics was required to consider alternative uses of the building that might mitigate the loss of revenue. Cash flow and economic analysis was prepared for conversion to a smaller sized structure to make room for a driveway and the conversion of the existing space to either a smaller restaurant, walk-up retail, or a combination of both. When comparing the two valuations Chris Hamilton Forensics was required to establish the “permanent” loss in value as opposed to temporary reduction in income. All of this was done in less than a week since the temporary injunction was filed and it was effectively choking the life from the business. There was an urgency to getting the valuations and declarations done so relief could be sought in court.

Result: The case settled with terms that preserved a landmark restaurant. A key aspect of the settlement was the valuation work, which demonstrated that the loss of business income was so significant that the driveway access issue had to be resolved. This caused the two parties to mutually resolve the matter in a way that was satisfactory to both, avoiding additional litigation.

#6: Bad Faith – Damages for Fire and Business Failure

Type of Matter: An insurance claim for a fire that destroyed one of two store locations was the catalyst for potential litigation against the insurance company.

Facts: In the middle of the Christmas shopping season, a high-end retail location was destroyed by fire in the early hours of the morning. Fortunately the store was closed so there were no injuries. However, the store was a total loss. Not only were holiday sales lost but there would be extensive repairs and remodeling to do before the store could be reopened. The rotten timing of the disaster was heightened by the fact that the store, like most other in its industry, was just beginning to recover from a deep and prolonged recession. A strong holiday season was needed to survive.

What followed was a fairly typical give-and-take between an insurance company, that wanted to pay as little as possible, and an insured, who wanted to get back up-and-running as quickly as possible. Eventually, the insurance company stopped paying on the policy because policy limits had been reached. The business needed more cash to effectively open the store.

The insured contacted an attorney whom in turn, contacted Chris Hamilton Forensics to assess what, if any, damages may be recoverable.

Chris Hamilton Forensics Work: We confirmed that, under the policy, the contractual funds had been paid. However, it became obvious that the company had been starved of cash to the point that recovery was now impossible. An analysis of historical cash flow required to maintain the business was prepared and then compared to the cash flow available after the fire. This analysis showed that within 30 days of the fire cash was sufficient. However, within 60 days of the fire the cash deficit was over $100,000 and by the end of the first 12 months post-fire the cash deficit was well over $1,000,000. We prepared an analysis that clearly showed that if the insurance company had made timely payments, the business could have survived. In short, there were two disasters: first, the fire, and second, the bureaucratic delay and obstruction of the adjuster.

Unfortunately, the business was not able to recover from these disasters and ultimately failed. As noted above, the business actually consisted of two locations. One was destroyed by fire and the other remained open and was instrumental in helping to overcome the delay of the insurance company. Ultimately, the double disaster of the burned store took down the entire business as there was simply not enough cash flow to maintain inventory and get the store open. Chris Hamilton Forensics prepared damage calculations showing the cumulative losses incurred after the fire, including the significant post-fire cash infusions provided by the owners.

Result: The insurance company rejected the premise that the business was lost because of their delay in paying on the loss. The case was heading towards litigation and seemed to be destined for a jury decision. At the eleventh hour a settlement was reached that closed the case. The insurance company paid a sum agreed upon in the settlement (terms cannot be disclosed), implicitly acknowledging that our theory of damages was credible.

#7: Lost Income via Facilities Management Company

Type of Matter: The owner of a parking structure contracted out the management of the facility. The management services included collecting the parking fee and remitting the appropriate amount to the owners.  At some point the owners began to suspect that money was being stolen. They did an investigation that included reviewing video surveillance evidence and determined that there was reason to proceed with a more formal investigation. They reviewed surveillance videos for several days and determined rather precisely how many cars entered the facility that were not reported as paying cars. With that evidence in hand they replaced the management company and called an attorney who contacted Chris Hamilton Forensics.

Chris Hamilton Forensics Work: Chris Hamilton Forensics initially reviewed the sampling of days that had been reviewed by management. There was little doubt that the amount of revenue actually collected on those days was materially understated. Based on the sampling we determined the methodology of the theft and, at least on those days, the amount of the theft. The methodology was confirmed by review of additional surveillance and documentation.

The next concern was to determine the period of time the theft took place so that the under-reported revenue could be quantified. Documents were reviewed and we found that the same company held the contract for several years and, additionally, the personnel hired by the management company to work at the parking structure had not changed since the beginning of the contract. The conclusion was that the loss period extended over the entire period of the contract.

