Financial experts usually start lost profits calculations with a company’s historical performance. However, sometimes the victim of a dispute or breach doesn’t have an established track record. Estimates for start-ups and early-stage companies that haven’t yet turned a profit require an alternative approach.
Using the past to predict the future
To estimate lost profits, experts need to project the plaintiff’s expected revenue and profit margin numbers. Projected lost revenue is based on certain assumptions and adjusted by appropriate profit margins to reach lost profits.
To project future revenue, experts typically use data from historical company performance, industry, and general economic trends and forecasts. A damaged business’s lost revenue is calculated using a variety of techniques, such as the yardstick and before-and-after methods. With a fledgling business, however, an expert may find insufficient performance data, insufficient firm data to correlate with industry trend data or a product so new that no projections have yet been made.
Similar problems complicate the process of determining profit margins, which requires analysis of a company’s fixed and variable costs. An expert will usually use historical company performance, industry profit margins, and internal forecasts based on projected revenue and cost structures. But a new company may have not yet generated much data for analysis and, if it markets a new product or service, comparable businesses might not exist.
Applying innovative solutions
Determining accurate lost profits damages for new businesses isn’t hopeless, though. Experts have alternative forecasting methods that can lead to supportable lost profits claims. For instance, they can use company projections for future revenue if the available data allows calculation of lost profits with “reasonable certainty” — in other words, the damages aren’t merely speculative or overly optimistic. The expert also may apply industry growth rate projections to existing company data and develop multiple sales projections using varied combinations of actual and projected data.
If the multiple projections arrive at similar conclusions, the expert can offer those findings as evidence of lost revenue. After lost revenue is calculated, the expert might use firm-specific data to model the cost structure by determining fixed and variable costs and the cost of goods sold.
Even when no useful firm-specific data can be identified, experts can cull useful information from outside sources. For example, they might look at models and studies of new-product life cycles to obtain market share and penetration estimates useful in projecting revenue.
Internal data and reports, industry forecasts, and other sources can then assist in formulating profit margins. And many governmental agencies, trade associations and research organizations issue regular reports that provide data — including expected demand, price and cost structures — that can be wielded to validate lost profits projections.
Experts also use discount rates. The discount rate applied to lost profits must reflect the riskiness and probability that the business would have realized the projected lost profits. It may be necessary to add a premium to the discount rate to account for overly optimistic internal forecasts. Or, when a company is in an early stage, experts may add an additional premium to the discount rate because lost profits aren’t as easily projected as they are for an established business.
Out-of-the-box thinking
Compared to more mature, stable businesses, start-up ventures seem to disproportionately experience contractual breaches, shareholder disputes and other types of litigation that necessitate lost profits calculations. To make matters worse, new companies often lack the resources to litigate these cases. Hiring an experienced valuation expert to support a claim can help improve your odds of winning in court.
