Whose losses are they anyway? And why this matters in damages assessment
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The approach to quantifying losses may differ significantly depending on who the claimant is. In this article, we consider how the quantification of a claimant’s claim may be influenced by the identity and characteristics of the claimant in two contrasting, non-specific scenarios.
- Assessment of damages
- Enterprise value versus equity value
- Company-level losses versus shareholder-level losses
- Characteristics of shareholders
In November 1925, Mahatma Ghandi wrote, ‘No two men are absolutely alike, not even twins, and yet there is much that is indispensably common to all mankind’. In his essay, the justly revered lawyer and political ethicist was dealing with considerably weightier matters than the topic of this article. Nevertheless, we posit that his words are instructive even for our purposes. International arbitration disputes are, by their nature, characterised by individual facts and circumstances that are often complex and nuanced. Yet, commonalities can be observed across different situations.
In this article, we consider how the quantification of a claimant’s claim in two contrasting, non-specific scenarios may be influenced by the identity and characteristics of the claimant. The scenarios we consider are:
- a claim for lost profits by Company A following an alleged breach by Company B to supply complex machinery to a particular specification or within a specified time frame; and
- a claim by Shareholder X, a shareholder in Company Z, which considers its interests as a minority shareholder to have been unfairly prejudiced by Shareholder Y, the majority shareholder.
When quantifying losses, it is important to understand the context and purpose of the analysis being performed, and to identify the appropriate framework for the quantification of losses earlier rather than later in the dispute resolution process. We explain in both situations identified above that the quantification of the claimants’ claims can be significantly influenced by considerations pertaining to the identity or characteristics of each claimant. This is particularly germane in a region such as the Middle East, where the beneficial ownership of large businesses is often concentrated within one or a handful of key individuals or organisations.
Scenario 1: an entity’s lost profits in the event of a contractual breach
Often, tribunals need to determine what losses are suffered by an entity following an alleged contractual breach by a counterparty. For example, suppose Company A contracts with Company B to purchase complex machinery that may increase the efficiency of Company A’s production processes. Company B will also likely commit to supply that machinery to a particular specification or within a specified time frame.
If Company B breaches these obligations, Company A could suffer losses, including ‘lost profits’. Typically, a claim for lost profits would be based on the difference, in monetary terms, between: (i) the present value of the net cash flows Company A would have earned if Company B had supplied the machinery in accordance with the terms of the contract in question; and (ii) the present value of the net cash flows Company A stands to earn as a result of a delay or non-supply of this machinery. In this instance, Company A may receive the agreed piece of machinery later than anticipated (which may cause delays in manufacturing products and earning revenue and profit). It may also involve Company A having to find another alternative piece of machinery, which may be more expensive or not as effective.
In the following subsections, we explain the established methods for identifying both projected net cash flows relevant to an assessment of Company A’s lost profits, and the risk or uncertainty pertaining to these cash flows, which may be influenced by the entity’s capital structure and industry factors. We then discuss the importance of preparing cash flow projections that are consistent with Company A’s characteristics, as well as industry and macroeconomic factors.
Which cash flows matter for an assessment of Company A’s losses?
It is likely that, in the circumstances described above, Company A will be the claimant in any dispute against Company B. This is because Company A is party to the contract that has allegedly been breached, and it is Company A whose financial position will be impacted by the alleged non-performance of Company B.
An assessment of Company A’s lost profits requires an assessment of the net cash flows that would have been earned in the absence of the alleged contractual breach, and an assessment of the net cash flows that Company A stands to earn in fact.
In assessing damages suffered by an entity (in this case Company A), the relevant net cash flows to consider are known as, ‘free cash flows to the firm’. Noted valuation commentators Shannon Pratt and Roger Grabowski define free cash flows to the firm as, ‘cash that a business or project does not have to retain and reinvest in itself in order to sustain the projected levels of cash flows in future years’. As such, it reflects cash generated by the operations of a project or business that is available to be paid to an entity’s providers of capital, including lenders and equity investors. Importantly, therefore, the cash flows relevant to an assessment of Company A’s losses are projected before the deduction of any interest to be paid to Company A’s lenders (or repayment of loans), and the payment of any dividends to shareholders.
