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What’s the difference between lost profits and diminution of value?

 

What’s the difference between lost profits and diminution of value?

Jul 23, 2019

Economic loss is a significant concern for businesses. When a company suffers some event that prevents it from generating the revenue it would have had that event not occurred, there is often an opportunity to recover that loss. But is that loss considered diminution of business value, or is it considered lost profits? What’s the difference? 

Diminution of value

Diminution of business value applies when a business has been destroyed, either physically or functionally. The measurement of economic loss is typically the value of the business. This diminution of value can be a 100% loss or some percentage of what was irreparably harmed. 

For example, if a city gas line gets hit by a utility company and an explosion destroys several buildings containing businesses, those destroyed businesses might make a diminution claim for the entire value of the company (especially if they are underinsured or they don’t expect to receive the payout from their insurance company for multiple years). 

Diminution of value also can apply when one company improperly takes information from another company and develops the same or slightly different product as the first company. The lost market share result to the originating company can vastly impact their value and ability to stay in business.

Lost profits

Lost profits applies when a business suffers an economic loss of income due to the acts of another party, but these acts don’t destroy the business physically or functionally. Instead, the acts either reduce the business’s revenue amount, or the business experiences greater costs than normal. There is an expectation or assumption that, at some point in the future, the business will recover from the situation.

For example, let’s say there is a fire in one store that burns part of the adjoining store’s space or causes severe smoke damage to part of their inventory. This adjoining store likely could claim lost profits. The partially damaged building itself can be remodeled, and they can still sell part of their inventory, so diminution of business value doesn’t apply. 

In many states, the damaged party has a duty to attempt to mitigate their losses. So in this case, the adjoining store would have to take steps to renovate the property and continue to sell their inventory while pursuing lost profits.

Generally, the lost profit amount covers the period of time when the injured party is actually losing profits.

Can I claim both lost profits and diminution of value?

The underlying theory behind diminution of value is that the business owner who receives damages based on the value of the business has, in essence, sold the business, or a component of the business.

So if a business suffers such an economic loss that they can’t go on, and if their insurance company (or some other payor) then steps in and pays for the loss of value, that’s treated by some of the courts as an imputed sale. In essence, the business sold themselves (even if it was unwillingly). 

If you’re trying to make a case for awarding lost profits in addition to loss of value, you’ll have challenges  in the courts if they treat it as an imputed sale. 

However, it’s possible to win loss of value and lost profits in the right situation. 

For example, let’s say there’s a long-time manufacturer that makes car parts, and they create a different division to begin making farm machinery parts. This division is only a couple years old when there’s suddenly a plant explosion that destroys the business. Now there’s a question of how much profits the new division would have generated in the future had the business survived. 

So not only do you have diminution of value for the entire business, but you could also have a claim for lost profits for that specific new division had it been able to establish itself. 

There is also case law allowing the recovery of lost profits up to the time a business is destroyed and then recovering the value of the business thereafter.

Take these next steps

Whether a case is diminution of value or lost profits is something that legal counsel and an expert should discuss related to applicable case law and how it may impact the client’s claim. It’s essential for the attorney and expert to be on the same page when taking a specific approach.

The valuation and litigation specialists at Wipfli can help you determine the best approach in your situation, as well as calculate damages. Learn more about our business valuation and litigation support services, or contact us to get started.

Author(s)

Thomas Copley
Thomas E. Copley, CPA, CVA
Partner
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