Chris Hamilton Forensics determined a ratio of reported cars to actual paying cars identified on the video surveillance and applied that ratio across the entire contact period to determine an amount of lost income. We compared our results with the actual results of income reported by the new management company and were satisfied that we had accurately estimated the lost income.

Result: A jury trial was conducted at which we provided expert witness testimony. The jury came back with a verdict against the defendants and awarded damages based on the lost income calculations prepared by Chris Hamilton Forensics.

#8: Impact of Tainted Food Product – Lost Profits

Type of Matter: A food processing company was notified by Federal and state agencies that Listeria had been traced to their facility. This began a process of sourcing the Listeria and commencing extraordinary measures to recall tainted food, eradicate the contamination and try to recover the business. The result was a lawsuit against the food supplier that shipped the Listeria to the plant.

Background: Chris Hamilton Forensics was retained to determine lost profit damages associated with the events surrounding the Listeria contamination, including shutting the facility for a period of time, recalling product, and overcoming the incredibly negative publicity associated with food poisoning. The source of Listeria was never in doubt. The litigation was almost entirely related to the question of economic damages.

Chris Hamilton Forensics Work: Initially our analysis considered the prospect that there would be a permanent loss of some or all of the value of the company since, at best, the recovery would likely require several years. The certainty of the Listeria contamination and the appearance to the marketplace of negligence or other failings on the part of the company made the prospect of recovery very difficult. After extensive discussions with management we were persuaded that it was reasonable to assume that the company could eventually recover in spite of substantial loss of income, reputation, and goodwill in the industry in the interim.

The next step was to calculate the amount of damages required to compensate the injured party for the injury sustained, and nothing more; such as simply make good or replace the loss caused by the wrong or injury. Because our work was being done before the business had fully recovered, two projections were required. First, we projected financial results for the company as if there has been no Listeria contamination. The second projection involved looking at actual financial results since the damage event and projecting into the future until results matched the “without Listeria” projections signaling the end of the “loss period.”

The difference between financial results as-if the Listeria event did not happen minus the results (actual and projected) after the Listeria contamination was the lost income damages. Finally, the projected lost income was discounted to arrive at a damage amount as of the date of trial.

Result: After extensive discovery and deposition testimony, the case settled on the eve of trial. Chris Hamilton Forensics’ work in clearly and independently identifying the lost income was compelling and that factor, along with others, drove the parties to a pre-trial settlement.

#9: Wildfires

Type of Matter: The recent fires in California are, and have been for a long time, an nearly annual event for which California has become famous. The depth and severity of the recent fires, however, are on a scale of what is rarely seen. Preliminary reports indicate the two largest fires may have been started by malfunctioning utility company equipment. If this is the case, there is significant litigation that will be filed between now and 2019. Hundreds of homes and businesses were damaged or destroyed and the quantification of those losses will be the focus of a lot of work and possibly litigation.

With the destruction of a business is the loss of an asset (the business), employees’ jobs, and also the product or service supply for all the customers. Often that business represents the hopes and dreams and lifelong efforts of one or several people. That loss can be quantified and, under certain circumstances, can be recovered either through an insurance claim or legal action to the extent it can be established that human error or negligence caused the fire.

Background: Several years ago, three major fires burned in Southern California. Each of the fires were separately started due to negligence. The sparks turned to flames and were carried all the way to the ocean by Santa Ana winds. In the wake of these three fires, hundreds of homes and businesses were destroyed. Because of the negligent causation, lawsuits were initiated on behalf of those business owners to recover the damages. Arxis was retained to determine the amount of the damages incurred by many of those business owners.

The nature of a fire necessarily means that the business is reduced to ashes, as are all the local business records. In cases like this, those records must be re-created sufficient to provide the basis for an opinion regarding damages. This is a situation where the forensic accounting and business valuation truly is forensic.

To the extent the business was damaged but would survive the damage calculation was based on lost income from the date of the fire until the business was restored to full function. For a destroyed business the damage was the amount of the business value immediately before the fire.

Arxis Work: The businesses we were hired to analyze included farms, manufacturers, and service businesses. In many cases significant work was done to re-create financial records. As can be imagined, we were dealing with business owners who were severely impacted by these circumstances, both professionally and personally. The human toll of this kind of loss is hard to describe. It is very common for small business owners to believe that their business is worth far more than it will sell for. This perception is doubly difficult to manage in the emotional dynamics of a natural disaster.

