Looking Back to Go Forward

A Review of the Basics for Lost Profits (Part III)

This is the third installment of this series. The first part provided an overall introduction to this review of the basics for lost profits. The second part reviewed the similarities and differences between estimating lost profits and litigious based business valuations. This installment takes a deeper look into the methods for calculating lost profits. Four methods based on the “but for” theory are examined. The discussion of each methodology highlights the approaches taken for calculating lost profits and weaknesses or concerns that arise with each method.

Read Part I Here | Read Part II Here

This is the third installment of this series. The first part provided an overall introduction to this review of the basics for lost profits. The second part reviewed the similarities and differences between estimating lost profits and litigious based business valuations. This article takes a deeper look into the methods for calculating lost profits.

In the first installment of this series, four approaches for estimating lost profits were discussed: before and after, yardstick, sales projection, and market approach. All of these methodologies have been accepted by the courts. As with any approach estimating economic damages, they have positive and negative aspects. It is up to an expert to determine which approach best fits the facts of the assignment calling for a lost profits calculation. The following explanations are intended to help with assessing which approach allows for the most reliable calculation of lost profits.

But For Projections

Most lost profits analyses are based on the underlying theory that “but for” the defendant’s alleged wrongful act the plaintiff would have generated more revenue and/or profit during the claimed loss period. “The but-for projection is the primary foundation of the lost profits analysis. The but-for projection is the assumed level of business activity that would have happened after the injurious event, absent the conduct of the defendant. The projection must be made carefully, with consideration of all facts and circumstances that surround the business in the post-event condition. In addition to considering external factors that could affect the projection after the incident, the projection should be supportable internally—by management intention and capability as well as existing and projected capital in the business.”[1]

Before and After

“The ‘before and after’ method determines economic revenues for the damages period by comparing the performance of the business before the event occurred and after the effects of the damaging event are over. The underlying theory is that, ‘but for’ the event, the plaintiff would have experienced the similar revenues and anticipated lost profits during the damages period before the event occurred and/or after the event has subsided.”[2]

This approach is best suited for established businesses with a profitable track record. This is sometimes referred to as the “book end” method because it looks at the success of the business before the alleged wrongful act occurred and its financial success after the effects of the alleged wrongful act have subsided. Many graphs of lost profits calculated by this method show constant growth until the alleged wrongful act, a fall off in revenue and profits, and a return to growing revenue and profits after the loss period. The calculations for lost profits show the money needed to “fill the hole” in the injured business’ profits made during the loss period.

“This methodology is valid if the financial expert can establish that the business was harmed and would have performed in a similar fashion before and/or after the event. Alternatively, the expert can use the before-and-after method to provide evidence that the plaintiff did not suffer any harm in sectors that were not damaged by the defendant’s alleged bad acts. Further, this methodology is sound if the pre- and post-event historical financial records support similar trends for the damages period that the financial expert is estimating.”[3]

The concern with this approach is that it assumes all other things remained equal during the damages period. That is, there were no other potential causes for losses in the injured business’ revenue or profits over the loss period and the market served by the business remained the same before, during, and after the alleged wrongful event.

“If the before-and-after method is not adequately supported, its application can produce an unreliable projection of the but-for revenue stream. It is important to identify and evaluate other business factors that are related to the activity projected and show that these factors have not materially changed (or to account for such changes as appropriate).”[4]

Yardstick

“The yardstick method utilizes guideline company or industry measures to serve as the proxy for what the revenues and profits of the affected business would have been but for the damaging event. When using the yardstick method, the financial expert will need to demonstrate that the operations of the selected comparables are sufficiently similar to the affected company. This requires analyses of the yardstick companies or business units to determine similar size, location, product, capabilities, etc. When the expert uses industry benchmarks, the data should be of sufficient comparability and derived from reputable and reliable sources.”[5]

The yardstick method is commonly used in estimating the lost profits for a franchise like Subway or Dominos Pizza. Using the franchisor’s data, an expert can estimate the profits of an average franchisee’s store and estimate losses relative to that. Finding data for a broader spectrum of percentiles (10^th, 25^th, 75^th, 90^th) can be more difficult.

