The opinion of the court was delivered by: John G. Koeltl, District Judge
This is an action alleging breach of an Agreement and Plan of Merger dated June 22, 2006 ("Merger Agreement") by which the defendant, LivePerson, Inc. ("LivePerson"), acquired Proficient Systems, Inc. ("Proficient"). Pursuant to the Merger Agreement, roughly 50% of the merger consideration was contingent and payable only if certain conditions were satisfied. The plaintiff, Gregg Freishtat, the former Chief Executive Officer of Proficient, acting as representative of the Proficient shareholders, claims that LivePerson failed to comply with the provisions of the Merger Agreement governing the computation of the compensation to be paid to the Proficient shareholders following the closing (the "Earn-Out Payment"), which was based on a multiple of recurring revenue in the month of March, 2007. The plaintiff claims that LivePerson failed to include properly revenue from seven Proficient customers. LivePerson claims that it properly calculated the revenue and that the plaintiff is raising these challenges in an effort to obtain payment for the Proficient shareholders to which those shareholders are not entitled. LivePerson contends that it in fact overpaid the Proficient shareholders and requests a refund for the amount of the Earn-Out Payment that it allegedly overpaid for one customer and for certain other errors that were allegedly made in favor of the Proficient shareholders.
Jurisdiction is based on diversity of citizenship.
The Court conducted a non-jury trial and now makes the following findings of fact and conclusions of law pursuant to Rule 52 of the Federal Rules of Civil Procedure.
1. Plaintiff Gregg Freishtat is a citizen of the State of Georgia. The plaintiff is the representative of the shareholders of the former corporation Proficient. (Stipulations of Fact ("SF") 1.)
2. Proficient was a provider of hosted proactive chat solutions that assisted companies to generate revenue on their websites. It was based in Atlanta, Georgia. (SF 4.)
3. Defendant LivePerson is a publicly-traded Delaware corporation (NASDAQ Symbol: LPSN) with its principal place of business in New York, New York. (SF 2.)
4. LivePerson is a provider of online conversation solutions that facilitate real-time assistance and expert advice. LivePerson's business solutions consist mainly of instant messaging and business analytics technologies that LivePerson customers use to provide online sales assistance and customer service to their own customers and consumers on the web. Its hosted software enables companies to identify and proactively engage online visitors to increase sales, satisfaction, and loyalty while reducing service costs. (SF 3.)
II. Long-Term Recurring Subscription Revenue as the Fundamental Business Model for Both Proficient and LivePerson
5. Both Proficient and LivePerson are or were service providers in the "software as a service" industry. (Tr. 161, 558-59, 664.) LivePerson provides its software from a hosted facility and charges for that software on a subscription basis. (Tr. 774.)
6. The business model of Proficient and LivePerson, as with other "software as a service" companies, is based on securing long-term, recurring monthly revenue on a subscription basis. (Tr. 160-61, 663-64.) Robert LoCascio, the Chief Executive Officer and Chairman of LivePerson, testified that "long-term contracts" are critical to LivePerson's revenue model because:
It's basically how we are valued. If you look at revenues today we do about 110 million in sales. We have a little over $400 million market cap. So our investors say, we are willing to give you 4 times the amount of revenue you make, because they assume that revenue will recur into the future. . . . It's the heart of our business model, all software as a service business model. We get what we call a very high premium for our revenues on a valuation because it's all recurring.
7. Timothy Bixby, the President and Chief Financial Officer of LivePerson, testified that LivePerson's "primary type of revenue is hosting the fees for recurring services. We also collect and earn professional services fees. And that's the vast majority of the revenue." (Tr. 727, 729.) James Dicso, a Senior Vice President of LivePerson, testified that, as a sales executive, he measured the success of the "software as a service" model by the "[l]ongevity of a customer relationship and increase in the recurring monthly revenue." The two components are therefore "[a]dding prospects into customers, and then growing relationships with existing customers." (Tr. 773-74.)
