ACC Case Study - David vs. Michael

David vs. Michael

Background

David is a company that runs a successful website hosting business. It is one of the largest and most

successful website hosting businesses in the country. David’s key differentiator is that it has a very well

laid out website that allows its customers to upload their websites, edit them and see traffic statistics.

David’s own website is the so?called “front end” software that users see and is widely viewed as being

one of the best in the business. The “back end” is the actual servers that host the customer websites.

David was started in 1999 and each year since it started has added about 30% more traffic to its web

servers. David’s revenues have not grown as quickly because the price it can get for hosting websites

each year has declined. So its revenues have grown at a more moderate 5?10% rate with its profits

showing year to year variation just depending on various investments and costs. I have shown David’s

traffic, revenues and profits in the following table and graphs.

2005 2006 2007 2008 2009 2010 2011 2012 2013

Traffic (mm pg.) 1,024 1,377 1,859 2,441 3,174 4,244 5,689 7,503 9,921

Revenues ($000) 10,242 11,999 14,405 17,158 20,643 24,227 28,682 34,670 41,140

Profits ($000) 1,599 5,780 10,603 9,763 18,495 514 16,907 8,072 12,940

David started out purchasing web servers – specialized computers that are customized to serve web

pages – but in 2007 decided to develop its own web servers. The servers it had been purchasing were

based on standard Dell computers but included some specialized web?serving hardware components

that had to be installed in slots in the Dells. Thus, these servers were relatively expensive – around

$6500 each and at the time David had over 100 servers. A single server was capable of serving around

10 million web pages each year. What it hoped to gain from developing its own servers was reduced

costs. It wanted to eliminate the specialized hardware components and increase the capacity of the

backend servers. The plan was to replace the hardware with new software it would develop based

primarily on some other software that it would license. In 2008, David contracted with Michael to provide it with the software it would require to develop its

web servers. At the time, Michael was well known in the industry as providing the best core web server

software. Its software was used by around 30 large companies to manage their websites. David’s plan

was to incorporate Michael’s software onto the Dell servers along with a bit more software that it would

develop to make the whole package work smoothly and easily for customers.

The contract between David and Michael called for annual payments of $300,000 per year. For this

money, David would get rights to use Michael’s software in an unlimited number of servers and get

support from Michael for any bug fixes. In addition, David would get any software updates or upgrades

that Michael might release over the term of the contract. The contract specified that the term was for

seven years (out through 2015) but that, even after the end of the contract, David would have the rights

to continue to use the software in its products but it would no longer be entitled to any support,

upgrades or updates.

In late 2009 David completed development of its new web servers and replaced all 120 servers it had at

the time with 90 new servers for a total cost of $1.8 million. The old servers were simply taken off line

and stacked in a closet somewhere. No one at David was able to testify what had happened to the old

servers.

By late 2009, David was very confident that it has the best web servers in the world and made

statements to that effect. The servers were fast and efficient. So David decided to add a line of

business by selling its web servers to other companies. It hired a couple of sales people and started

trying making sales calls. By 2010 David had sold 25 servers to other companies and was continuing to

pursue some other leads. By 2011, it became apparent that other companies were not very interested

in purchasing web servers from David. While David made a few more sales, the other companies were

telling David’s sales people that 1) they weren’t comfortable buying from a competitor; 2) the price

David was asking was too high; and 3) they were more likely to purchase webhosting services from

Amazon than install their own equipment. Thus, by the end of 2011, David fired its sales force and

continued to focus on web hosting as its business.

In 2010, Michael received a buyout offer from MegaCorp for $30 million. MegaCorp was interested in

Michael’s technology for use in a product that wasn’t web servers but used much of the same

technology. Some time after the acquisition was concluded, MegaCorp did two things: 1) it sent notices

terminating the agreements of all the existing customers; and 2) it open?sourced almost all of Michael’s

code.

With the lack of any ongoing support for Michael’s code, many of Michael’s old customers decided to

replace their Michael’s software. The single biggest beneficiary of this was Michael’s biggest competitor

– Eugene, Inc. Eugene was based in Germany and had been selling software that functioned very

similarly to Michael’s. Eugene got a flood of calls from former Michael’s customers to get quotes on

how much it would cost to switch to Eugene’s code. The price ranged a bit, but the biggest users were

receiving quotes of $650,000 up front and then $80,000 per year for maintenance and upgrades. There

would be some transition costs – the companies would have to spend between $100,000 and $150,000

to revise their own software in addition to paying Eugene. Some of the companies decided to go a

different direction and implemented the open?source version of Michael’s code. This turned out to cost

around $500,000 to implement. The advantage to this was that the companies got full source code andcould customize it to fit their needs. The disadvantage was that there was no support for any bug fixes

or future upgrades.

