Uncharted territory: Recovering lost profits for a new or unestablished business
Lost profits are a common measure of damages in commercial litigation. But how do you prove lost profits for a new or unestablished business that has no earnings track record? Most courts permit unestablished businesses to recover these damages, provided they show the existence and amount of lost profits with “reasonable certainty.”
Looking to the future
Regardless of whether a damaged business is established or unestablished, proving lost profits requires experts to predict the plaintiff’s future performance. If the business is established, the expert analyzes its historical earnings and uses that information to estimate the profits it would have earned but for the defendant’s alleged wrongful conduct.
In doing so, causation is key. So, an expert considers a variety of factors — both internal and external — that aren’t caused by the damaging act but may cause the plaintiff’s future performance to improve or decline compared with its past performance.
For an unestablished business, an expert’s job is essentially the same, but without the benefit of historical performance as a benchmark. The factors the expert considers include:
- Management quality (its skills, experience and track record with similar businesses),
- Business plans and financial projections,
- Performance of comparable companies,
- Industry and market statistics and benchmarks, and
- Risk factors, such as the damaged business’s age, stage of development, growth rate and expected time to reach profitability.
An expert should also consider factors — such as general economic conditions, industry developments or legal issues — that would have affected the business’s performance regardless of the defendant’s alleged wrongdoing. The expert needs to analyze the impact of these factors to isolate the impact of the defendant’s alleged misconduct on the plaintiff’s performance.
Considering postincident events
Although not absolutely necessary, information about the business’s performance after the incident that triggered the litigation (that is, hindsight) can be valuable in proving lost profits with reasonable certainty. This is particularly true for unestablished businesses that lack a preincident track record. Also, it can be extremely difficult to identify truly comparable businesses, so the plaintiff’s postincident record may be the best benchmark available.
One common approach for calculating lost profits is the “before and after” approach, which bases damages on a comparison of profits before and after the defendant’s alleged misconduct. When a plaintiff’s business is unestablished, there’s no “before.” But the plaintiff’s postincident performance in alternative or parallel business endeavors can serve as a proxy in measuring the expected success of the business opportunity that was lost as a result of the defendant’s alleged wrongdoing.
For example, management’s strong postincident performance in alternative business activities — that is, activities pursued to replace the lost opportunities for which the litigation was brought — lends support to the argument that the plaintiff would have been successful but for the defendant’s alleged misconduct. Although profits from such activities tend to mitigate any potential damages award, their absence might cast doubt on management’s abilities and, therefore, make it more difficult to prove lost profits with reasonable certainty.
Parallel business activities — or postincident activities that would have occurred regardless of the defendant’s actions — can be even more effective. For example, the plaintiff may have been developing two distinct product lines. If the defendant’s alleged misconduct damaged one of the product lines, the plaintiff’s postincident success with the second product line might provide some evidence of management’s ability to turn a profit with the first.
Raising the bar
Although lost profits damages are available for new and unestablished businesses, the evidence offered to support such damages will be subjected to a higher level of scrutiny. So it’s important to work closely with your expert to build a solid case.
Can experts rely on management projections?
Generally, management’s internal projections are the best predictor of future performance because no one understands the business, the industry and the market better than management. With that in mind, however, it’s important for a damages expert to ensure that management projections are reliable.
In Merion Capital, L.P. v. 3M Cogent, Inc., for example, the Delaware Chancery Court accepted management’s cash flow projections as a reliable starting point in valuing a company in connection with litigation arising out of a merger. Although Merion wasn’t a lost profits case, the court’s discussion of the reliability of management projections is instructive.
Generally, the court said, it “prefers valuations based on contemporaneously prepared management projections because management ordinarily has the best first-hand knowledge of a company’s operations.” The court explained, however, that management projections may be less reliable, and not entitled to the same level of deference, if:
- Management had never prepared projections beyond the current fiscal year,
- There was a likelihood of litigation, and
- The projections were prepared outside of the ordinary course of business.
Absent evidence that management projections are unreliable, or that management had a conflict of interest when preparing them, a damages expert will usually be permitted to rely on them in calculating lost profits.