III. Merger Agreement Negotiations
8. Proficient and LivePerson engaged in merger negotiations in the spring of 2006. In the context of these negotiations, Proficient's representatives based the value of Proficient to LivePerson primarily on Proficient's long-term recurring revenues, understood as revenues that would continue without expectation of stopping. Mr. Freishtat testified that he would use the definition of "recurring revenue" as revenue that "would continue into the future at least without a fixed stopping point" in order "to describe the status of my business when I sold it." (Tr. 161-62.) Mr. Freishtat also acknowledged that he was selling Proficient to LivePerson on the basis of Proficient's "good and healthy customer base," and that Proficient would get credit for revenue that occurred "over and over again." (Tr. 268-69.) Stephen Hufford, the former Executive Vice President of Proficient, understood the "revenue base" in the context of the "software as a service industry" to mean "the revenue that you would see month after month." (Tr. 557-59.)
9. Proficient initially presented a very optimistic projection of its annual revenues, both internally and to LivePerson. Mr. Freishtat included a figure of $6,816,976 in projected revenue from Proficient in an attachment to an email he sent to Proficient's Board in June, 2006. (Pl. Ex. ("PX") 23 at PL0000773.) Mr. Freishtat testified that this figure was "a guidance number that says, yes, this is what we're hopeful will happen in March of 2007." (Tr. 177-78.) Mr. Freishtat testified that he would not have any reason to disagree that he had told Mr. LoCascio during merger negotiations that "there was $8 to $10 million of annualized revenue in Proficient." (Tr. 180.) Mr. LoCascio testified credibly that after an initial meeting with Mr. Freishtat to discuss the sale of Proficient to LivePerson, the two men started to "talk very loosely about revenue, because we want to know how much revenue do you have and then we know there's a value for that revenue." Mr. LoCascio testified that, in those discussions, "originally, Proficient was supposed to have eight to ten million in revenues, and we thought that was worth somewhere around 20 or 30 million dollars . . . ." (Tr. 670-71.)
10. LivePerson's initial non-binding purchase price of four million LivePerson shares was based on Proficient's initial optimistic projections. The term sheet that LivePerson provided to Proficient on May 15, 2006 included a purchase price of four million shares and the disclaimer that "[t]he following summary of terms is intended solely as a basis for further discussion and does not constitute a legally binding obligation except for the confidentiality provision set forth at the end of this term sheet, which is binding on and enforceable against the parties." (Def. Ex. ("DX") 21 at PL0000710.) Mr. LoCascio testified that the preliminary four million share figure was "[b]ased on this revenue number from our conversation [with Proficient] of around $10 million . . . ." (Tr. 674.)
11. LivePerson's doubts about the certainty of Proficient's existing and potential revenues led to its proposal of an earn-out provision, approximately two weeks after the introduction of the initial term sheet.
12. Mr. Freishtat and Mr. LoCascio travelled to London as part of the due diligence process sometime between the initial term sheet, which was sent to Mr. Freishtat on May 15, 2006, and the closing of the deal in July, 2006. (Tr. 79; DX-21.)
13. Mr. LoCascio testified that he attended a meeting in London at which Abe Smith, Proficient's European head of sales, presented Proficient's sales projections. Mr. LoCascio "felt that a lot of the things that [Mr. Smith] was reporting were not accurate, and I think he wanted to make it look like he had this great business going but it wasn't." In particular, "a lot of the deals that [Mr. Smith] thought were going to close or that were certain to have as full-time customers were not legit because [LivePerson] had closed them or [LivePerson was] in the middle of the deal, and we got a verbal agreement of closure." Mr. LoCascio also testified that "after that meeting, I sat with my head of sales and we evaluated it, and I realized that this was not going to be a $10 million deal, there's not $10 million of revenue that I can see in this company now that I've seen U.S. and now the final, which was the U.K. revenues." (Tr. 680-81.)
14. Mr. Freishtat testified that it was in London that "Mr. LoCascio informed me that he was not willing to move forward with the structure that we had and would require what he called at that point an earn-out." (Tr. 80.)
15. According to Mr. Freishtat, "the reason that [Mr. LoCascio] wanted an earn-out was that the nature of the agreements with these customers were not all locked-in agreements that had long-term value and this was true because there were many early-stage pilot agreements for Europe because this was still a nascent market . . . ." (Tr. 81.)
16. As a result of Mr. LoCascio's lack of confidence in the Proficient UK revenue projections, he proposed an earn-out because "in an earnout situation the company's protected . . . . So I wanted to protect the company, and I said, OK, if you think these revenues are going to close and you believe this guy, great, either way it's going to get structured as an earnout." (Tr. 680-82.)
