The trouble with start-ups and never-started-at-alls

Lost profits damages
The trouble with start-ups and never-started-at-alls

Although calculating lost profits damages for businesses involved in litigation is always complicated, damages experts can use the company’s historic financial statements to make their projections. They can, that is, if the business has a history. Calculating damages for early-stage and never-launched businesses requires a different set of analytical tools — including industry data — if experts are to prove to a court’s satisfaction that their damages estimates are reasonably certain.

The big gap

The problems when estimating damages for new or never-launched businesses stem from a lack of data. Experts generally project the plaintiff business’s lost revenues and adjust that amount by appropriate profit margins. They typically base revenue projections on data related to the company’s own projections, its historical performance and its industry, as well as on larger economic conditions and forecasts.

With a new business, experts typically face inadequate or nonexistent performance data and insufficient business data that can be correlated with trend information. How then can a damages expert project revenues and profit margins that will stand up in court?

Market data to the rescue

Fortunately, those calculating lost profits need only determine them to a reasonable certainty. An expert, then, might be able to apply industry growth rate projections to individual company data to develop multiple revenue projections, varying the combinations of actual and projected data.

If the results from the different projections fall within the same range, experts can proceed to use company-specific data to develop cost structures. But if company data is sparse, they may need to determine market share and estimated penetration based on models and studies of new-product lifecycles. They can validate revenue projections with data from governmental agencies, trade associations and other sources that track expected demand, prices and cost structures.

When determining profit margins for new businesses, experts again run into insufficient historical performance data or internal forecasts. Instead, they may rely on internal data and reports, industry forecasts, and other information sources to develop profit margins.

Discounts have currency

As with all calculations of this kind, experts apply a discount to projected lost profits. Courts recognize the need for such discounts on two bases. First, a plaintiff can invest its award and earn an additional return on it — meaning that a plaintiff who receives an undiscounted amount of lost profits would stand to recover more than its actual damages.

Second, projected lost profits necessarily carry an element of uncertainty. In the case of a new business, the discount must reflect the increased risk usually associated with young ventures and the possibly unrealistic — and unreliable — nature of the company’s own projections.

Looking to the courts

The decision of the Court of Appeal of the State of California, Fourth Appellate District, Division 3, in Parlour Enterprises Inc. v. Kirin Group Inc. provides some valuable lessons in how experts can help establish reasonable certainty of damages for new businesses. The Parlour court criticized the plaintiff’s expert for relying on “groundless pro forma projections” when making his calculations and for failing to prove similarities between the subject company and similar businesses in his market study.

In addition to the importance of expert testimony “supported by tangible evidence with a ‘substantial and sufficient factual basis’ rather than by mere ‘speculation and hypothetical situations,’” Parlour’s outcome suggests that experts use:

• Market surveys and analyses, particularly if the market is established,
• Business records of similar companies,
• Prelitigation financial projections, and
• The plaintiff’s, or a third party’s, prior experience in the same or similar business or industry.

And, of course, the expert should use as much economic and financial data for the subject company as is available.

Expertise is essential

Calculating lost profits damages for start-ups and businesses that never even got as far as starting up is a complicated task. Be sure you engage an expert with actual experience with these types of companies. It can mean the difference between your client getting the damages it deserves (perhaps giving the venture a second chance) or walking away with significantly less — possibly even nothing.