Valuing Lost Profits of a License Agreement
Avoiding Speculation
The author of this article, Dr. Kreuter, recently testified in a jury trial in New York State Supreme Court. The case was heard in April 2023. In the case, Kela Tennis, Inc. (“Kela”) sued the City of Mt. Vernon (“Mt. Vernon” or “the City”). On behalf of Kela, Dr. Kreuter calculated the economic damages in connection with the City’s breach of contract with Kela. The City had wrongfully destroyed the tennis bubble Kela had operated, leading to severe losses. This article explores the method used to compute damages, which included careful consideration of partially offsetting mitigation, a reasonable growth rate, and discount rate to define the present value of damages back to a certain date.
Dr. Eric Kreuter testified in a jury trial in New York State Supreme Court in April 2023, in the case of Kela Tennis, Inc. (“Kela”) suing the City of Mt. Vernon (“Mt. Vernon” or “the City”). On behalf of Kela, Dr. Kreuter calculated the economic damages in connection with the City’s breach of contract with Kela. The City had wrongfully destroyed the tennis bubble Kela had operated, leading to severe losses.
This article explores the method used to compute damages, which included careful consideration of partially offsetting mitigation, a reasonable growth rate, and discount rate to define the present value of damages back to a certain date.
The judge in the case bifurcated the trial into liability and damages phases with the same jury sitting for both. In the liability phase, attorneys for both plaintiff and defendant called witnesses then the jury deliberated for many hours, returning a unanimous verdict in favor of plaintiff that the City breached its license agreement with Kela Tennis—the key issue in the case. Next up was the trial on damages.
What the Case is About
In the early 2010’s, the City initiated a plan to erect a year-round tennis operation in a newly renovated park. Kela was one of five companies that responded to the Request for Proposals (RFP) and was the selected bidder. In 2015, the City and Kela signed a license agreement for 15 years, requiring Kela to pay a set fee each month to the City in exchange for the right to operate the facility.
The City was also obligated to construct the infrastructure where the tennis facility, which included a state-of-the-art tennis bubble, would be developed. However, it had significant trouble doing so. The delays resulted in Kela operating a less-than-complete facility with fewer courts than expected and a lack of completed space to install a fitness center and vending machines. Nevertheless, Kela, through astute management, earned and reported substantial taxable income in each of the three years prior to the abrupt termination.
Shortly after midnight on June 1, 2018, the former Mayor, without consultation with the City Counsel, arranged for a local contractor to use heavy equipment to deflate the intricate bubble apparatus and bring it to the ground. The owners of Kela received word about this terrible event and were at the site in the morning. Due to this event, Kela’s operations ceased.
Twelve years remained on the term of the license agreement. There was no recourse for Kela other than to engage counsel and file suit. As a result, Dr. Kreuter was engaged to compute Kela’s economic damages related to this severe business interruption.
Approach to the Case
Kela suffered substantial monetary damages due to the irreparable physical damage to the tennis bubble and other property at the tennis center, as well as being evicted from the site, which led to loss of income from Kela’s business operations. Kela was unable to re-open another tennis center in the New York metro area because no other local municipalities were seeking license agreements at the time. Furthermore, Kela lacked the required capital to build a tennis center on his own.
At the time that the City disrupted Kela’s business in 2018, 12 years remained on the license agreement until November 2029. To compute Kela’s economic damages, we determined the following:
- Lost net profits between April 1, 2015 through May 31, 2018 (start of agreement until destruction of the tennis bubble)
- Lost future net profits discounted to present value from June 1, 2018 through November 30, 2029 (start of business cessation until end of initial agreement)
- Additional unanticipated expenses incurred by Kela due to the City’s failure to perform obligations from the license agreement
- Loss of ancillary revenue sources
- Monetary damages from the destruction of the tennis bubble
Had everything gone smoothly, there was every reason to believe the term of the license agreement would extend beyond November 2029. However, we did not compute additional damages for extension as we deemed that would have been speculative. Every fact in evidence, however, strongly suggested good rationale to compute future lost net profits out to the contractual expiry of the license agreement.
Included in our quantum of damages were an offset to the damages from mitigation and reduction for additional license fees that would have been paid had the infrastructure been completed by the City. Kela was allowed to deduct 50 percent of its license fees due to the City’s failure to perform agreed-upon obligations. Furthermore, we acknowledged that Kela Simunyola, the owner and operator of Kela, began working as a tennis pro outside of his now destroyed tennis business. His actual and projected earnings from this employment were considered and reduced our damage calculation.
Methodology and Results
Lost net profits between April 1, 2015–May 31, 2018:
The City caused Kela to operate a less-than-complete tennis facility with fewer courts than expected and no space to install its planned ancillary revenue sources involving a fitness center, a pro shop, concession stand, and vending machines. As a result, Kela earned less revenue than it forecast at the time of its original bid proposal. Through no fault of its own, Kela was unable to keep the facility open from September 2015 through April 2016 and again from September 2016 through November 2016. Kela was also only able to operate six tennis courts instead of the contractual eight, which was the number of courts outlined in the license agreement. We calculated lost net profits from the beginning of the license agreement until the date of the tennis bubble destruction that considered these damaging constraints against Kela.
To estimate lost revenues, we took a conservative approach by averaging Kela’s actual revenues based on their tax returns with their pre-litigation revenue projections. The City had reviewed the pre-litigation projections as part of Kela’s RFP approval making it the best available evidence for how Kela would have performed under unimpeded circumstances. On the expense side, we took an average of the actual expenses based on Kela’s tax returns as a percentage of revenue and applied those margins to our projected revenues.
