Part 7: Measuring the Loss - How a Damages Expert Selects a Methodology
Once the financial records have been analyzed and the but-for projections have been evaluated, the next major decision in a damages engagement is selecting the right methodology for measuring the loss. This is not a one-size-fits-all exercise. The right framework depends on the nature of the harm, the law, the type of business, and the specific facts of the case.
The Two Primary Frameworks
In most commercial damages cases, the analysis falls into one of two methodological frameworks: lost profits or diminution of value, both forms of compensatory damages.
A lost profits framework is the most common of the two forms of compensatory damages. It applies when the harm caused by the alleged wrongful act is temporary in nature, meaning the business continues to operate at a reduced level of profitability. The analysis compares what the business actually earned during the damages period to what it would have earned in the but-for world. The difference between the two is the measure of damages.
This comparison is more straightforward when the business has an established operating history to anchor the but-for analysis to. When the business is newer and lacks a meaningful track record, the analysis requires additional care. Courts have historically been skeptical of lost profits claims for new businesses because of the inherently speculative nature of projecting performance without historical data to rely on. That skepticism is not unfounded, but it does not mean damages are unrecoverable. In our practice, we address this by leaning more heavily on external benchmarks such as comparable businesses, industry data, market studies, and the founders’ expertise to support the but-for projections and give the analysis the grounding it needs to hold up under scrutiny.
Diminution of value is a less common framework that applies when the harm is more severe. If the alleged wrongful act effectively destroyed the business, or damaged it so significantly that it could no longer continue to operate, lost profits is not the right framework. There are no actual profits to compare against in a but-for scenario if the business has ceased to exist. In that situation, the analysis shifts to a valuation question: what was the business worth before the damaging event, and what was it worth after? The difference in value is the measure of damages.
The Slow Death Scenario
There is also a third scenario that sits between these two frameworks, sometimes referred to as the slow death of a business. This occurs when a business suffers harm, continues to operate for a period of time at a reduced level, but ultimately ceases operations as a result of the harm suffered.
In this situation, a damages expert may need to apply both frameworks. Lost profits captures the damages during the period the business continued to operate at a reduced level. Diminution of value captures the loss of the business itself at the point it ultimately failed. Getting the boundary between the two right requires careful analysis and clear documentation of how the two components interact, and how the expert has not double-counted the losses.
Causation and the Damages Period
Before any of the above methodologies are selected, two threshold questions need to be answered. First, did the alleged wrongful act actually cause the financial loss being claimed? Methodology selection presupposes that causation has been established, and that is not always straightforward. It is worth noting that causation is ultimately a legal question and one for the court and counsel to resolve, not the financial expert. Our role is to measure the financial impact once that causal link has been established, which is why early coordination with counsel on this threshold issue is essential before any damages analysis begins. A damages expert needs to understand the causal link between the alleged harm and the financial impact before deciding how to measure it.
Second, what is the relevant damages period? When did the harm begin and when did it end, or should it have ended? That boundary question is closely tied to methodology selection and can be just as contested as the methodology itself. A clearly defined damages period is essential to building an analysis that is both accurate and defensible.
Up next: With the methodology selected, the next step is building the actual damages model. In Post 8 we will cover how a damages analysis gets constructed, what role assumptions play, and what it takes to build a model that holds up under scrutiny.