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.