We calculated the estimated net profits that Kela should have achieved from April 1, 2015 through May 31, 2018, had the City allowed Kela to operate his business with what the City had promised according to the license agreement. We then subtracted from this amount Kela’s actual net profits during the same period. As a result, we estimated lost net profits of $2.3 million from April 1, 2015 through May 31, 2018.
Lost future net profits discounted to present value from June 1, 2018–November 30, 2029:
Once the tennis bubble was destroyed on June 1, 2018, Kela was forced to cease operations. We projected lost net profits for Kela from June 1, 2018 until November 30, 2029, the end of Kela’s license agreement with Mt. Vernon.
We calculated a growth rate by taking the average percentage change of Kela Tennis’s actual ordinary business income from 2015 to 2016 and from 2016 to 2017. This growth rate was applied to the projected gross sales for the years 2018 through 2029 using 2017’s projected revenue as a starting point. Then, the average actual historical expense margin from 2015 through 2017 was applied to calculate projected expenses to calculate net profit.
Kela’s projected ancillary lost profits were calculated using guideline transactions for fitness centers and vending machine operators that were similar in size, financial metrics, and location to Kela Tennis.
After estimating the lost net profits, we determined an appropriate discount rate, which was used to calculate the present value of Kela’s future lost net profits as of June 1, 2018, the date Mt. Vernon destroyed the tennis bubble. We used the build-up method to calculate our discount rate of 15.45 percent, which was comprised of a risk-free rate, size risk premium, equity risk premium, and client specific risk. We utilized professional judgement to arrive at our company specific risk based on the depth of management, geographic concentration, financial strength, key person risk, vendor concentration, and industry/regulatory risks.
The present value of Kela’s future lost net profits from June 1, 2018 through November 30, 2029, was $6.9 million.
Additional elements of damages:
From April 2015 through May 2018, Kela incurred additional and unanticipated capital expenses totaling $366,724 to make the tennis facilities operational and which were necessary to install the tennis bubble. The capital improvements incurred and other related costs were the responsibility of the City as outlined within the agreement. As a result, the City further agreed to an addendum, which was created for the purpose of restricting the license fees and discounting such fees by 50 percent due to the incomplete tennis facilities. We calculated 50 percent license fee reduction as a $90,445 reduction of damages.
Kela Tennis leased the tennis bubble along with certain items inside the bubble from a third-party vendor. Through an Agreement for Confession of Judgment, Kela had agreed to have owed the third-party vendor $526,067 relating to damages on the remaining leased property and equipment.
As part of his duty to mitigate, Mr. Simunyola began working as a tennis director at a different facility. His actual and projected earnings from his new job offsets damages from the time he started the new employment. These wages were reduced by his projected compensation in our lost profits model because this expense reduction would ultimately be paid to Mr. Simunyola. We projected that his 2023 through 2029 income would grow at annual-average inflation over the next 10 years, measured by the CPI as reported by the Livingston Survey. The difference was then discounted using the mid-year convention to represent that salaries were paid throughout the year rather than in one lump sum at the 10-year treasury yield curve rate.
In total, we estimated that the total economic damages to be rewarded to Kela was $9,455,610.
Conclusion
On April 14, 2023, the jury decided that the City of Mt. Vernon must pay Kela $9,391,567 for its actions. The final verdict on economic damages was approximately 99.4 percent of what we had calculated.
We are proud to have taken a significant part of Kela’s pursuit for justice against the City. However, we understand that the story is not over. Kela now must do what it can to collect the monetary damages. At least, for our part as damage experts, we did what we were asked to do. The jury and the judge paid very close attention to the economic data. James Borkowski and Andrew Tureaud, the attorneys from Keane and Beane for Kela, did an excellent job laying out the case and making very thorough and convincing arguments on behalf of Kela resulting in, first, the unanimous verdict of liability on the part of the City of Mt. Vernon then the damage award in the bifurcated trial.
Eric Kreuter, PhD, CPA, CGMA, CFE, CBA, MAFF, is a Managing Director at CBIZ Marks Paneth and was an Adjunct Professor in the Graduate Finance Program at Manhattanville College in Purchase, NY where he taught Forensic Accounting. He previously served as an Associate Professor at Mercy College in Dobbs Ferry, NY, where he taught graduate classes in Human Resource Management. He also served as a volunteer at the Bedford Hills Correctional Facility and the Taconic Correctional Facility in Bedford Hills, NY. He is a Counselor at St, Christopher’s Inn located in Garrison, NY.
Dr. Kreuter can be contacted at (212) 201-3117 or by e-mail to ekreuter@markspaneth.com.
Andre Castillo, CPA, ABV, CFE, MBA, is a Supervisor in the Financial Advisory Services group at CBIZ Marks Paneth. He provides services related to forensic accounting, litigation consulting, economic damages, internal control reviews, and fraud investigations for his clients. Prior to joining CBIZ Marks Paneth, Andre started his career at KPMG LLP providing audit services to public companies in the sports and entertainment industry and the consumer products industry. He holds a BA in Economics from Boston College and an MBA/MS in Accounting from Northeastern University.
Mr. Castillo can be contacted at (914) 909-4932 or by e-mail to acastillo@markspaneth.com.
Alexander Dokuchaev, CPA, ABV, CFE, MSA, is Supervisor at CBIZ Marks Paneth. He can be contacted at alexander.dokuchaev@cbiz.com.