The comparability of the yardstick data is common fodder for a Daubert challenge. “The yardstick method is best suited when an independent financial benchmark can be found that can be statistically correlated to the plaintiff’s historical activity. … When properly applied, the yardstick approach can be a scientific method that supports the validity of a but-for projection and may convincingly remove the projection from the realm of speculation. The difficulty with the method lies in identifying substantially similar financial statistics, operating metrics, or industry benchmarks to compare to the plaintiff’s business activity. A second complication with the approach is that it may require adjustments to be made to the statistics or industry data to make them more comparable to the subject. The very necessity of making adjustments may raise questions about the comparability of the yardstick data.”[6]

Sales Projection

A review of financial forensic literature provides two somewhat differing explanations for the sales projection approach. The first explanation is this: “The sales projections method utilizes company-specific forecasts for certain items, preferably by using forecasts that the company has prepared in the ordinary course of business or for some purpose other than the litigation.”[7] The other explanation states: “Under this approach, some activity of the plaintiff, usually revenue, is projected during the post-incident period, based on the to-be-proven assumption that the projections would have been achieved but for the alleged effects of the defendant’s actions.”[8]

The first explanation emphasizes using company-specific sales projections made prior to the litigation for analyzing the injured business’ lost revenues/sales. The second seems to call for making projections of lost sales after the alleged wrongful act occurred.

It has been my experience that most businesses seeking lost profits assessments do not make formal sales and income forecasts or budgets annually. Some may give thought to the next year’s anticipated revenue, expenses, and ultimately profits, but those are generally optimistic and with limited foundation. So, while experts would enjoy having sales projections made by the injured business’ management for non-litigious purposes prior to the alleged wrongful act, unfortunately, that data rarely exists.

This is why the second explanation of this method goes on to discuss a broader set of sources for generating projected sales. “The projection of achievable sales can be based on historical sales activity, management estimates, analysis of markets and competitors, and other relevant factors. It may incorporate elements of the yardstick and before-and-after approaches, but usually characterized by incorporating more company-specific information and business plans, and tailoring the sales projections to plaintiff’s expected but-for world.”[9]

This method is generally used for more complex lost profits analyses. The sales projection approach allows the expert to identify the lost sales for a particular product or service provided by a business as opposed to looking at the combined reported sales for that business. This is important if the business claims to have only lost profits for that particular product or service. This may be particularly true for litigation involving wholesalers or manufacturers.

“Damages experts typically prepare the sales projection by discrete calendar segment (e.g., year, month) within the overall damages period. Determination of the but-for revenue for any calendar segment of the damages period may form a quite simple estimate to a complex determination. Depending on many possible contributing factors. A simple sales projection might involve a terminated supply contract that specified the order quantities, unit prices, and delivery dates. A more complex sales revenue projection might require the damages analysis to consider myriad potential variables, such as the competitive environment, consumer preferences, general economic conditions, and plaintiff’s internal resources (e.g., production facilities, personnel, intellectual property, and capital). As a result of a thorough analysis, the expert will eventually opine that the but-for revenue stream consists of credible, reasonable amounts based on reasonable, supportable assumptions.”[10]

Because this method is used in assessing more complex lost profits situations, it also contains more opportunities for challenges to the expert’s work. “Weaknesses of this methodology include identifying and measuring the effects of other factors as well as supporting the underlying foundation for the projections. … The courts continue to rule that a sales projection method for calculating damages is generally reliable. However, the challenge for the financial expert remains how to make the appropriate estimates and analyses and then relate them to the performance that the specific event impacted so the conclusions are reliable.”[11]

Market Approach

This methodology is not used as often as the other three already discussed. I do not remember being involved in a case where the opposing expert has used it.

“According to this methodology, the expert considers the plaintiff’s market share prior to the defendant’s alleged act to determine lost revenues/sales. … The use of the market model is generally more prevalent in patent infringement cases. In using this methodology, the financial expert needs to define the appropriate market and analyze the subject company’s historical sales as well as those of its competitors. Some economic experts utilize this methodology because of their particular understanding of the market and industry. Using this methodology requires identifying the plaintiff’s historical market share trends, the entrance/exit of competitors in the marketplace, and other changes that might affect a particular company’s market share.”[12]

As with any of these methodologies, there are weaknesses which open experts for criticism and Daubert motions. “There are two challenges to applying the market share approach. The first challenge is obtaining reliable data defining the market for the product or industry under study in the analysis and assuring the market data are comparable to the subject. In its simplest form, the approach is applied to a two-competitor market that can be easily defined but, unfortunately, most damage situations are not so simple. The second issue is ensuring that the presumed decline in the subject’s market share is caused by the allegedly wrongful activities of the defendant. Market share data can be obtained from various independent sources, such as trade groups and regulatory bodies, and often from the company itself. However, data for some industries are more difficult to measure with accuracy than others.”[13]

One of the drawbacks with the market approach is the lack of comparable market data for small and closely held businesses. This is not unlike trying to find comparable business data when applying the market approach for a small or closely held business in a business valuation assignment. Because of these limitations, an expert may find the other discussed methods more reliable for projecting the but for results.

