Abstract: Lost profits estimates are often based off of a company’s historical performance. But the usual methods of calculating these damages may fall short when a start-up is involved. This article explains the alternative methods of assessing lost profits that experts use for companies without an established track record.
Calculating lost profits for start-ups
Lost profits estimates are customarily based off of a company’s historical performance. But what happens when the victim of a dispute, breach or tortious interference is a start-up without a track record of profits? The nature of start-ups causes projections of future revenues and profits to be subject to much greater uncertainty. These situations typically call for alternative methods to arrive at a reliable lost profits calculation.
Traditional approach: Look to the past
To calculate lost profits, the expert determines the business’s lost revenue using a variety of techniques, such as the yardstick and before-and-after methods. Projected lost revenue is based on certain assumptions and adjusted by appropriate profit margins to reach lost profits.
Regardless of the method applied, the expert needs projected future revenue and profit margin numbers. But this can prove difficult with new businesses, because they lack financial histories and, in some cases, comparable industry data.
To project future revenue, experts typically use data from historical company performance, industry, and general economic trends and forecasts. With a new 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 business may offer insufficient data for analysis, and, if it markets a new product or service, comparable businesses might not exist.
Find unconventional 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. 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 business 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.
Put an expert on your team
Claims for lost profits damages arise in many types of litigation, including shareholder disputes, insurance litigation, breach of contract and intellectual property actions. Unfortunately, many of the plaintiffs in these cases are start-ups that lack the financial resources to prevent litigation and defend against wrongdoing. The good news is that entrepreneurs can estimate lost profits with confidence by hiring valuation specialists who are trained in such out-of-the-box thinking and creative — but defensible — solutions.