Lost Profits Damages to New Businesses: Adjusting for Survival

Abstract

Survival risk of new businesses is a challenging issue to incorporate into lost profits analyses used in litigation, an issue some financial experts and courts ignore rather than consider explicitly. This paper considers several ways to make qualitative and quantitative adjustments for the survival rates of new businesses. The paper concludes firm-specific modeling of survival rates is the most appropriate way to weight future economic returns because it offers the best alternative in terms of fitting the analysis to the facts of the case and doing so in a credible and clear manner.

The likelihood of survival by a new business is an overarching factor in consideration of lost profits yet this topic has been largely unexplored. New businesses, historically considered "unestablished" businesses, previously were unable to recover lost profits or even lost value of the entire business due to the "new business rule"; namely, courts considered profit claims for such businesses speculative due to lack of operating history. Over time, legal standards for new business lost profits have moved away from the dichotomous new business rule to a standard based more on reasonable proof of damages. Still, lacking much if any operational history, especially profitable operations, means estimating damages for new businesses is still problematic for legal and economic reasons; moreover, evidence of future viability of the new business becomes an important factor. This paper offers and evaluates four qualitative and quantitative ways to adjust lost profits damages for survival: (1) qualitative approaches using factor lists, including factors which may be associated with higher or lower cost of capital; (2) quantitative approaches which rely on survival averages of cohorts of new firms; (3) quantitative approaches which use survival averages of subgroups of firms in (2); and (4) quantitative survival adjustments using empirical studies of new firm survival and matched characteristics of the target business.

Background

A new business can experience damages for several reasons, including breach of contract, business interruption due to a fire, flood, earthquake or other natural disaster, intellectual property infringement, death or injury to a "key" person, or other cause of actions and the courts have increasingly allowed lost profits as a part of damages to such businesses. As several authors have noted, especially Dunn (2000) and Lloyd (2002) the current and developing standard used by courts puts the emphasis on evidence in consideration of reasonable certainty of lost profits by the new businesses. Included in this evidence are factors such as (1)-(3) plaintiff's experience before and after the damaging event and plaintiff's experience at other locations; (4) lost customers; (6) defendant's experience; and (7) industry and economic factors, including the experience of others in the same industry, market, and location. Survival evidence is also needed.

Qualitative Approaches

One way for the valuation consultant to "adjust" for new business survival is to list and analyze a number of factors which might reasonably bear on survival. This might include the seven factors listed above regarding the reasonable certainty of any profits. In addition, one might refer to components associated with specific risk factors in computing a risk adjusted cost of equity capital. This list includes the following components:

The list is suggestive and not all factors may apply to the target business. Also, there is some debate as to exactly how best to use this particular list. For instance, Hitchner and Vogt offer three suggestions in the context of cost of capital analysis: assign specific values to each component, score each as + or - or NA, or just provide a summary risk factor for the entire list. Lloyd offers a similar list when discussing firm survival and also suggests consideration of cash flow, the quality of company records, the economic milieu in which the business operates, third- party information on the target company, and non-economic factors such as possible willingness of self-employed owners to accept lower than expected income due to possible advantages of self employment.

Exactly how the damages expert makes qualitative adjustments for survival is case-specific. One possibility, that implied by Hitcher and Vogt (2005) involves an analysis leading to a greater (or lower) company-specific risk factor as a component in the cost of capital used to discount future lost profit damages; but that is not the only way to surface survival as a factor. The point is the qualitative approach to survival adjustments for a new firm is largely a judgment call by the expert and sometimes the line between legal and economic views may not be that clearly defined. For these reasons it is important to consider quantitative adjustments to survival, especially methods which include some of the qualitative factors associated with survival of a new business.

Quantitative Approaches

A number of articles address new firm survival and the impression one gets from these is most new businesses fail within a few years after start up, thus possibly reinforcing the traditional new business rule used by some courts that lost profits in such firms are indeed speculative. For instance,

• "An analysis of start-up ventures in a wide variety of industries found, for example, that more than 80% failed to achieve their market-share targets."
• In describing results of a national study conducted at the Bureau of Labor Statistics, the author observes "the data show, across sectors, 66 percent of new establishments were still in existence 2 years after their birth, and 44 percent were still in existence 4 years after."
• Six years after birth, two studies found nearly identical new firm survival rates after six years, 39.5% for Headd (2003) 9 and 39.8% for Phillips and Kirchhoff (1989)10 even though they considered different data sources and different time periods.

An implication of this research for litigation involving lost profits or business value of a start up is to weight lost profits by average survival rates found in the studies above; this is a second approach to survival-adjusting lost profits for new businesses. Yet, is it appropriate to multiply economic returns by the overall average likelihood of survival to derive expected economic returns? To address this question calls for a more detailed analysis of each source.

• As noted, the Lovallo/Kahneman citation is vague regarding critical details and unlikely to be useful in making a quantitative adjustment to profits or value.
• On first impression the Knaup study suggests weights of 66% for 2 years and 44% for 4 years; however, closer examination of exits by year is worth considering:

. . .Continue to read rest of article (PDF).