Any assessment of Company A’s losses should be based on its operating cash flows pertaining to the project in question. This encompasses cash inflows related to the sale of products, and cash outflows related to the manufacture of products, the purchase of materials, and the payment of salaries. It may also be necessary to allocate a certain proportion of total overhead costs that Company A incurs to the project in question. It excludes financing cash flows such as debt drawdowns, investments from shareholders, debt repayments, interest payments and dividends.
Is an entity’s borrowing relevant to an assessment of lost profits?
Although an assessment of Company A’s losses is based on a projection of free cash flows to the firm, which excludes financing cash flows, this does not mean that Company A’s capital structure is irrelevant to an assessment of its losses.
Adverse changes to an entity’s risk of default can affect operating cash flows. Aswath Damodaran, a professor of finance at the Stern School of Business at New York University, notes that, ‘the operating income, for many firms, will drop as the default risk increases. . . for instance, a bond rating below investment grade may trigger significant losses in revenues and increases in expenses’.
More widely, capital structure is an important input into the calculation of Company A’s weighted average cost of capital (WACC). WACC represents the weighted average rate of return required by an entity’s investors, including both shareholders (who provide equity capital) and lenders (who provide debt capital), in order to provide capital to the entity. Koller, Goedhart and Wessels explain that, ‘since free cash flow [to the firm] is the cash flow available to all financial investors (debt, equity and hybrid securities), the company’s WACC must include the required return for each investor’.
In a calculation of Company A’s losses, projected free cash flows to the firm are discounted at a rate equal to Company A’s WACC. Discounting converts future cash flows into a monetary lump sum amount as at the date of assessment and reflects: (i) the time value of money, or that a dollar today is worth more than a dollar in the future, as it can be invested and earn a return; and (ii) the uncertainty of future cash flows (both in the amount of the cash flow and the anticipated time at which they will be earned).
All else equal, a higher WACC will reduce losses, and loss calculations can be highly sensitive to changes in the WACC applied. As a firm’s leverage increases beyond an optimal ratio of debt to equity, WACC increases. This arises primarily as shareholders require increased returns to compensate for increased risks associated with an equity investment in an entity with high levels of third-party debt, to which the interests of shareholders are subordinated. Accordingly, to the extent that cash flows are discounted at a WACC calculated with reference to an entity’s projected actual capital structure, the entity’s borrowing could materially change the result of an analysis to quantify losses.
Are Company A’s characteristics relevant?
In short, ‘yes’. As noted above, the starting point for an assessment of Company A’s lost profits is to project the cash flows that Company A would have earned in the absence of the alleged contractual breach, and to compare these to the net cash flows that Company A stands to earn in fact.
In preparing cash flow projections, it is important to reflect Company A’s features and circumstances, so far as possible. Furthermore, cash flow projections should reflect the most probable results (calculated by reference to a probability weighted forecast) in a given scenario, rather than those that result from overly optimistic or cautious assumptions.
Accordingly, assumptions underlying projections should be consistent with the business in question. Often, past performance is used to inform projections about future financial performance. In the present example, Company A’s past results may provide evidence of its profit margins, growth rates, market share and its performance relative to budgets and peers. Additionally, contemporaneous correspondence, agreements, meeting minutes, business plans and projections may provide evidence as to Company A’s plans and expectations. For example, evidence that Company A was planning to embark on a capital expenditure programme to meet anticipated growth in demand for its products may support assumptions as to future growth in excess of recent trends.
It is also important to consider prevailing market conditions in the industry and economy in question. Often, such data is valuable to assist the preparation of reliable, robust projections. Industry considerations are also relevant to an assessment of WACC, as the cost of equity is typically measured with reference to returns earned on equity investments in comparable businesses.
Scenario 2: claim for unfair prejudice
Damages experts are also instructed in circumstances where the claimant is a shareholder in an entity. We now consider a scenario in which Shareholder X is a minority shareholder, and Shareholder Y is a majority shareholder, in Company Z, an unlisted logistics company. Shareholder X considers that contrary to the terms of a shareholder agreement entered into between Shareholder X and Shareholder Y, its interests as a minority shareholder have been unfairly prejudiced. The shareholders’ agreement contains provisions for Shareholder X to elect for its ownership interest in Company Z to be purchased by Shareholder Y, in such circumstances.