Result: The litigation was managed by several law firms on either side of the cases. The initial cases were vigorously litigated. Opposing financial experts were strongly challenged. Calculations, assumptions, and conclusions were tested and verified under the auspices of the court. Ultimately, the first case settled which set the stage for all subsequent cases also settling.

#10: Risky Business: When Lost Value Damages Do Not Involve Lost Income

The following case study examines the veracity and application of one of the most basic formulas used in the valuation of businesses and other intangible assets. The damages case was much more complex and nuanced than presented here. However, the energetic and complex litigation boiled down to a very basic question: Is it possible for a business to lose value even though cash flow generated by the business stayed the same, or increased, after the damage event?

Is it possible that a business can have minimal to no loss of net income or cash flow and still lose value? Theoretically—and most likely, practically—the answer to that question is yes.

A large, profitable, privately held business was up for sale. The sellers (a small ownership group) had adequately prepared for the process, and their efforts resulted in the submission of several letters of intent, with more expected. The sellers had substantial alternative investment opportunities that were dependent on a well-planned and rapid sale of the subject company, and a lot of work had been done to make the business attractive to strategic buyers. The subject company had a significant presence in a well-defined industry with relatively few competitors and high barriers to entry into the market. The sellers knew the company was attractive to competitors and other synergistic buyers and, therefore, anticipated a smooth due diligence process and a quick closing.

The seller’s favored strategic buyer had already submitted an offer, as had the second and third choices. All pending offers were based on the same general formula: 10 times adjusted EBITDA, or more. Several of the potential buyers were granted access to a virtual data room and had visited the business to tour the plant and commence negotiations.

One buyer, in particular, was pressing to close the deal and eventually the other suitors were pushed aside. The formula for calculating adjusted EBITDA and the multiple to be applied to adjusted EBITDA had been negotiated, and both parties agreed. The plan was to complete normal operations the following month, calculate adjusted EBITDA based in part on those operating results, and complete the transaction at the predetermined formula.

The subject company was highly dependent on a single supplier, although there were many available suppliers in the industry. Because it looked like there was going to be a sale of the business, the buyer requested that the sellers contact the supplier to notify it of the sale and to get assurances that there would be no interruption in supply for the new owners. For reasons that are not important for this narrative, once the supplier was informed about the sale, it actively and knowingly sabotaged the sale by immediately cutting off all supply and creating negative publicity throughout the industry and with the company’s customers. Because of the potential reputation damage within the industry, the seller was forced to notify potential buyers of the supply interruption. In response, all potential buyers either dropped out of the process or immediately amended their offers for substantially lower amounts.

Meanwhile, the seller was able to replace inventory supply through new vendors within two weeks and allay customers’ concerns sufficiently to resume normal sales. But the damage had already been done. After several weeks, the primary buyer reengaged in the process. Inventory supply and cash flow had returned to normal and improved. However, the potential buyer dropped its offer from more than 10 times adjusted EBITDA to less than six times adjusted EBITDA. When the sellers rejected the modified offer, the sales process was terminated.

The sellers sued the supplier to recover the lost value of the business and damages related to interrupting a transaction that caused lost opportunity for the sellers. In short, the claim was that the deliberate and dramatic effort of the supplier to damage the subject business and prevent the sale was successful and damages were, therefore, due to the sellers to compensate for lost value related to the contemplated sale. Ignoring the permanence of the loss for purposes of this analysis, the controversy became whether it is possible that a business can have minimal to no loss of net income or cash flow and still lose value. Theoretically—and, most likely, practically—the answer to that question is yes … of course! The shareholders (potential sellers) thought so.

Theory Becomes Application: A basic formula in business valuation, or in the valuation of any intangible asset, is that value equals income1 divided by risk.2 To the extent that expected cash flow (or some other measure of benefit) and the risk associated with that cash flow can be identified, the associated asset (invested capital, in this case) can be valued. For an experienced valuator, this is akin to the law of gravity; it is foundational to valuation theory and practice. The basic formula contains the elements and mathematical relationship of the two core elements of any valuation analysis: income and risk. The formula (income ÷ risk) is the mathematical and theoretical platform for the income and market approaches to valuation.

Every business or intangible asset valuation method, with the exception of the asset approach, uses some form of the “formula.” Even the asset approach may include those elements if an income approach is used in a tangible asset appraisal. The market approach is the search for a multiple that, when inverted, becomes a “risk rate” that is used to capitalize income or cash flow. The formula (income ÷ risk) is also known as the capitalization of earnings method/formula. A variation of that basic formula is the application of a multiple to a benefit stream as is done in the market approach or as an income approach. The discounted cash flow method is based on the same formula and the same two elements: income and risk.

