Measuring lost profits damages for new or early-stage businesses can be a daunting task. Traditional damage analyses that rely on historical results are often meaningless since, by definition, startup companies usually lack a track record of operating results. Without an historical operating history for measuring lost profits, the damages expert walks a thin line between speculation and a reasoned analysis. Under most circumstances, to be admissible evidence, damage analyses require relevant and reliable factual bases. These legal and evidentiary requirements are often heightened when measuring damages for new businesses.
In a chapter from The Comprehensive Guide to Economic Damages, 6th edition, valuation expert Neil J. Beaton, CPA/ABV/CFF, CFA, ASA (Alvarez & Marsal), and attorney Tyler L. Farmer, Esq. (Harrigan, Leyh, Farmer & Thomsen LLP), explore seven credible techniques that experts can utilize to measure and/or estimate damages for new or early-stage businesses. The following is an excerpt from that chapter, which includes a more exhaustive discussion.
- Legal Requirements: The Basic Parameters. The legal basis for seeking business damages takes many forms, including breach of contract, negligence, patent infringement, unfair competition, and various other claims and causes of action. Monetary damages can be measured by a reasonable royalty, lost profits, or, alternatively, the destroyed value of the entire business including unjust enrichment, out-of-pocket expenses, and other methods.
For established businesses, plaintiffs more frequently assert damages claims on the basis of lost profits than on the value of the entire business. (There are, however, numerous cases in which established businesses claim a loss of business value.) New business damages, on the other hand, frequently involve a claim for the value of the entire business because the defendant’s act allegedly caused the business to cease operations and/or shut down.
- Methods for Proving Lost Profits for New Businesses. New business damages need to be measured with “reasonable certainty.” Expanding on the legal definition, in economic terms, reasonable certainty can be thought of as the absence of speculation in the proffer of financial proof. In other words, the financial expert must present a damages “story,” sufficiently credible and complete under the circumstances that the trier of fact will be able to tie the proffered damages calculations to the expert’s reasonable assumptions and empirical support. This does not mean the court will not accept some degree of speculation, since a new business, by definition, does not have an established track record. However, along the speculation “continuum,” the more relevant and reliable the evidence, the better, with the goal being to minimize the number of uncertain components inherent in any new business damages claim.
- Collecting and Analyzing the Data. How does one establish the “certainty of damage” in a new business? Of course, no single methodology exists; rather, experts must gather a mosaic of data that, as a whole, evidences the “certainty” the courts and case law require. In compiling this mosaic, the expert should consider as many factors as practicable in light of the magnitude and complexity of the engagement. For example, an expert most likely would (and should) gather more documentation to support a billion-dollar claim versus a claim for only $100,000. Although all businesses face general competitive pressures, the new business is particularly susceptible since it typically has not had time to establish customer or brand loyalty. Success rates for new versus established businesses can provide evidence showing the specific hurdles a nascent business will face.
- More Factors for Assessing New Businesses. What factors should an expert consider when assessing the probability of success for a new business? The following list identifies some, but not all, of the factors:
- Threat of new entrants;
- Threat of substitute products;
- Bargaining power of customers;
- Bargaining power of suppliers;
- Competition within the industry;
- Capital adequacy;
- Prior business experience;
- Prior business experience in the particular industry;
- Experience of the management team;
- External economic conditions; and
- A formal (written) business plan.
- Guidance From the Courts on Determining New Business Damages. Given the difficulty in calculating damages for new businesses, how might a financial expert avoid the apparent problems and pitfalls? A number of published opinions by both federal and state courts provide substantial guidance for determining such damages. As a preliminary, cautionary note, new business damage calculations can provide fertile ground for motions in limine to preclude an expert’s opinion under the Daubert or an analogous standard.
- The Special Case of Venture-Backed Companies. Venture-backed companies (VBCs) generally possess completely different economics than non-VBCs. Typically, VBCs are defined by highly technical, often unproven business models (at least at the time of their initial funding) that may take years to come to fruition and determine the venture’s success. Common examples of VBCs include biotechnology companies searching for a new medical cure or procedure, for which it might need 10 to 15 years to prove the efficacy of its product or service (if ever). Other VBCs, such as online social networks and media, may demonstrate tremendous success in generating traffic to their websites, but they lack a defined business model to exploit for future profits, e.g., Twitter, which has generated tremendous revenue but has been unable to generate positive net income. Despite their inherent risk and some degree of uncertainty, all VBCs have a common thread: One or more investors have purchased equity securities in the enterprises, which can provide at least one basis of value from an external, third party (related or unrelated). Thus, unlike non-VBCs, VBCs can point to an external transaction in an attempt to validate that their company is worth some amount, even if the firm has failed to post any revenues or profits to date. This equity investment alone often provides the necessary evidence for a trier of fact to ascertain damages for a new venture even though traditional damages measures, such as prior profitability, might fail. As in all lost profits cases, however, the legal standard of reasonable certainty still applies, and the VBC plaintiff must prove its damages with more than a simple reference to some external investment or investors.
- Lost Profits Versus Lost Business Value. Claims for whole damages relate to the loss of the entire business and are more prevalent for new businesses, since they are more susceptible to complete failure than established companies. (Claims for partial damages arise when the new business has lost a product or a division for a finite period of time.) The question often arises: Can whole business damages exceed the value of a business? The answer often depends on the facts and circumstances of the individual engagement, with some experts believing that total damages cannot exceed the value of the total business (or it would contradict the principle of substitution, i.e., the value of an asset should not exceed the cost to reproduce it or an equally desirable substitute) and others believing lost profits can exceed the value.
Experts have various techniques to consider when measuring damages in connection with a lost profits claim by a new or early-stage business. The prevailing legal standard for ascertaining and awarding damages, reasonable certainty, is somewhat nebulous and thus will necessarily depend on the facts and circumstances of each case, so the financial expert must know relevant case law applicable to the case. Although it is often more difficult to calculate new business damages than damages for an established business, the potential rewards of a successful claim may far outweigh the potential expense and disappointment of a negative litigation outcome.
To learn more about economic damages as they relate to business valuation, be sure to check out BVR’s Comprehensive Guide to Economic Damages, 6th edition. Preview the table of contents and look inside to learn more about this invaluable resource for every attorney and business valuation professional to stay ahead of the game.