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net profits are allowable as damages. Net profits are calculated by subtracting variable costs from lost revenue.

The theory behind the “before-and-after” approach is that the plaintiff would have attained sales during the damage period similar to what it actually attained prior to the damaging event. Without sufficient historical sales data for comparison, this method cannot be used effectively for new businesses.

A second common approach used by experts is the “yardstick” method. This method uses either comparable businesses, other locations from the same organization, industry data or a combination of all three to determine how the impacted business would have performed “but for” the defendant’s actions. Because this approach does not require historical data of the injured party, this is an accepted method for calculating lost profits for new businesses. The critical issue when using this method is comparability. Extra care should be taken in this regard because the expert’s comparison will be fertile ground for cross examination by the opposing party.

In the third “sales forecast or projection” approach, the expert compares the plaintiff ’s budgets and forecasts to actual performance over the damage period. Preferably, the forecasts used should be those prepared in the ordinary course of business versus forecasts prepared for the current litigation. If the latter is used, the expert will need to be well prepared to defend their relevance. Statistical modeling or regression analysis to forecast what sales would have been “but for” the defendant’s actions is a variation of this method. This approach can also be used for new businesses, preferably in combination with the yardstick method.

Legal StandardsThe same legal standards and

requirements applicable to lost profits for established businesses also apply to new businesses. Damage calculations need not be exact but they must be

Calculating Lost Profits for New Businessesby Kip Hamilton, CPA, CFE

Someone coined the term “money isn’t everything” but the pursuit of it is the

motivation behind most commercial litigation. The majority of businesses are

started for the purpose of making money. When a new business experiences

damages for breach of contract, business interruption, unfair competition,

natural disaster or other cause of actions, measuring lost profits presents

challenges that do not exist with established businesses.

Historically, new businesses were precluded from recovering lost profits because the courts considered these claims speculative due to the lack of any prior operating results. Today, courts around the country have recognized it is unfair to allow a defendant to avoid liability for damages it caused simply because the wronged party is a new business. Most jurisdictions allow recovery of damages when the damages can be proved with reasonable certainty. While courts differ in their definition of reasonable certainty, in the context of lost profits calculations, this rule essentially means damages do not need to be calculated with absolute mathematical precision, must avoid speculation, and be supported with facts and evidence that will allow the trier of fact to reasonably estimate the damages.

While every damage calculation requires credible financial proof, the bar is raised when the calculation involves a new business. This article examines some of the key issues relating to the calculation of lost profits for new businesses.

MethodologyPractitioners utilize a variety of methods to calculate lost profits. Three common

methods used by practitioners are the “before-and-after,” “yardstick” and “sales forecast” methods. The most common “before-and-after” approach compares revenues before the harmful event to revenues after the event. The difference represents lost revenues. As with each method of calculating lost profits, only lost

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reasonable and based on objective, verifiable facts and data. In addition, they cannot be based on mere speculation and ignore business reality. Experts must link the defendant’s wrongful act to the damages and make adjustments for other factors that may have impacted the damages. There are countless situations under which lost profits arise so the required evidence and proof differs with each case. However, as discussed below, there are certain issues that stand out when calculating lost profits for new businesses.

ManagementThe expertise and experience of

management are of particular interest. If a management team previously owned similar successful businesses, this prior experience can be used to demonstrate the team’s ability to earn profits in the future given adequate capital, market conditions and demand for the product. The case for lost profits becomes even stronger if it can be shown that management earned profits after the wrongful act.

When making a compar ison with a business previously owned by management, the expert should assess whether the business, market conditions, product and other factors are in fact similar. Consider the Pet Rocks product, which was introduced in the mid 1970s. Approximately one and a half million of the Rocks were sold in a short period when the product became a fad. Whether this success could be repeated by management with a similar product is an issue the expert should evaluate closely.

Projections and Business Plans

Budgets, projections and business plans prepared prior to litigation can be useful to demonstrate expected profits but should be validated with other supporting analyses like those discussed above. While defendants may argue these internal documents are biased, this does not render them unusable for damage purposes.

Experts cannot simply calculate damages based on the plaintiff ’s

projections. First, one needs to consider the purpose of the projection. Any client prepared projection used by an expert should be examined critically and adjusted as necessary.

Market FactorsWhen evaluating the likelihood of

success of a new business, experts should consider as many issues as possible that are relevant to the business. Market factors include competition in the specific industry, legal and financial barriers to enter the business, regulatory environment, economic conditions, existing contracts, capacity constraints, customer base, growth opportunities and the size of the market.

Information regarding the success of other participants in the same business or at other locations can also be used to support a claim for lost profits. A fran-chise is a good example where measuring the success of another participant would be effective. However, even with the similarity of franchises, it is important to assess the other market factors that might impact the injured party’s success.

In one matter, I was retained by a defendant, which had started a large manufacturing operation in the U.S. The plaintiff, a new agency providing temporary employees in the manufacturing sector, had secured a large contract with the defendant. The majority of the employees specified in the contract were welders. The defendant allegedly breached the contract, and the plaintiff submitted a $4.3 million claim for lost profits it would have earned supplying

temporary employees. The claim settled in mediation for a fraction of the $4.3 million after it was shown the plaintiff did not have the capacity to provide qualified welders that were in high demand during the term of the contract.

Operating CapitalA new business must have adequate

operating capital, access to financing or both in order to operate and generate profits. Inventory, production costs, accounts receivable, payroll and operating costs all require cash. For both new and established businesses, the expert should verify that the lost profits calculation is actually achievable based on the entity’s resources. With new businesses, this is particularly important due to the lack of historical data.

So What to Do?While estimating lost profits for a new

business can be challenging, it is certainly achievable with the proper approach. If an expert avoids speculation, considers a variety of management, market and financial factors, and uses reasonable “business reality” assumptions, an injured party has every chance to recover its loss.

Kip Hamilton, CPA, CFE, is a principal with GlassRatner Advisory & Capital and a member of the ASCPA. He has provided forensic accounting services for more than 30 years and has testified on dozens of economic damage related cases. He can be reached at khamilton@glassratner.com.

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