David received the letter terminating its license with MegaCorp/David in July of 2011. In August of

2011, David sued MegaCorp claiming breach of contract. Because of the suit, MegaCorp decided to

continue to support to David – responding to its requests for bug fixes and giving it some newly?

developed software. The CEO of David continued to make public statements to the effect that his web

servers were better than anything else out there – including Amazon’s – and David continued to run all

of its growing business on the web servers that included the Michael’s software.

The Complaint

In its complaint, David alleged that it had been harmed in three ways:

? Insufficient support. It claimed that the quality of support it received after the MegaCorp

acquisition of Michael was not as good as the support had been previously. Furthermore, there

were bugs in Michael’s software that David had repeatedly asked Michael to fix that had never

been fixed. The specific bugs went by the names ACG, WNP and Speed. The ACG bug was in a

feature that was rarely used and, if turned off, allowed the software to run just fine. The WNP

problem was very rare and unpredictable. Michael’s engineers could never replicate it on their

own hardware, it only seemed to occur on David’s servers. In addition, David claimed that it had

always expected to get 50% more speed from its servers than it ever did.

? Inability to sell servers. David claimed that, due to the purchase of Michael it was unable to sell

any more webservers because it could not guarantee support for any servers it did sell.

? Replacement cost. It claimed that, due to the lack of support from MegaCorp/Michael it was

going to have to replace all of its servers. At the present time, MegaCorp had 500 servers and it

viewed the only viable server replacement as buying new servers for $7,500 each from BigBox,

Inc. that included the old?style specialized hardware components.

Dr. Vino’s Opinion

Dr. Vino offered four calculations. In his deposition, Dr. Vino stated that he performed these

calculations because they were calculations that the CEO of David had asked him to perform.

1) The total value of the hardware that had been replaced by David when it installed its new

servers incorporating the Michael software was $905 thousand broken out as:

a. $450 thousand in computers

b. $225 thousand in specialized web server hardware

c. $230 thousand in maintenance and support for the servers between 2004 and 2009.

2) The total cost to replace the existing 500 servers with BigBox servers amounted to $12.1 million

broken out as:

a. $6.5 million in computers

b. $1.0 million in specialized web server hardware

c. $4.6 million in support over the next five years

3) Loss in business value for David of $15 million. Dr. Vino calculated this $15 million on the basis

that, in 2009, CityCorp had purchased a company for $20 million named Victor that competed

with David both for the provision of web?hosting services and sales of web?host servers. Dr.Vino deducted the tangible assets of Victor from the $20 million to arrive at an estimated value

of the goodwill and core technology of Victor of $15 million. He then opined that, since Victor

and David’s sales of web?host servers were similar, David’s goodwill and core technology must

also be worth $15 million and further, that this was the value that had been destroyed by the

breaches and termination of the contract.

4) Total cost to fix the alleged problems with Michael’s software of $165,000 broken out as:

a. ACG: $25,000

b. WNP: $32,000

c. Speed: $108,000

Things to Consider

? This is a breach of contract case. What are the form of damages available for breach of

contract?

? Assume that all of the allegations are true – how has David been damaged?

o Additional costs?

o Benefits it didn’t receive?

o Lost Sales? (Both of servers and web?hosting services).

? What options are available to David to replace its web servers without Michael’s software?

? The contract was a seven year contract signed in 2008. It is now 2014 and the contract

terminates in 2015.

? How does the fact that MegaCorp continued to support the Michael’s code affect damages?

? What is the causal link between each of Dr. Vino’s calculations and any harm suffered by

David’s.

? What effect does “partial performance” of the contract have on any calculations of damages?

Assignment

Write a 2 page report replying to Dr. Vino. Your opinion should address flaws (if any) with each of his

proposed calculations. While you don’t need to address each of the “Things to Consider” from above,

they will be helpful in your thinking. You should also propose a damages calculation – the number that

you believe is most appropriate assuming liability for breach of contract by MegaCorp / Michael’s.

Follow the discussion forum. Discussing this case with me and your fellow students will help a lot in

thinking about the response.