Business loss issues can arise in a variety of circumstances including expropriation, business interruption insurance claims, and breach of contract. Whether resolved by negotiation or litigation, it is likely that litigation counsel, as well as experts in the field of business valuation, will be involved. Business loss quantification is becoming increasingly sophisticated and requires inter-disciplinary understanding on the part of the valuator. To properly fulfill the mandate of a business loss engagement, the valuator must have an understanding of the legal issues or compensability of the claim, restrict the quantification to those damages which demonstrably flow from the expropriation/incident/breach or for which causation can be proven, and must consider the impact of business, economic, and industry conditions on the conclusion reached.

To ensure the compensability of the claim, it is imperative that the valuator be familiar with the relevant legislation, insurance policy, or contract and discuss any questions as to compensability, heads of damage, and quantification issues with counsel at the earliest possible stage of the process. This will enable counsel and the valuator to proceed to a successful resolution of the matter in the most efficient and effective manner. With regards to an expropriation, the relevant legislation would be the expropriation act for the particular province involved. For example, in Ontario, section 19(1) of the Ontario Expropriation Act states that "where a business is located on the land expropriated, the expropriating authority shall pay compensation for business loss resulting from the relocation of the business made necessary by the expropriation…"

For simplicity, the remainder of this article will focus on a business loss arising from an expropriation.

HOW IS A BUSINESS LOSS DETERMINED?

A business loss claim must include only those losses attributable to the expropriation. An overly simplistic, mechanical approach to the claim may result in a host of factors unrelated to the expropriation being included in the quantification, for which none can be compensated. The legitimate component of the business loss claim may then be dismissed due to the tainting of the entire claim, or the inability to segregate the valid portion when the unrelated circumstances are revealed. In quantifying a business loss, consideration must be given to a number of factors including:
a.) the circumstances of the expropriation, both from a chronological and physical
     effect point of view;
b.) the financial impact of the expropriation, through review of the company’s financial results
      both before and after the expropriation
c.) the nature of the business, its operations, and the industry in which it operates at the time
     and over the duration of the loss; and,
d.) the state of the economy at the time and over the duration of the loss.

It is this knowledge, when properly documented, which will demonstrate the business rationale of the claim and take the quantification out of the realm of a mechanical exercise.

QUANTIFICATION TECHNIQUES AND CONSIDERATIONS

The term business loss is generally defined as the "loss of profit" or the profit not realized due to a shortfall between actual operating profit and the profit that could have been reasonably anticipated had the expropriation not occurred. The determination of the reasonably anticipated profit can be fraught with difficulties, and involves the application of all of the business, industry, and economic knowledge gathered in the valuation process to demonstrate that the expectations are not mere speculation or the result of an arithmetic exercise.

Loss of profit is a ‘net’ calculation, that is after consideration of revenues and expenses. The first step usually involves the examination of the revenues of the business both before and after the expropriation to assess the impact, if any, of the event. Following the determination of the effect of the expropriation on the revenues of the business, consideration is then given to the effects on the expenses incurred by the business. The expenses of the business must be analyzed having regard to their nature (e.g. variable, semi-variable, or fixed) and integrated into the business loss claim accordingly. Those expenses which are determined to be "saved" or not incurred as a result of lower revenues relating to the expropriation (i.e. generally variable expenses) must be deducted from lost revenues in quantifying loss of profit.

The techniques used to quantify the impact on revenues can include the following:

Review of Actual Revenues/Trend Analysis
This involves review of the pre-expropriation revenues to determine if a certain trend was apparent, and then applying this trend to determine what the post-expropriation revenues may have been had it not been for the expropriation. An arithmetic calculation of the indicated shortfall, if any, would then be made.

Review of Forecasted Revenues
This involves comparison of forecasted revenues for the period subsequent to the expropriation versus actual revenues for the same period, resulting in an arithmetic calculation of the indicated shortfall, if any.

