Lost Profits for Existing and New Businesses: How They Occur, and How To Prove Them, with Guest Blogger Timothy Gillihan

This week, the ladies of Smith Shapourian Mignano LLP are proud to collaborate with Timothy Gillihan, Senior Manager, Forensic Accounting Consultant at Hagen Streiff Newton & Oshiro (“HSNO”).  

In the past, we have worked with Tim and HSNO in advising our business clients regarding lost profits claims.  HSNO provides forensic accounting, litigation support and insurance, claims accounting, and investigation services.  Tim is a seasoned Certified Public Accountant (“CPA”) with a specialized background in forensic accounting, and extensive experience in diverse industries including construction/real estate, financial services, energy, health-care, manufacturing, and agriculture.

For the purpose of this blog, we collaborate with Tim to discuss lost profits from both a legal and financial analysis perspective.

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Lost Profits: How Might They Occur, and How Do You Prove Them?
By: Smith Shapourian Mignano LLP

A business may lose profits due to another party’s commercial tort or breach of contract.  

For example, a business’ website launch, which was expected to generate substantial revenue for the company, was substantially delayed when a third party negligently flooded the business’ main retail store.  The business owners had to focus on repairing the retail store, with little time to devote to launching the website, resulting in lost profits.  See e.g., Kids' Universe v. In2Labs (2002) 95 Cal.App.4th 870, 876.  

Another example is where a business owner agreed to purchase a business and storefront location from another business owner, only to learn later on that the former owner hid the fact that the storefront was severely contaminated.  Because the purchaser of the business could not operate the storefront during remediation, he was entitled to lost profits.  See e.g., Shah v. Steam & Starch Corp. (May 23, 2012, B221487) [nonpub. Opn.].  

Simply put, a business with a lost profits claim must prove it was reasonably certain it would have earned profits but for the conduct or incident at issue.  To decide the amount of damages for lost profits, the business must prove the gross amount it would have received and then subtract from that amount the expenses that the business would have earned had the incident or conduct not occurred.  The amount of the lost profits need not be calculated with mathematical precision, but there must be a reasonable basis for computing the loss.  See California Civil Jury Instruction No. 3903N, “Lost Profits (Economic Damage).”

Where the operation of an established business is prevented or interrupted, such as by a business tort or breach of contract or warranty, damages for the loss of prospective profits are generally recoverable for the reason that their occurrence and extent may be ascertained with reasonable certainty from the records indicating the past volume of business and other provable data relevant to the probable future sales.

However, for emerging small businesses and startups in particular, proving lost profits is a bit more complicated.  Generally speaking, where the operation of an unestablished business is prevented or interrupted, damages for prospective profits that might otherwise have been made from its operation are not recoverable for the reason that their occurrence is uncertain, contingent and speculative.  They are generally objectionable as conjectural and speculative.  However, a new business' anticipated profits, which were dependent upon future events, may be recovered where their nature and occurrence can be shown by evidence of reasonable reliability.  So, loss of prospective profits are recoverable where the evidence makes reasonably certain of their occurrence and extent.  

Because the ways in which the courts interpret and decide cases based on the evidentiary standard of ​reasonable reliability is complex, emerging small businesses and startups may seek the advice of a business lawyer and forensic accountant/economist to determine, among other things, the nature and extent of any (anticipated) lost profits, and whether the lost profits actually resulted from the incident, or from another cause entirely, as discussed further by Tim below.

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The Role of a Forensic Accountant/Economist in Determining Lost Profits
By: Timothy Gillihan, Senior Manager, Forensic Accounting Consultant at HSNO

Most civil lawsuits ultimately come down to a fight over money – someone paid too much, or didn’t receive enough.  This means that most lawsuits could use the assistance of a forensic accountant or economist, an expert in determining the financial amounts at stake.  

In general, a forensic accountant/economist will calculate, and in the case of lawsuits, provide expert witness testimony pertaining to, what would have happened financially had the event in question not occurred.  They’ll also be able to accurately depict what happened financially, and separate the effects of the breach from other factors which might have contributed to the lost profits.

For example, in a recent case an upscale retail owner claimed that his sales were severely impacted by a major fire in the Bay Area.  The business owner’s lawsuit claimed damages for the drop in net income from the year before the fire.  However, in the months leading up to the fire, the retail shop’s sales had dramatically decreased due to a recent move to a new location.  By assessing the actual financial effect of the fire, and separate out the effects of the fire from the effects of the recent move, the parties were able to agree on the true impact of the fire on the business and resolve the lawsuit.

A forensic accountant/economist lends clarity and credibility to a plaintiff’s or defendant’s position in bringing or defending a claim of lost profits.  When you bring a lawsuit for your business’ lost profits, they’re important not only for supporting your case, but also for providing insight into the strengths and weaknesses of the financial claims being made by both sides.

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Smith Shapourian & Mignano, LLP is available to answer any questions or concerns you may have regarding bringing or defending against claims of lost profits.  Feel free contact us to learn more.

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.