Estimating lost profits for new businesses

Historic financial statements provide a logical starting point for estimating lost profits. But how does an appraiser estimate lost profits for startups or early-stage businesses without historic data? A recent case, Parlour Enterprises Inc. v. Kirin Group Inc., outlines factors to consider when calculating damages for un-established businesses.

Background - Starting in 1963, Bob Farrell owned and operated 55 Farrell’s restaurants, which he sold to Marriott Corporation in 1972. Marriott opened an additional 85 Farrell’s Ice Cream Parlours. By the mid-1980s all had been shut down, except for one restaurant in San Diego.

A former Farrell’s employee, Herman Chan, formed The Kirin Group and purchased Farrell’s trademarks and trade names in 1996. Kirin opened a Farrell’s in Temecula, Calif., which closed in 2002.

Kirin also entered into a series of sub-franchise agreements with Parlour Enterprises to develop eight Farrell’s restaurants. Under the agreements, Parlour would receive an upfront fee and royalties based on a percentage of net sales.

Parlour opened one Farrell’s within the time frame specified in the agreements in Santa Clarita, Calif. Although Parlour had specific plans to open three other California restaurants, it was unable to find investors. No locations had been selected for the four remaining new restaurants specified in the agreement.

Kirin terminated the subfranchise agreement in 2003 because Parlour had failed to pay attorneys’ fees. Parlour subsequently filed suit against Kirin for breach of contract, intentional fraud, negligent misrepresentation and defamation.

Parlour’s expert estimated approximately $6.5 million in lost franchise fees, royalties and profits. These estimates were based in part on five-year financial projections Parlour had created to attract potential investors. The expert also considered financial data from the existing Farrell’s operations in San Diego and Santa Clarita, as well as market data from various unrelated ice cream parlors and Friendly’s, a publicly traded restaurant chain.

Finally, the expert used actual account records to estimate $202,929 in extra expenses Parlour and its limited partnerships incurred to develop the three proposed locations.

Findings - A judgment from the Superior Court of Orange County awarded Parlour approximately $6.6 million in damages. On appeal, the Court of Appeals of the State of California, Fourth Appellate District, Division 3, rejected the expert’s lost franchise fees and profits estimates, finding that the evidence was unreliable.

In particular, the court criticized Parlour’s expert for relying on “groundless pro forma projections,” which contained various disclaimers. The expert also failed to prove similarity between Farrell’s and the comparables used in his market study. Accordingly, the Court of Appeals reduced the judgment to $202,929 (the expert’s estimate of extra expenses).

Lessons learned - Parlour sets forth factors that expert witnesses can use to help establish reasonable certainty of economic damages for new businesses, including:

•Economic and financial data for the subject company,

•Market surveys and analyses, particularly if the market is established,

•Business records of similar enterprises,

•Prelitigation financial projections, and

•The plaintiff’s (or a third party’s) prior experience in the same (or similar) business or industry.

Parlour also stresses the importance of expert testimony “supported by tangible evidence with a substantial and sufficient factual basis rather than by mere speculation and hypothetical situation.”

A higher bar - Obviously, proving damages in the case of a new business is difficult. But valuators who take the extra steps to meet a higher standard can reach reasonable conclusions — supported by sufficient empirical data and sound professional judgment.