By: Zachary Reichenbach and Bradford Muir
This article was originally published online by Construction Executive.
When business owners take on a contract, they are also taking on the risk that there might be issues with the agreement. Usually, the contract process will go according to plan without any problems. But inevitably, there will come a time where the complications associated with a contract will manifest themselves. By that point, a contractor may have been the victim of a delay, defect or breach of contract that resulted in damages. At this point, it may be time to call legal counsel to decide what to do next.
There are various forms of remedies for the impaired construction business in response to the delay, defect or breach of contract. One of the most prevalent remedies is the recuperation of lost profits damages. Another may be lost value damages, but the focus of this article will remain on lost profits.
If the decision is to proceed with a lawsuit, the first step is to contact legal counsel. Hire a damages expert to analyze the lost profits associated with the company’s impairment. There are many things a contractor can do at this time to help the case and to help the damages expert complete their analysis. They will be basing their analysis on objective, factual, reasonable and well-supported information, so It’s critical the business owner provides the necessary documentation and resources that will help the damages expert build the most credible analysis possible.
The first thing a contractor can do is coordinate with the management team and get the damages expert the documents necessary for them to conduct their analysis. Such documents include, but are not limited to:
- income statements;
- balance sheets;
- cash flow statements;
- cash flow projections;
- work-in-progress schedules; and
In many instances, the quality of the damages expert’s analysis is dependent upon the quality of information they get from the business owner and their company.
In their analysis, the damages expert is going to review the company’s financial information and consider two scenarios over a specified period of time to determine lost profits. The first is the “but-for” scenario, which reflects the cash flows the company would have generated over a specific period of time had the damaging event not occurred. One of the critical elements of this part of the analysis is making sure the damages expert has various projections and budgets that were prepared prior to the damaging act. This helps the damages expert build a credible but-for scenario analysis.
If the impaired company prepares budgets or financial projections on a regular occurrence, it is helpful to share several years’ worth of budgets/projections. The expert will be able to review and determine various trends and growth rates that help build a credible analysis. Setting up a meeting or a conference call can be helpful for the expert because the business owner and team can help explain the assumptions and reasoning that went into building these budgets/projections. Remember, many times the damages expert will use these budgets/projections as the basis to creating the cash flows in the but-for scenario.
The second scenario of a lost profits analysis is the “actual” scenario. This consists of the cash flows that the company actually generated over the same time period. It is important that the impaired company provide the damages expert several years of historical financial information so they can build a supported “actual” scenario analysis. The difference between the cash flows in the but-for scenario and the actual cash flows represents lost profits.
Another thing that a business owner should do to help the damages expert is allow access to the team, including giving the damages expert access to speak and meet with the CFO, controller, accountant or financial analyst. There are times when a damages expert may have documentation but has several questions about the information received, such as revenue and cash flow projection. By speaking with the CFO or controller, who most likely prepared these projections, many of those questions can be answered quickly.
The CFO and controller can also be critical in helping a damages expert understand the impaired company’s variable and fixed costs. When determining the profits for the but-for and actual scenarios, only variable costs are deducted from revenue. Fixed costs are not deducted. In many of these types of cases, the determination of variable versus fixed costs becomes a battleground issue when there are multiple experts involved. Help facilitate a call or meeting between the damages expert and the CFO or controller. Most likely, they’ll have detailed knowledge of these expenses and can help the damages expert understand which ones are fixed or variable expenses so they can make a determination.
In addition, the business owner can help the damages expert gain an understanding of the length of time the company will be impaired before it reaches the operational level it had achieved prior to the damaging act. In a lost profits calculation, there is a definitive start and end date to the calculation. The start date is typically the date of the damaging act, but the end date is less certain. Sometimes the end date can be when the contract that was breached expires. In other cases, the end of the damage period may be when the impaired company expects to be operating at a level they were prior to the damaging act. The business owner likely has insight on this and can be a resource for the damages expert in determining the length of the damage period.
The business owner can provide insight on the specified contracts and help the damages expert understand if there are any provisions in the contract that may affect the lost profits analysis. This is something that legal counsel can also assist with. In many instances, there are provisions written in contracts that spell out the remedy of damages available to the impaired party in the event that something goes wrong. In other instances, the provisions in the contract may limit the amount of damages available to the impaired party.
There may be several other questions and issues that are raised by the damages experts or by legal counsel during the lost profits analysis phase. As the business owner, it is important to be transparent and provide clarity to issues that are raised. Litigation is a long process, so once the damages expert prepares the report, there may be depositions, mediations or settlement conferences that the damages expert needs to be prepared for. By having all of the details, the process can move forward without having to go back for missing information.
Credibility is a critical component to any damages expert’s analysis and report. If the business owner can provide the necessary credibility, facts and supportive information to allow the damages expert to business a credible opinion and report, they can do their job effectively. Work closely with legal counsel and the damages expert to provide the requested documentation. It’s the best way to ensure an efficient and effective process and allow a business owner the chance to recuperate what’s due.
ZACH REICHENBACH, CFA, CPA / ABV is a principal in Ellin & Tucker’s Forensic and Valuation Services Group and member of the firm since 2008, specializes in complex commercial damages, valuation, intellectual property, litigation assistance and forensic accounting assignments. Zach has worked on hundreds of cases ranging from simple contract disputes to complex litigation with millions of dollars at stake. He can be reached at firstname.lastname@example.org.
BRADFORD MUIR is an analyst in the Forensic and Valuation Services Group at Ellin & Tucker in Baltimore, MD. As an analyst, Brad prepares detailed analyses for valuations and expert reports, as well as conducts industry and client research. Brad is a graduate of George Washington University. He can be reached at email@example.com.