After the damage was done to the subject company, adjusted EBITDA continued to increase, yet the price suitors were willing to pay for the business decreased. The decrease in value was evidenced by real-time negotiations and additional offers received for the business after the damage event. Since there was no sustained reduction in cash flow, the cause of the decrease in value must have been the increased risk resulting from the supply interruption and other actions of the supplier. The unsystematic risk associated with the plaintiff’s business was the only factor that changed. The uncertainty of inventory supply and the industry stigma surrounding actions taken by the defendant supplier obviously impacted the perceived reliability and stability of expected earnings for the business, increasing the risk of the investment and resulting in lower multiples (higher risk rates).

In litigation, where the value of a business is at issue, there is surprising resistance to the concept that both factors (cash flow and risk) affect value. There is ready acceptance that a decrease in cash flow caused by the act of another can result in damages in the form of lost business value. The alternative cause of lost business value—greater risk—may be more difficult for courts to embrace. Where the perceived risk surrounding a benefit stream is elevated, value decreases (all other things being equal). This is, admittedly, less common in damages cases, but no less relevant.

The same buyers making significantly smaller offers based on the same, or greater, annual cash flow, reflects as clearly as anything that such a concept exists.

Multiples as a Measure of Risk: A multiple is a capitalization rate, and a capitalization rate is a multiple. If $100,000 in cash flow is divided by a capitalization rate of 20 percent, it results in a value of $500,000 ($100,000 ÷ 0.2). That is the same result as multiplying $100,000 times a multiple of five. That relationship is not a coincidence, of course. A multiple of five is the inverse of 20 percent (1 ÷ 0.2) and 20 percent is the inverse of a multiple of five (1 ÷ 5). A multiple, therefore, operates as the inverse of a capitalization rate. The higher the capitalization rate, the lower the multiple; and, of course, the higher the multiple, the lower the capitalization rate. This is a critically important relationship in business valuation and the pricing of equity. Embedded in the multiple are all the risk factors traditionally ascribed to a capitalization rate.

A multiple of 11 times EBITDA represents a capitalization rate of 9 percent (1 ÷ 0.11). When an offer to buy changes from 11 times EBITDA to six times EBITDA, and EBITDA has not changed, that change in price is due entirely to a change in the capitalization rate from 9 percent to 16.7 percent (1 ÷ 6). If there are no systematic factors explaining the dramatic drop in the multiple being used to price the asset—and growth is assumed to be constant—the remaining element must be the unsystematic risk factors associated with the asset. In this case, those were easily identified as risks associated with supply interruption as well as negative information about the business, whether true or not, that put customer relationships at risk.

Practical Evidence: There is significant evidence of the relationship between value and risk in short-term public company markets on an almost daily basis. At times, the broad market reflects the adverse impact of increased perceived risk on equity prices. The mortgage market meltdown of 2008 and 2009 is a good example. The circumstances of that crash would certainly impact the cash flow and risk of banks, investment bankers, and others in the financial industry. However, for much of the market, there was no cash flow impact and yet the price of most stocks went down for a sustained period of time. The reason was uncertainty and risk, not cash flow. Reporting on litigation, government regulatory action, political or social upheaval, new technology, or even consumer sentiment can impact perceived risk, resulting in a decrease in stock prices, even when there is no known or expected impact on cash flow.

Conclusion: Many in the valuation community understand the relationship between value, income, and risk. The users of our work in the litigation arena, depending on the circumstances and venue, may not possess as deep an understanding. It is the starting point for describing valuation and one of the easiest formulas and concepts to explain to a trier of fact. Testifying that a business lost value because of a damage event that reduced cash flow may be more logical and rational to a trier of fact. However, it may be more difficult for an inexperienced judge to understand that an increase in risk has the same effect. Since damage calculations in the courtroom are often correlated with reduced cash flow, evidence of damages associated primarily with increased risk must be delivered with clear, concise, and convincing testimony.

1 The generic term “income” encompasses several potential measures of income or benefit to the owner of the asset. The alternatives include net income, pre-tax net income, EBIT, EBITDA, cash flow to equity, cash flow to invested capital, etc.
2 An experienced valuator recognizes this as the formula used for the capitalization of earnings, where the capitalization rate or “risk rate” is adjusted for expected growth and is assumed to be static. The same formula is relevant in the discounted cash flow method where, for a period of time, growth is variable and accounted for in projected cash flows rather than the risk rate.