Regression Analysis
Regression analysis is a statistical technique used to develop a functional relationship between two variables. For example, the revenues of an auto-parts manufacturer would likely be related to automobile sales. In this case, revenues would be defined as the dependent variable and automobile sales would be defined as the independent variable. The relationship between the dependent and independent variables is determined during an ‘unaffected’ or pre-expropriation time period, and provided the relationship between the variables is sufficiently strong and statistically valid, the relationship is then applied to the post-expropriation period to project the "what-if" results. The advent of computers and statistical programs have made regression analysis applications relatively easy, however it may also result in a misinterpretation of the results. An in-depth understanding of the assumptions underlying the technique is critical.

Comparable Company Analysis
This involves comparison of the subject company’s revenues before the expropriation to a "comparable" company’s (e.g. a competitor) revenues over the same period to determine if there is a relationship between the two. If a relationship is found to exist, the "comparable" company’s post-expropriation operating results may be used to project what the subject company’s revenues may have been had the expropriation not occurred. In using this technique it is important to ensure that the companies are truly comparable. For example, if the expropriation involved a retail store, the valuator should ensure that the subject store and the "comparable" store have similar demographics as between the locations, that the stores are of similar size, configuration, and parking availability, such that practical capacity issues would not be exceeded in the projection, and that there were no changes in the relative markets serviced by the two locations which occurred before or after the date of the expropriation. For example, if additional competition entered the market of only one of the locations during the projection period, the relationship existing prior to such occurrence likely would not remain and the model would not produce valid results.

Often combinations of the above methodologies are considered in determining the loss of revenues of a company. For example, regression analysis may be used to determine if a relationship existed between the subject company’s revenues and a "comparable" company’s revenues prior to the expropriation.

Once the valuator has determined the loss of revenues attributable to the expropriation, he/she will perform a similar analysis to determine the expenses that should be deducted from the lost revenues in quantifying the business loss. For example, the valuator would likely review the company’s historic cost structure, forecasted expenses, and "comparable" company expenses both before the expropriation and during the period of loss (if such information was available).

It is imperative that the valuator’s knowledge gained through discussion with management of the subject company with respect to changes, if any, in the operations of the business over the loss period and his/her review of economic and industry conditions both before and over the loss period be integrated with the results of the above analyses so that the impact of factors unrelated to the expropriation are excluded from the claim. Factors unrelated to the expropriation may be internal or external to the company’s operations and can include, but are not limited to, the following:

Internal Factors

• A change in the company’s management during or just prior to the loss period which either positively or negatively impacted the financial results of the company;

• An increase or decrease in raw material costs during or just prior to the loss period, thereby impacting the gross margins of the company;

• A loss of a key customer of the business unrelated to the expropriation. For example, the customer may have experienced financial difficulty due to the economic or other conditions unrelated to the expropriation; and,

• Personal expenses, non-market remuneration, or other non-arm’s length expenses or revenues being recorded in the company’s financial statements in the period prior to and during the loss period. These must be adjusted to arm’s length amounts so that the pre-expropriation and post-expropriation financial results are comparable and the loss reflects an economic loss.

External Factors

• A change in the economic conditions in which the company operated just prior to or during the loss period (e.g. a recession),

• A change in the company’s marketplace such as the entrance or exist of a competitor just prior to or during the loss period, and,

• A change in the industry conditions in which the company operated during or prior to the loss period. For example, the industry may have experienced an increase or decline in demand due to the nature of the product/service offered by the company or a duty related to the company’s product may have been increased or decreased just prior to or during the loss period.

After having been immersed in the technical and detail aspects of the business loss quantification exercise, it is incumbent upon the valuator to pause and review his/her conclusion in light of its compensability, his/her ability to demonstrate that the loss is attributable to the expropriation, and to assess its reasonableness from a common sense perspective. Ultimately, it is only through the valuator’s accumulation and application of the knowledge of the business and the industry and economic environment in which the business operates that the business loss quantified will be consistent with reality and attributable only to the causal event.

Paula Frederick, CA, CBV
This article appears in the OEA SPRING 1998 NEWSLETTER