Executive Summary: Imagine the extraordinarily unusual challenge of valuing a going-concern start-up enterprise yet to make their first sale which was completely destroyed by a casualty loss and never-reopened. Further complicated by the inherent ambiguity, risk and complexity of the embryonic development stage industry in which they were attempting to operate and succeed.
Summary Conclusion/Foundational Premise: From the extensive professional practice guide, expert literature and caselaw research we completed, in our professional opinion the basis for loss quantification is the fair market value of the enterprise immediately preceding the date of the loss and not a lost-profits computation due to a business interruption.
Situation/Background: The primary facts and issues at play were as follows:
In contrast to prevailing professional practice, case law and the professional literature recommendations, opposing experts opted for a lost profits approach, estimating damages using the following approach grounded in these foundational assumptions:
A. Facility would be at full-production capability and operating at close to 100% of capacity within two weeks of the casualty.
B. Purportedly, "general operating metrics" for the industry were obtained by opposing experts and analyzed from the date of the casualty (mid 2011) through 12/31/2014.
C. Relying on an alleged "contract' (verbal) between the firm and the adjacent business where the casualty loss was triggered, they assumed that immediately upon commencement of operations at the date of the casualty, that 100% of the by-product would be purchased by this other business throughout the stated time-period.
D. No start-up losses, inefficiencies, one-time impacts, or learning curve impacts were factored into the lost damage estimate.
E. The opposing experts in fact assumed the firm would be immediately profitable, operating at full capacity with no start-up impacts whatsoever on day one and but two weeks from the date of loss. Even though:
- They had only produced but two batches of test product (100 gallons) and only 50% of the equipment was operational. Their annual capacity was 2 million gallons.
- The firm lacked a specific marketing plan, no marketing organization, or outside sales and marketing resources. They had no shipping or distribution arrangements in place, no working capital facility available.
- They had no raw material vendor relationships in place. No agreements, contracts or purchase orders in place prior to the casualty.
- They opted to include revenue streams from a variety of potential sources such as government incentives, rebates, tax credits, subsidies, etc. None of these potential streams were supported with documented and firm agreements from the providers.
One essential question to be answered is the applicability of the known and/or knowable limitation commonly encountered in valuation- Moreover, given the challenges of applying reasonable certainty to a wish, a hope and an aspiration, must we rigidly adhere to the concept of "known or knowable" at the date of the casualty:
As such, additional critical facts, industry trends and post-casualty events were critical to analyze, but largely discounted or ignored by the plaintiff's experts:
The standard of "reasonable certainty" is the prevailing industry standard in cases dealing with assertions of lost profits, in particular with start-up firms with no operating history in a development stage industry. Business valuation is almost always used in cases where there is "complete business destruction".When there has been permanent impairment/diminution in the value of the business, in cases where the business will never recover from the act of harm, the expert should strongly exercise caution and refrain from the use of a lost profits approach. Damages may not be awarded on the basis of wild conjecture; they must be proved to a reasonable certainty that is applicable to proof of damages generally.Whether or not a business was able to open and begin operations is a critical factor, along with whether the business was around long enough to be able to reasonably project profits. If the business never made profits while operating, this may preclude the ability to reasonably project future profits.
Tony Wayne, CPA, CFF, CVA, CIRA, is a Certified Public Accountant with over 25 years of private industry senior operations experience. After a diverse career spanning 15 years in Big 8 public accounting/consulting and private industry, Mr. Wayne founded IronHorse in 1998 with an emphasis on complex turnarounds and restructuring consulting, crisis management, advisory services, CFO services, and litigation support. IronHorse is an ideal solutions resource for the closely held, family owned middle, or small-market industrial firms in transition serving a six-state region including Nebraska, Iowa, Kansas, Missouri, Oklahoma and Arkansas.
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