Page 13 - Calculating Lost Profits

Chapter 2

Legal Principles

Introduction

A practitioner performing forensic services as a damages expert should develop an understanding of the
legal principles governing the recovery of damages. At times it is helpful to discuss these legal matters
with counsel, such as when the applicable state or federal law affects the calculation. As a general mat-
ter, the plaintiff will likely need to prove that (a) the asserted wrongful acts proximately caused the al-
leged harm (causation) and (b) the damages were calculated to a reasonable degree of certainty (reason-
able certainty). When damages are the result of a breach of contract claim, the damages must also have
been foreseeable.

These concepts can be illustrated in the context of the American Kitchen example summarized in chap-
ter 1. For example, causation concerns may arise regarding the adequacy of Franchisee’s financial re-
sources to expand to an 11th location, or the opening of other competitive restaurants near the new loca-
tion. Reasonable certainty challenges may arise if there are no financial projections available or there is
a lack of benchmark data, or both. Further, foreseeability considerations may arise if, for example, Fran-
chisee seeks recovery of damages beyond the 10th year of the parties’ arrangement. These interrelated
topics are addressed further in the next section.

Lost Cash Flow Versus Lost Income

Practitioners engaged to measure lost profits damages may calculate either lost cash flow or lost incre-
mental income, depending on the facts and nature of the income and cash flow stream in question, and
the nature of the dispute. Although practitioners often assume the two measures to be the same, this is
not always the case, and which measure is appropriate is case-specific. Using the American Kitchen ex-
ample, Franchisee may have had to expend cash early on, but these costs may be capitalized. This situa-
tion may cause profits to equal cash flow in the long term, but time-period differences may affect dis-
counting or prejudgment interest calculations. In addition, a plaintiff may need to make ongoing work-
ing capital investments, such that cash outflows exceed costs on an income statement. As a result, practi-
tioners should be aware of these differences when developing a lost profits model.

Types of Damages

The following table summarizes two types of compensatory damages that the plaintiff may have experi-
enced in the context of a breach of contract:

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