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Lost Profits: Calculating the Damage

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When a business has been damaged by another party, an expert may be needed to estimate the damages. Photo by Dovis from Pexels

Financial experts are often hired to measure economic damages in contract breach, patent infringement and other tort claims. Here’s an overview of how experts quantify damages, along with some common pitfalls to avoid.

Estimating Lost Profits

Where would the plaintiff be today “but for” the defendant’s alleged wrongdoing? There are three ways experts address that question:

1. Before-and-after method. Here, the expert assumes that, if it hadn’t been for the breach or other tortious act, the company’s operating trends would have continued in pace with past performance. In other words, damages equal the difference between expected and actual performance. A similar approach quantifies damages as the difference between the company’s value before and after the alleged tort occurred.

2. Yardstick method. Using this technique, the expert benchmarks a damaged company’s performance to external sources, such as publicly traded comparables or industry guidelines. The presumption is that the company’s performance would have mimicked that of its competitors if not for the tortious act.

3. Sales projection method. Projections or forecasts of the company’s expected cash flow serve as the basis for damages under this method. Damages involving niche players and start-ups often call for the sales projection method, because they have limited operating history and few meaningful comparables.

Experts will consider the specific circumstances of the case to determine the appropriate method (or methods) for the situation.

Discounting Damages

After experts have estimated lost profits, they discount their estimates to present value. Some jurisdictions have prescribed discount rates, but, in many instances, experts subjectively build up the discount rate based on their professional opinions about risk. Small differences in the discount rate can generate large differences in valuators’ final conclusions. As a result, the discount rate is often a contentious issue.

Mitigating Factors

Another key step is to address mitigating factors. In other words, what could the damaged party have done to minimize its loss?

For example:

• A manufacturer that suffers a business interruption should minimize the impact by resuming operations at a temporary location or outsourcing production to another company, if possible.

• A wrongfully terminated employee needs to make a reasonable effort to find another job.

• An antitrust plaintiff prevented from entering a particular market should explore opportunities to invest in alternative markets.

• A plaintiff in a breach-of-contract case should make a reasonable effort to replace the business lost as a result of the defendant’s wrongdoing.

Most jurisdictions hold plaintiffs at least partially responsible for mitigating their own damages. Similar to discount rates, this subjective adjustment often triggers widely divergent opinions among the parties involved.

Avoiding Potential Pitfalls

Some key factors need to be considered to avoid over- or underestimating a plaintiff’s loss. For example, the taxation of damages can have a significant impact on an expert’s conclusion. If the plaintiff must pay taxes, an after-tax assessment wouldn’t be equitable. Also realize that some parts of a damages award, such as return of capital, may be nontaxable and require an after-tax estimate.

Taxes also need to be handled properly when lost profits are discounted to present value. In other words, if damages need to be calculated on a pretax basis, the expert should use pretax discount rates. Mismatching after-tax discount rates to pretax cash flows would overstate damages, all else being equal.

In addition, it’s important to not assume that damages will occur into perpetuity. Economic damages generally occur over a finite period. They have a beginning and an end. Eventually most plaintiffs can overcome the effects of the defendant’s alleged wrongdoing.

For More Information

When calculating economic damages, there isn’t a one-size-fits-all approach. What’s right depends on the facts of your particular case. Contact the experts at Advent Valuation Advisors to develop an estimate that avoids potential pitfalls and can withstand scrutiny in court.

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NY May Force Insurers to Pay Business Interruption Claims

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New York is one of several states where legislation has been introduced that would require insurers to pay business interruption claims related to the coronavirus pandemic. Photo by Anastasiia Chepinska on Unsplash

It may be worthwhile to file a claim for coronavirus-related losses under your company’s business interruption insurance policy, even if the policy specifically excludes coverage for losses related to virus outbreaks.

A bill introduced in the New York State Assembly would require policies that include business interruption insurance to cover interruption claims incurred during the state emergency resulting from the coronavirus pandemic. The bill would apply to policies held by businesses with fewer than 250 eligible employees, defined as full-time employees who normally work 25 or more hours per week.

Business interruption insurance typically covers the loss of income that a business suffers due to the disaster-related closing of the business and the rebuilding process after a disaster. Coverage may include lost revenues, rent or utilities, among other things. A contingent business interruption provision generally provides coverage for a loss of income related to a problem experienced by a supplier or vendor.