IV. Executed Merger Agreement and Earn-Out Provision
17. On or about June 22, 2006, LivePerson, SOHO Acquisition Corp., Proficient and Mr. Freishtat, as agent and attorney-in-fact for each shareholder of the Company, entered into the Merger Agreement. (PX-30.)
18. The Merger Agreement provided that LivePerson would acquire all of the outstanding capital stock of Proficient in exchange for, among other things, 2,000,000 shares of LivePerson common stock to be paid at closing, as well as up to 2,050,000 shares of LivePerson common stock to be contingently paid based on the number of customers still engaged in long-term contracts as of the measurement date, and the expected long-term, recurring revenue streams produced by those customers (the "Earn-Out Payment"). (PX-30 at §§ 2.04(a), (b); SF 6.)
19. The amount of shares issued as Earn-Out Consideration was to be determined by taking the "Normalized March 2007 Revenue," which is defined as the "Normalized Monthly Revenue for March 2007," multiplying that number by 12 to calculate the "Net Annualized Revenue," multiplying that number by "0.93 shares," and subtracting the 2,000,000 shares that were already delivered to the Proficient shareholders at the Closing Date. (PX-30 at §§ 1.01, 2.04(b).)
20. Section 1.01 of the Merger Agreement states, in relevant part:
"Normalized Monthly Revenue" for any given month means (A) the monthly recurring revenue which [LivePerson] books as revenue in that month, according to [Generally Accepted Accounting Principles ("GAAP")], generated from [Proficient] Existing Customers, [Proficient] Business Development Customers and [Proficient] Pipeline Customers (which explicitly excludes (X) any one-time or non-recurring revenues such as testing or training fees and (Y) any revenue booked by [LivePerson] from [Proficient] Existing Customers, [Proficient] Business Development Customers or [Proficient] Pipeline Customers that have indicated to [LivePerson] in writing that they intend to cancel their contract and (Z) any revenue recognized by [LivePerson] in connection with the provision of professional services (unless such professional service fees are ongoing rather than one-time in nature)) plus (B) one-half of the monthly recurring revenue which [LivePerson] books as revenue in that month, according to GAAP, generated by [Proficient] Business Development Customers or [Proficient] Pipeline Customers that are on a 90-day paid trial contract, plus (C) the monthly recurring revenue which [LivePerson] books as revenue in that month, according to GAAP, generated from the customer, if any, of [LivePerson] that is listed on Annex II . . . that generates the least amount of revenue for [LivePerson] in that month . . . . (PX-30 at § 1.01.)
21. Section 2.04(b)(iii) of the Merger Agreement states that: "On or before the Earn-Out Payment Date, [LivePerson] shall deliver to the Shareholders' Representative a memorandum . . . specifying in reasonable detail (i) the calculation of Net Annualized Revenue, and (ii) the amount of the Earn-Out Payment, if any, due to the Shareholders." (PX-30 at § 2.04(b)(iii).)
22. On or about May 11, 2007, LivePerson furnished to the plaintiff a formal notice setting forth its calculation of Net Annualized Revenue and the amount of the Earn-Out Payment (the "Earn-Out Notice"). (SF 13; PX-203 at PL0000344.)
23. The Earn-Out Notice stated that the Net Annualized Revenue, as defined in the Merger Agreement, was $3,368,108, and the amount of the Earn-Out Payment due to Shareholders was 1,132,341 shares of LivePerson Common Stock. (SF 14.) This was about 870,000 shares less than the 2,000,000 shares that were potentially available under the Earn-Out Provision, not including the additional 50,000 shares which were only available if an additional revenue target was met.
24. On or about May 11, 2007, LivePerson delivered the number of shares of LivePerson Common Stock reflected in the Earn-Out Notice to the Shareholders' Representative. (SF 17.)
