Claims for lost profits arise in many types of cases, including contract disputes, business torts, insurance claims, personal injury and antitrust claims.
Measuring lost profits damages would seem to be a relatively straightforward concept of determining the difference between the amount a business could have reasonably expected to earn during the relevant period as compared to the amount the business actually earned during that period.
However, determining the amount that the business could have reasonably expected to earn typically requires comprehensive analyses and projections supported by reliable evidence.
I have worked on hundreds of lost profits cases in my career. During many of those cases, I have had to address misperceptions that parties involved in the case had as to the determination of lost profits.
Let’s discuss some of the most common misperceptions and explain the appropriate considerations in determining lost profits.
1. Lost Profits Equal Lost Revenues
Many business owners estimate their claim for lost profits to be equal to the amount of revenues that the business lost. Lost profits damages are lost “net” profits, not loss of revenue or loss of gross profit.
Proof of loss of revenue, by itself, is not sufficient to prove a lost profits claim. Using the amount of revenues lost to make a claim for lost profits ignores consideration of costs and expenses that would have been incurred to generate the revenues that were lost.
Damages for lost profits should be computed by determining lost revenues and then subtracting avoided (saved) costs and expenses. Avoided (saved) costs and expenses are those costs and expenses that would have been incurred in connection with the generation of lost revenues, but were not incurred during the damage period.
2. Businesses That Lose Money Don’t Sustain Lost Profits
There are businesses that report net losses as a result of expenses exceeding revenues. Some parties believe that since those businesses don’t report profits, those businesses will not have a basis for claiming lost profits. A business operating at a loss can sustain damages from lost profits.
Once again, the computation of lost profits should be based on the amount of lost revenues minus avoided (saved) costs and expenses. If the amount of lost revenues exceeds the total of the avoided (saved) costs and expenses, the resulting difference is the amount of lost profits. That lost profits amount will result in the business reporting a higher net loss amount than it otherwise would have incurred.
I’ll use an example to illustrate the loss of profits sustained by a business that has been operating at a loss. A business was completely shut down for a month as a result of the actions of the defendant. Based on an analysis of the business, the projected revenues and expenses of the business were expected to be the same as the preceding month had the business remained open.
In the prior month, the business had revenues of $100,000 and expenses of $105,000 resulting in a net loss of $5,000. During the month the business was shut down, there were no revenues and the expenses totaled $40,000, resulting in a net loss of $40,000. The lost profits should be based on the lost revenues of $100,000 minus avoided (saved) costs and expenses of $65,000 (projected expenses of $105,000 minus actual expenses of $40,000), therefore lost profits are $35,000. Note that the net loss sustained by the business during that month of $40,000, as compared to the expected net loss of $5,000, reflects an increased net loss of $35,000, which is due to the lost profits.
3. All Decreases In Business Should be Included In the Lost Profits Claim
Claims for lost profits frequently assume that all decreases in revenue during the damages period should be included in the lost profits calculation, even when other factors may have caused or contributed to the decrease in revenue. The lost profits calculation should only include lost profits caused by the actions of the defendant.
In computing lost profits damages, other factors that could have affected profits during the damage period should be taken into consideration, and evaluated to exclude the lost profits attributable to such other factors.
4. New Businesses Lost Profits Claims Are Speculative and Therefore Not Recoverable
In years past, many courts applied what is referred to as the “new business rule,” which is that claims for lost profits of a newly established business are inherently speculative and, therefore, cannot be recovered.
However, in recent years, most courts have moved away from this general rule and instead have considered the quality of the evidence presented to determine whether or not the plaintiff has demonstrated a supported basis for a reasonable estimate of its damages. The recent trend by courts recognizes that a business should not be precluded from recovering lost profits just because it is a new business.
The recent trends recognize changes in the types of evidence and analyses available to financial and economic experts, such that strict adherence to the “new business rule” is no longer necessary. Reasonable evidence needs to be presented by the plaintiff to demonstrate with reasonable certainty that it would have made a profit. Damages may be established with reasonable certainty through economic and financial data, market surveys and analyses, business records and experience of similar businesses, experience of the business owner, and through expert testimony.
In summary, lost profits damages should reflect the lost “net” profits, generally calculated based on lost revenue reduced by avoided (saved) costs and expenses. The plaintiff must demonstrate that the lost profits damages caused by the defendant are reasonable, calculated using reliable factors, and not based on speculation.
Our Forensics & Litigation Support Group can help. Jim Kern, CPA, CFE, CVA, specializes in damage calculations including lost profits, extra expense, business valuations, fraud and embezzlement investigations, and evaluations of financial condition and earnings of individuals and businesses. Contact him online or call 800.899.4623.