Other Methods

The four discussed methodologies are those most commonly used to estimate the but for damages in a lost profits litigation. However, this is not an exhaustive list. In the Honeywell International case, the court listed alternative methods.[14]

“1) the regression method, which involves linear regression analyses of the plaintiff’s total costs against total sales;

  2) the ‘high-low method,’ which takes the month with the highest sales and the month with the lowest sales and divides the change in costs between those two;

  3) the incremental method, which takes each set of succeeding months, divides the incremental change in costs between those months by the incremental change in sales to obtain a percentage, and takes the median of such percentage.”[15]

While discussing these alternative methods in its decision, the court expressed concern over the use of the high-low method and seemed to favor the regression method.

Conclusion

In this installment of Looking Back to Go Forward, the four methods most commonly used for calculating lost profits have been reviewed. These four approaches have been discussed separately. This does not mean that they may not be used in some form of combination.

“Depending on the facts and circumstances of a particular case, financial experts may utilize a single methodology or a combination of the methods to substantiate their primary analyses. For example, in developing a lost profits analyses, the financial expert may look at growth rates that the plaintiff experienced prior to and after the damages period. In addition, the expert might compare the subject company’s actual experience to other operating units of the company and/or industry guideline candidates (those that are comparable to the subject business unit that was damaged). Finally, in certain tort cases, such as a misappropriation of trade secrets and breach of confidential/fiduciary relationships, the proper remedy might include disgorgement of the defendant’s profits; and in these cases, the expert might use an accounting of the sales and/or profits realized by the defendant as a measure of the plaintiff’s lost profits.”[16]

My firm has made calculations seeking the disgorgement of the defendant’s profits during the claimed loss period. In addition, we have used the defendant’s revenue and profit data during the loss period as an example of the revenue and subsequent profits the plaintiff could have earned were it not for the alleged wrongful act. Courts have found either approach reliable and have dismissed any challenges against these calculations.

As with any litigation assignment, an expert must choose the appropriate methodology for calculating damages based on the facts and circumstances of the case. When the proper approach is selected and applied, courts will more than likely accept the opinions and conclusions of the expert. This will allow the expert to present his or her findings to the trier-of-fact. By sharing with the trier-of-fact how the facts of the case fit with the methodology used for calculating the lost profits, the expert can show how the lost profits results are reliable and relevant to the case. In this way, the expert is fulfilling the assignment given to him or her.

[1] Lost Profits Damages: Principles, Methods, and Applications, 2^nd Ed., Everett Harry, III, Jeffrey Kinrich, Valuation Products and Services, 2022, p. 71.

[2] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3^rd Ed., Vol. 1, Nancy Fannon, Jonathan Dunitz, BVR, 2014, p. 2019.

[3] Ibid., 220.

[4] Lost Profits Damages: Principles, Methods, and Applications, 2^nd Ed., p. 75.

[5] The Comprehensive Guide to Lost Profits and Other Commercial Damages, p. 221.

[6] Lost Profits Damages: Principles, Methods, and Applications, p. 72.

[7] The Comprehensive Guide to Lost Profits and Other Commercial Damages, p. 223.

[8] Lost Profits Damages: Principles, Methods, and Applications, p. 75.

[9] Ibid., 75.

[10] Ibid., 76.

[11] The Comprehensive Guide to Lost Profits and Other Commercial Damages, p. 225.

[12] Ibid., 226.

[13] Lost Profits Damages: Principles, Methods, and Applications, p. 76.

[14] Honeywell International, Inc. v Air Products & Chemicals, Inc., 858 A.2d 392 (Del. Chan. 2004).

[15] The Comprehensive Guide to Lost Profits and Other Commercial Damages, p. 227.

[16] Ibid., 218–219.

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Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings. In 2021, Dr. Needham received a NACVA Outstanding Member Award. He is also a member of NACVA’s QuickRead Editorial Board.

Dr. Needham can be contacted at (817) 348-0213 or by e-mail to aneedham@shippneedham.com.