Quantifying Business Loss Involving Expropriation of Newly Established Businesses
25 July, 2013
Canada
With increasing activity in public works projects in the Greater Toronto Area (e.g. the Toronto-York Spadina Subway extension) and other highway expansions across Ontario, we can expect a large number of businesses to be affected by expropriation. This article will highlight some of the challenges associated with quantifying business loss, especially when a newly established business’ premises are affected.
Typically, forensic accountants and business valuators (collectively referred to as “accountants”) are retained in expropriation matters when a business’ activities or profitability are adversely affected and business loss attributable to the expropriation and related disruption must be quantified.
Unique Challenges of Newly Established Businesses
The main objective of economic damage quantification is to project the profits that the claimant’s business would have earned “but for” the expropriation and/or the related disruption and then compare them to the actual profits that were earned. The difference between the projected and actual profits represents the business loss. Some of the challenges and potential solutions in determining the “but for” profits with newly established businesses are described below:
Lack of Historical Information
In the quantification of business loss for a mature business, the “but for” profits can be assessed, in part, by historical financial records – adjusted for any trends and changes in the business. However, what is to be done when the claimant’s business has only recently commenced operations or had not yet commenced operations? Limited historical records would be available to assist in developing the “but for” profits. This necessitates a different approach and poses a unique challenge for the accountant.
Reliance on management’s forecasts (or business plans developed to obtain financing) may be one source of information. The accountant must ensure that these forecasts are suitable for the purpose of business loss quantification (e.g. when were they prepared, how reliable are they, etc.). Extreme care must be exercised to understand the underlying assumptions and natural biases in the forecasts before concluding whether the forecasts are reasonable. Additional “sanity checks” based on industry trends, common sense, current economic conditions, claimant’s business acumen, financial and capital resources, etc. should be evaluated against the forecasts to assess reasonability and reliability. Should the forecasts appear unreliable, alternative methods must be considered such as comparable companies and industry benchmark analysis which adds a further layer of difficulty in establishing reasonable “but for” profits.
Chicken Before the Egg? Difficulty in Establishing Causation
The danger in quantification of business loss is adopting a mechanical approach to the claim which may result in including losses for factors which are unrelated to the expropriation, none of which should be recoverable. The accountant must exercise great care to ensure that only the business loss attributable to the expropriation and related disruption is quantified. It can be difficult to establish a direct causal link to the expropriation or the construction activities, especially when the business has limited historical information or proven track record. Furthermore, it may be difficult to isolate the negative impact from business disruption resulting from expropriation versus other factors such as entry of new competitors, economic conditions, lack of customer demand, key employee departure, etc. The accountant must perform adequate analysis in understanding the impact of other factors, both internal and external, and assess their impact on the claimant’s profits during the affected period.
For example, a claimant’s business may report significantly lower profits during the affected period and attribute the poor results solely to the disruption caused by the public project works. However, the accountant, through interviewing the claimant and due diligence performed, may find that a major customer was lost due to a defective product, unrelated to the expropriation. Adjustments must be made to take these types of situations into account and isolate the effect of unrelated factors from the quantification of business loss.
Speculation Spectacles
Although in the past, the courts generally avoid awarding loss of profits to newly established businesses because they felt that prospective profits were too uncertain, contingent or speculative. In Canada, courts appear to accept quantification methods that do not involve speculation. Therefore, in order to quantify economic damages, there must be some form of credible evidence to support the loss of profits. The claimant’s experience either before or after may help demonstrate that the projected “but for” profits could have been earned and would thereby remove some of the speculation.
Another possibility is the claimant may be able to satisfy the court that they have or had operated a similar business previously at some other location (e.g. franchisee). Such past experience, adjusted for relevant particularities of the subject business, may provide a credible basis for quantification of loss of profits.
You Cannot Fail if You Never Try
Unfortunately, not all attempts at new businesses are successful and the average success rates of new businesses can be considered in assessing the discount factor to present value any future losses, if applicable. Statistics Canada, in its publication “Failure Rates for New Canadian Firms: New Perspectives on Entry and Exit“, examines the failure rates of businesses and the reasons for such failures. In some circumstances, accountants may consider it appropriate to apply a failure rate to establish the “but for” profit, especially if the business is facing a lengthy loss affected period. The accountant needs to recognize the degree of uncertainty inherent in projecting the profits “but for” the expropriation and related disruption during the affected period and to recognize that such uncertainty increases as projections are made further into the future. Success rates are one way to consider this increased uncertainty.
Conclusion
We have highlighted some of the key issues for each party’s legal counsel and accountants to consider. Since all quantification is case specific, diligent and sound professional judgment is required.
Irrespective of the age of the business, it is important to note that newly established businesses can be impacted by the same factors that impact established businesses. While quantification of business loss for a newly established business does present unique challenges, understanding the business’ operating climate, exercising common sense and due diligence will allow the accountant to formulate reasonable assumptions to support his/her opinion of the business loss.
Published in the Ontario Expropriation Association’s 2013 Spring Newsletter.
The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.
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