Damages experts who are retained to quantify the harm suffered by a new business, such as a claim for lost profits, often face unique challenges that arise from issues such as the business’ lack or operational history or limited history of sales or profits. These issues, in turn, cause damages experts to confront questions such as:
- Does the business have the capacity to ever generate a profit?
- Is the management team capable of growing the business?
- Will consumers buy the product under development?
- Will the technology work?
- Does the company have appropriate access to capital and funding?
- Will the subject company ever get out of the development stage of the business life-cycle?
Because of the limited history, and the questions that need to be answered in order to develop a credible claim for damages, the courts have grappled with the extent to which new businesses should be entitled to recovery of any alleged lost profits.
What the case law demonstrates
The analysis of case law surrounding the challenges to lost profits claims involving new businesses does not establish any hard and fast rules, but rather identifies concepts that the damages expert may wish to consider when analyzing lost profits for a new business. For example, the case law demonstrates that the courts are increasingly willing to consider moving away from the strict application of the “New Business Rule.” In many jurisdictions, the “New Business Rule” historically limited recovery of lost profit damages sought by a new business on the basis that a lack of historical profits made lost profits claims for new businesses inherently speculative. However, more recently, the courts have allowed for consideration of lost profits claims for new businesses if sufficient reasonable evidence of loss is presented. In addressing the question of what constitutes sufficient reasonable evidence, the courts have indicated that:
- While a new business may not have a history of profits or performance on which to base a analysis of lost profits, the courts are often open to admitting expert testimony on the issue if the damages expert employs generally accepted approaches and methodologies such as the before-and-after method, the yardstick method and multiple analyses that are reconciled to support the sufficiency of the analysis. Moreover, the courts have been accepting of yardsticks, as long as there is substantial similarity between the facts forming the basis of the profit projections and the business opportunity subject to analysis.
- Projections, and particularly projections that were prepared prior to litigation, can provide a basis for the lost profits analyses where the record indicates that the damages expert knows who constructed the projections, and the expert and/or individual who prepared the projections has the requisite expertise and training to support the assumptions and data used in the projections. These findings are consistent with the overall findings regarding the use of client supplied data.
- An evaluation of the industry is important, including whether the industry itself is new and/or whether the overall industry experience may provide a basis for the analyses of lost profits.
- The profitability of the business over its period of existence is relevant. To the extent that a new business has been in operation for a period of time, the courts have examined the time period covered by the relevant data used in the damages analyses, and whether the business in question had been profitable over its period of existence.
- Damages expert experience and credentials matter. The courts are inclined to consider lost profits for a new business when the analyses is prepared by a damages expert who possesses the requisite credentials and expertise, such as industry experience, and uses those credentials and expertise to demonstrate the reasonableness of the analyses.
- Management experience and expertise also matters. As previously noted, the courts are more inclined to consider a claim for lost profits for a new business when the damages expert has applied analytical techniques such as the yardstick approach, and has demonstrated substantial similarity between the facts forming the basis of the profit projections and the business opportunity subject to analyses. In demonstrating substantial similarity, the damages expert needs to be mindful that this comparison should include an evaluation of the background, experience, and expertise of subject company management to deliver results similar to those of the yardsticks selected.
As the courts have continued to evaluate claims for lost profits associated with new businesses, it is clear from the case law that there is an increased willingness on the part of the courts to consider such claims, assuming that the appropriate sufficient, relevant evidence is provided to support and substantiate the claim. The evaluation of what constitutes sufficient, relevant evidence, in turn, includes an evaluation of whether the claim is based on accepted methodologies and approaches; the critical evaluation of the inputs to the analyses, including financial projections; and analyses of other factors relevant to the claim, including the state of the industry, the background and experience of management, and the credentials and expertise of the damages expert who prepared the claim.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.