Thousands of businesses in New York State have been forced to close as a result of the COVID-19 outbreak and the resulting state of emergency, which was declared by Governor Andrew Cuomo on March 7. The state has ordered nonessential businesses to close, and many businesses that continue to operate have been hampered by a combination of supply chain interruptions, staffing issues and plunging demand.

Insurers typically do not provide coverage for closures related to widespread illness. In fact, some insurers began to specifically exclude diseases from policies in response to the SARS outbreak of the early 2000s. The Assembly bill would nullify any policy provisions that allow insurers to deny coverage based on “a virus, bacterium, or other microorganism that causes disease, illness, or physical distress.”

Similar legislation has been introduced in several other states, including New Jersey and Pennsylvania.

Companies with 100 or fewer employees face business continuity losses of $255 billion to $431 billion per month because of the pandemic, according to the American Property Casualty Insurance Association, which opposes bills such as the one introduced in New York.

“Pandemic outbreaks are uninsured because they are uninsurable,” David Sampson, president and CEO of the association, said in a prepared statement. “Any action to fundamentally alter business interruption provisions specifically, or property insurance generally, to retroactively mandate insurance coverage for viruses by voiding those exclusions, would immediately subject insurers to claim payment liability that threatens solvency and the ability to make good on the actual promises made in existing insurance policies.”

New York’s bill was introduced March 27, 2020, and is currently before the Assembly’s Insurance Committee. It would apply to any policies in effect on and after March 7. It calls for any business interruption policies that expire during the period of the declared state emergency to be subject to an automatic renewal at the current premium. It would allow insurers to seek state reimbursement for business interruption payments. The state, in turn, would be permitted to raise funds for these reimbursements through a levy against all insurance companies doing business in the state.

To learn more about the quantification of lost profits, please contact Advent. You can read more about business interruption insurance claims related to COVID-19 here: https://adventvalue.com/are-your-companys-covid-19-losses-covered/

Lost Profit Claims Face High Hurdles in NY

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Photo by Shopify Partners from Burst

Lost profits claims are difficult to prove under New York law. This is particularly true for a new business, or an existing business entering a new market or line of business.

A recent decision in a case heard in Arizona District Court – but involving a supply agreement governed by New York law – provides some insight into the hurdles faced by such claims.

In IceMOS Technology Corporation v. Omron Corporation (2:17-cv-02575) , the plaintiff, a business that sells semiconductor components, sued the defendant alleging breach of the supply agreement. The plaintiff’s claims included lost profits. The defendant countersued, and the case is ongoing.

In November, the court granted the defendant’s motion to dismiss the lost profits claim, finding that the plaintiff did not establish lost profit damages with reasonable certainty.

Three-Part Test

As explained in the decision, under New York law, there are two broad categories of damages that can result from a breach of contract. The first is the general damages that are the natural and probable consequence of the breach. The second is special or extraordinary damages that do not flow directly from the breach. A claim for lost profits is an example of a claim for special or extraordinary damages. New York uses a three-part test to determine if a party is entitled to recover lost profits:

  1. The damages must be caused by the breach of contract. 
  2. The loss must be proven with reasonable certainty. 
  3. The party making the claim must demonstrate that the lost profits were foreseeable, that they were in “the contemplation of the parties at the time the contract was made.”

For a new business, the bar is set even higher. In order to establish reasonable certainty, a new business making a lost-profits claim must generally support the claim “with evidence of a history of profit or comparison of the new business with other comparable and profitable businesses.”

In addition, a new company must consider general market risks that might hurt its future profits, such as new competitors, technological or regulatory changes, or general market movements.

The hurdles for new businesses also apply to existing businesses entering new markets. This was the case for IceMOS, which reached an agreement with Omron Corporation in 2011 under which Omron would fabricate semiconductor wafers for IceMOS over several years. IceMOS purchased just a small fraction of the agreed-upon quantity. The court found that the plaintiff was a new business, as IceMOS was entering a new market, and held it to the higher standard.

The plaintiff’s lost profits claim relied on projections by the company’s president and a pair of experts. The plaintiff did not show a history of profits or any comparisons with profits of similar businesses. The court noted that, in New York, projections are generally not sufficient to establish lost profits with reasonable certainty. “Without a history of profit or evidence showing the profitability of other like-businesses, Plaintiff cannot establish lost profit damages with the reasonable certainty New York law requires for new businesses.”

The decision builds upon a series of earlier rulings that address aspects of the three-part test and the heightened evidentiary burden for new businesses. You can read the decision here.

Advent Valuation Advisors provides a variety of litigation support services. Please contact us if you have questions about the determination of lost profits or the calculation of other types of damages.