Business interruptions are becoming more common, and it is expected that claims associated with lost profits will likely increase. In these situations, it is important to know the legal requirements and to vet your experts accordingly. For example, California law does not require lost profits arising from business interruption to be calculated with mathematical precision. However, it does require a reasonable basis for calculation. In business cases, damages must be based on net profits as opposed to the gross revenue of the business.
To calculate the lost profit, the expert will generally take one of three approaches: the before-and-after approach, the comparable approach or the sales-projection approach. All of these require the expert to make some judgments concerning the relevant projected cash flows and costs. In order to do so, the expert must first ascertain the relevant information from the financial statements, contracts, or business plans to support the basis of lost profits. Projections have to be examined from a multifaceted perspective. A well-trained eye should lookout for seasonality, cyclicality and underlying macroeconomic conditions adjusting projections accordingly.
The expert should also be familiar with how to appropriately breakdown the cost structure of a business and distinguish between fixed and variable costs when analyzing financial statements, as these are the factors that allow the economist to determine “the gross amount the business would have received but for the interruption and then subtract from that amount the expenses.”
After the reasonable basis for the losses has been established, the present value of the loss of profit due to the interruption must be calculated. In general, for a lost-profits case, the expert economist should know to not use the weighted average cost of capital, as would be used in a loss of business value case. Lost profits are typically discounted less heavily by using the plaintiff ’s marginal cost of capital, thereby taking into account the rate associated with the plaintiff ’s ability to borrow as opposed to the company’s opportunity cost should extra capital be required.
California law specifies: Damages must be pled with particularity but they must also be proved to be certain both as to their occurrence and their extent, albeit not with mathematical precision. Evidence makes reasonably certain their occurrence and extent. Historical data, such as past business volume, supply an acceptable basis for ascertaining lost future profits. In some instances, lost profits may be recovered where the plaintiff introduces evidence of the profits lost by similar businesses operating under similar conditions. Regarding lost business profits, the cases have generally distinguished between established and unestablished businesses. “Where established business is prevented or interrupted, as by a . . . breach of contract . . . ,” reads Grupe v. Glick, “damages for the loss of prospective profits that otherwise might have been made from its operation are generally recoverable for the reason that their occurrence and extent may be ascertained with reasonable certainty from the past volume of business and other provable data relevant to the probable future sales.”
Complexities arise due to the nature of the business and sales process. A retail store, an online store or both have terminals or point-of sale-systems providing different types of information in terms of transactions would exist and there may be duplicate entries and so on. A well-prepared expert will examine all available information, confirm and project sales and expense records, and figure out what the sales, expenses and, hence, profits would have been had the interruption not happened, considering seasonality, as well as cyclicality and time trends.
As one can see, the issues associated with lost profits from business interruptions can be complex and vary widely. From the cause of the interruption to the very details that establish a reasonable basis and determine the award. Contact an economist should you need help with calculating your losses.