In the following subsections we outline key considerations in undertaking a valuation exercise on behalf of a shareholder, in circumstances such as those outlined above.
A key distinction between a claim by a shareholder of an entity and a claim by the entity itself is that the shareholders have what is often described as a ‘residual’ interest in an entity’s assets, meaning the value left over after all other claims – such as amounts owed to providers of debt – have been paid. It is important that this is accurately reflected in an analysis to value Shareholder X’s ownership interest in Company Z. The characteristics of the shareholding may also be important. For example, practitioners often argue, particularly in the case of minority shareholdings, that it is appropriate to apply a discount to account for the absence of a ready market in which to dispose of a shareholding in Company Z, as it is a private company.
Which cash flows matter to value Shareholder X’s shares?
We previously explained that, to assess an entity’s losses arising from an alleged contractual breach, it is necessary to project the change in free cash flows to the firm that have arisen due to the alleged wrongful conduct. Free cash flows to the firm reflects cash generated by the operations of a project or business that is available to be paid to an entity’s providers of capital, including lenders and equity investors.
If Company Z is valued based on the discounted net present value of projected free cash flows to the firm that Company Z generates (which is commonly referred to as a ‘DCF analysis’), the result of the calculation provides the ‘enterprise value’ of Company Z. Enterprise value corresponds to the theoretical purchase price for an entire company, including the value attributable to an entity’s shareholders and its providers of debt. Accordingly, to determine the equity value of Company Z, a valuer would need to reduce the result of their calculation by the market value of Company Z’s net debt, and claims from any other non equity investors.
Alternatively, a valuation of Company Z’s equity could be based on the discounted value of a projection of Company Z’s free cash flows to equity. Free cash flows to equity represent the amount of cash a business generates that is available to be distributed to its shareholders, after accounting for financing-related outflows such as the repayment of debt, and interest payments.
Under this approach, the valuer would discount projected future cash flows to equity at a discount rate equal to Company Z’s cost of equity rather than its WACC. Cost of equity is typically higher than WACC. This is primarily because equity investors require a higher return than providers of debt, to reflect that equity investors are exposed to greater risk, as their returns are subordinate to amounts owed to providers of debt capital. Additionally, debt costs are typically tax deductible for companies, whereas dividend payments to shareholders are not.
Accordingly, the value of Shareholder X’s equity interest in Company Z could be assessed based on an analysis of Company Z’s free cash flows to the firm (and net debt is subsequently deducted) or free cash flows to equity. As noted by Koller, Goedhart and Wessels, ‘both methods lead to identical results when applied correctly’. However, Professor Damodaran emphasises the risks of improper application of either method. He explains:
The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm.
Are Shareholder X’s characteristics relevant?
The present scenario involves an assessment of the value of Shareholder X’s shares in Company Z. On the face of it, Shareholder X’s characteristics are not particularly relevant to the value of Company Z’s shares. The value of its shareholding in Company Z derives from Company Z’s ability to generate cash that can be distributed as dividends or reinvested for the purposes of obtaining capital appreciation. If Shareholder X is a dermatologist with no experience in the logistics industry, or a serial bankrupt with a miserable commercial track record, this is likely of little relevance to the value of shares in Company Z (unless Shareholder X also manages or operates Company Z, which could change matters somewhat!).
Conversely, the characteristics of Shareholder X’s shareholding may be relevant to an assessment of its value. For example, Company Z is a private company. This means that its shares are not traded on a centralised market, and may not be readily obtainable by parties that may wish to purchase shares. Practitioners often argue, particularly in the case of minority shareholdings in private companies, that it is appropriate to apply a ‘marketability discount’, which is described by Emory as, ‘a general term in business valuation referring to impairment of value for reasons relating to marketability and/or liquidity’. Bajaj, Denis, Ferris and Sarin explain the basis for such a discount as follows:
investors value marketability. Therefore, other things being equal, investors will pay more for an asset that is readily marketable than for an otherwise identical asset that is not readily marketable.
