Feature Article

Delay versus Lost Profits Damages
By: Howard Zandman, CPA/CFF, CFFA

I was recently involved in an exceptionally interesting economic damages case in which the primary issue was whether the appropriate measure of damages was delay damages or lost profit damages.Since the case reached a confidential settlement, I have changed all of the names and circumstances so there is no link to the actual parties and/or case.

Plaintiff was a corporation that built and operated public miniature golf courses.It had developed and continued to operate a number of courses at the time of the instant action.Plaintiff was planning to build and operate a new facility in a different geographic region than its existing facilities.Another twist with respect to the new course was that it was to be developed in an indoor facility.The Defendant in the matter was the project management team that Plaintiff had retained to obtain site permits, clear the property and ultimately develop the property.Plaintiffs claim against the Defendant alleged that the Defendants actions/inactions were the direct and/or proximate cause of construction delays which slid the opening of the indoor course by twelve months.Plaintiffs prayer for relief included a claim for lost profits.

Plaintiffs expert, who had served as Plaintiffs corporate accountant for many years, concluded that Plaintiff had sustained $3 million in economic damages as a result of the one year delay in the project.In arriving at his damages figure, Plaintiffs expert compared the gross profit from one of Plaintiffs other courses with the first five months gross profit (the only actual information then available) of the new course.The comparable course was selected because it was the newest in the Plaintiffs portfolio, although it had been operating approximately three years.Based on the gross profits relationship, Plaintiffs expert then projected lost gross profits for the twelve month period.In addition, the expert calculated interest on the carrying value of the underlying construction loan for the additional twelve month period in question.

At deposition, Plaintiffs president, as well as its accountant/expert testified that when a course first opens, there is typically a honeymoon period of approximately 6-12 months in which revenues increase dramatically from month-to-month.After the honeymoon, course revenues flatten out and reach a steady revenue flow (with seasonal variations) from year-to-year.Both deponents also testified that, with respect to the new indoor course, there were no external factors or conditions that changed or would have changed the economic projections of the new course over its first year of operations.That is, the accountant/expert clearly stated that the revenues for the new indoor course actually sustained would have been no different had the course opened a year earlier.

As Defendants expert, I had to tackle the following questions: What were the lost profits if any?How would that measure be established?What comparables were available to try a yardstick approach to reasonableness?

There were several readily apparent flaws in Plaintiffs experts analysis: in initially comparing gross profits rather than gross revenues; comparing an established facility to a start-up course; and ignoring any saved or avoided operating expenses over the alleged delay period.Ultimately, I questioned if this was a lost profits case at allor an instance of a business (in this case, an indoor miniature golf course) eventually achieving all of the revenues it would have otherwise earned, just doing so one year later?

To explore the notion that this was a delay claim and not a lost profits case, I turned to the financial and other operating information available from the new indoor course.First, as this was Plaintiffs first indoor course, there was no empirical data available for this type of facility from these owners.I then considered if miniature golf courses in general have a finite life.Again, Plaintiff had no historical data on this point as its other courses were less than five years old.From my research, I did learn that miniature golf courses require extensive maintenance as they age and the wear and tear of continual use mounts.In addition, to remain attractive and competitive in the marketplace, miniature golf courses require recurring modernization and theme updates.If a course owner does not fund the necessary maintenance and modernization programs, it becomes more economically feasible to sell the property for a better-and-higher use, harvest the capital gains, and look to new opportunities.

Based on my industry research, I concluded that miniature golf courses have a predetermined life.This is different from the typical lost profits case.That is, a lost profits analysis assumes that the underlying business will continue for the foreseeable future, so an interruption in normal operations results in lost profits.In addition, lost profits do not result from a delay in the start-up of an enterprise, but an interruption of existing operations that can be measured.In most jurisdictions, proving lost profits for a start-up business ranges from very difficult to virtually impossible since the economic damages analysis is deemed to be too speculative to meet the requisite reasonable certainty standard.

To compute the economic damages sustained by Plaintiff as a result of the delay in opening the indoor course, I first referenced Recovery of Damages for Lost Profits [1] to ascertain that the damages from a delay is the difference between the net revenue with and without the delay measured by the difference between the net present value of the income stream with and without the delay and not the value of the lost production during the period of delay (emphasis added). Given the deposition testimony noted above, the revenue for year one would have been no different had the course opened twelve months earlier.Hence, by Plaintiffs own testimony and admission, there was no difference in the net revenues that would have been realized with a timely opening.

The measure of Plaintiffs economic damages, therefore, was the time value of money from the alleged delay in completing construction of the course, offset by the additional cash flows generated by the course in the succeeding years.That is, assuming the new course had not been delayed and opened in June 2004, the cash flows generated by the course in each month after July 2005 (twelve months after the opening), on average, would be less.The time value of money on the delayed cash flows would be favorably offset by the time value of money on the additional cash flow, and the cash flow in the out-years, until the end of the life of the course.The time value of money on the net excess cash flows would equal the interest on the excess cash flows for that month, discounted back to the date the course opened.

Ultimately, Plaintiffs method of determining its economic damages failed.As time went on and additional operating data became available, the gross profit relationship between the new and existing course changed dramatically.This development clearly indicated that the methodology was flawed.While Plaintiffs economic damages claim had diminished from $3.1 million to under $2.0 million by the time of trial, my damages calculation was just over $88,000.I understand the case settled for a sum favorable to my client.

It is critical that an economic damages analyst explore the various theories of recovery that may be available to his/her client at the outset of every engagement.In this instance, I think Plaintiffs expert jumped to the lost profits conclusion before thoroughly understanding and considering the facts at hand.As you can see from the outcome, the difference between lost profits and delay damages can be significant.

Howard A. Zandman, CPA, CFFA is a Parter with Habif, Arogeti & Wynne, LLP. Mr. Zandmans practice focuses on economic damages, forensic accounting and business valuation services.He has qualified and testified as an expert witness in a variety of courts across the country and is a frequent public speaker.Mr. Zandman can be reached at 404-814-4915 or by email at howard.zandman@hawcpa.com.

This article is adapted from Delay versus Lost Profits Damages published in the June 2007 issue of National Litigation Consultants Review.

[1] Dunn, Robert L.; Recovery of Damages for Lost Profits; 6th edition; Lawpress; 2006; pg 188.

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