There are a number of factors that influence the marketability or liquidity of a minority interest. These include:
- whether the shareholder has a put option or other such right, providing liquidity;
- whether the company pays regular cash dividends – a company that pays regular cash dividends is more marketable than one that does not because it provides a regular monetary return on investment rather than just capital appreciation;
- the number of available buyers – the number of buyers will impact the relative bargaining power of the buyers and sellers;
- the likelihood of the company going public or being acquired;
- whether the shareholder has tag-along or drag-along rights, providing liquidity if another shareholder sells its stake;
- whether there are any restrictive transfer provisions that would prevent the shareholder from exiting, such as a ‘lock-in’ for a certain time period;
- the financial strength and position of the company; and
- the size of the interest relative to the total number of shares and other shareholdings.
There are different approaches to estimate the marketability discount appropriate in a given scenario. These are mostly based on attempts to compare prices for readily marketable assets to prices for similar or the same assets where there is restricted marketability. In practice, the available methods can give rise to a wide range of proposed discounts, and the appropriate level of discount can be hard to quantify with certainty based on empirical data. In applying such a discount, valuers should ensure that they explicitly state the methodology they have used and the information they rely upon to formulate an estimate of the appropriate discount.
Finally, in the present circumstances, the shareholder agreement between Shareholder X and Shareholder Y may stipulate that the buy-out price is to be calculated without any discount to the pro-rata value of the shareholding. If this is the case, discounts and premia that could apply to a valuation of Shareholder X’s shareholding based on the characteristics of the shareholding – such as the marketability discount or a minority discount – could be inapplicable for contractual reasons. Valuers are likely to rely on counsel to interpret the terms of such clauses.
The two scenarios we consider above are simplified, generic situations. Nevertheless, they demonstrate that the quantification of claims can be significantly influenced by considerations pertaining to the identity or characteristics of the claimant. In general, there are established approaches to deal with these issues. To ensure that a tribunal is able to rely on the valuations conclusions provided, the valuer must understand the context and purpose of the analysis being performed, and identify the appropriate framework for the quantification of losses. Failure to do so may result in overstated or understated claims that provide limited use for a tribunal making an award of damages.
 The Mahatma and The Poet: Letters and Debates between Gandhi and Tagore, 1915–1941,
Part II, Chapter 8, ‘The Poet and the Charka’.
 Cost of Capital, Applications and Examples, Third Edition, Pratt & Grabowski, 15.
 Investment Valuation, Second Edition, Damodaran, 583.
 Valuation: Measuring and Managing the Value of Companies, McKinsey, Fifth Edition, Koller, Goedhart & Wessels, 235.
 Investment Valuation, second edition, Damodaran, chapter 15.
 For a discussion on the use of a DCF analysis and other valuation methods, see ‘Valuation in International Arbitration’ by Noel Matthews and Andrew Wynn of FTI Consulting in The Middle Eastern and African Arbitration Review 2016.
 Net debt reflects the value of debt outstanding plus the value of the company’s cash balance.
 Valuation: Measuring and Managing the Value of Companies, McKinsey, Fifth Edition, Koller, Goedhart & Wessels, 104.
 Investment Valuation, Second Edition, Damodaran, page 19.
 If the standard of value applied to the valuation is market value, then the characteristics of Shareholder X are explicitly excluded from any such analysis, as market value considers a hypothetical willing seller.
 ‘The Value of Marketability as Illustrated in Initial Public Offerings of Dot-Com Companies May 1997 through March 2000’, 1997, Emory, page 1.
 ‘Firm Value and Marketability Discounts’, 2001, Bajaj et al, page 2.
 A minority discount is the economic concept that the ownership of a portion of a company (less than 50 per cent) may be worth less than the pro-rated valuation of the company. This concept is premised on the fact that a shareholder with less than half of the available shares does not have control of the company and, therefore, cannot manage the company, set strategic direction, or declare dividends without agreement from other shareholders. The level of such a discount depends on various factors, including the corporate governance structure in place and the legal protections for minority shareholders. These vary by country and by company.