VI. Disputed Revenue Calculations
25. The plaintiff contends that LivePerson failed to include, in its computation of the Earn-Out Payment, revenue that LivePerson in fact recognized, or that LivePerson should have recognized under GAAP, in March, 2007 revenue. The dispute centers around seven former Proficient customers: (1) Allstate Insurance Co. ("Allstate"); (2) H&R Block Mortgage Corp. ("H&R Block"); (3) MD Nationwide; (4) Adobe Systems, Inc. ("Adobe"); (5) Mark Travel Corp. ("Mark Travel"); (6) Government Employees Insurance Co. ("GEICO"); and (7) The Governor and Company of the Bank of Scotland ("HBOS"). In addition, LivePerson contends that it erroneously provided an earn-out based on revenue from CorCell, Inc. that should not have been included and that LivePerson is therefore entitled to a refund. Some of the amounts involved are quite small but the parties, unable to resolve the disputes, have pressed them in this litigation and expended considerable effort in pursuing them.
26. The disputes can be grouped under four general categories. First, LivePerson contends that when it received notices of intent not to renew contracts prior to the end of March, 2007, the revenue from those contracts should not have been included in the computation of the Earn-Out Payment, while the plaintiff asserts that the revenue should be included because a notice of an intent not to renew a contract is not a notice of cancellation that would trigger the exclusion of revenue. Second, LivePerson excluded certain revenue that it claimed was non-recurring revenue, while the plaintiff asserts it should not have been excluded. Third, LivePerson excluded certain revenue from trial or proof of concept contracts that the plaintiff claims should have been included. Finally, the parties dispute whether certain additional revenue was required to be recognized under GAAP in March, 2007.
27. The credible evidence establishes that the exclusion in the Merger Agreement for revenue from LivePerson customers "that have indicated to [LivePerson] in writing that they intend to cancel their contract" was intended to cover, among other things, customers who indicated to Liveperson that they would not be continuing their contracts at the end of an automatically renewable term, as shown by the plain language of the contract and the course of dealing between the parties. While the plaintiff asserts that such revenue should have been included, even though it was clear that the customers would not be continuing customers of LivePerson, that contention is not supported by the structure of the deal, the contemporaneous documents, and the credible testimony. Customers would not be producing continuing income for LivePerson whether they cancelled contracts before the terms ended, or whether they indicated before the end of March, 2007 that they were not renewing their contracts. In either event, it was clear that LivePerson would not have the bargained-for benefit of recurring income from those contracts and therefore the income from those contracts should not have been included in revenue for earn-out purposes.
28. The Merger Agreement expressly excludes from the earn-out calculation "any revenue booked by [LivePerson] from [Proficient] Pipeline Customers that have indicated to [LivePerson] in writing that they intend to cancel their contract . . . ." (PX-30 at § 1.01.) The words "cancel" and "non-renew" are not defined in the Merger Agreement.
29. Given that the acquisition of long-term revenue streams was a key motivation for the merger, LivePerson was concerned about whether Proficient's existing or pipeline customers would continue on as LivePerson customers after the acquisition. Mr. LoCascio testified credibly that LivePerson engaged Proficient in negotiations because it desired the latter's customer base. Later in London, when Mr. LoCascio discovered that several of Proficient's purported "full-time customers were not legit because [LivePerson] had closed them or [LivePerson was] in the middle of the deal," Mr. Locascio requested that an earn-out provision be included in the Merger Agreement. (Tr. 669-70, 680.)
30. The earn-out provision was designed to protect LivePerson in the event that ongoing revenue streams acquired by LivePerson as a result of the Proficient acquisition were lower than expected. Mr. LoCascio testified credibly that he requested incorporation of an earn-out provision in the Merger Agreement because it allowed for Proficient to receive compensation for the deals it contributed to the acquisition, while ensuring that LivePerson was "protected" in the event that not all the ongoing revenue streams materialized as Mr. Freishtat predicted. (Tr. 681-84.) Mr. Freishtat acknowledged that Mr. LoCascio was not pleased with the events that transpired in London and stated that, at the time, he assured Mr. LoCascio that if Mr. LoCascio had concerns about Proficient's future value, pipeline, and European pilots, Mr. Freishtat would be willing to incorporate a provision into the Merger Agreement which, while not a traditional earn-out, would reflect the value of Proficient at a point in the future. (Tr. 81-83, 195-98.)
31. Specifically, the earn-out provision was designed to give credit to the Proficient shareholders only for revenue that was expected to "recur" into the future for LivePerson, measured using March, 2007 as a proxy and then annualizing March, 2007 to yield an expected ongoing annual revenue stream. By definition, the earn-out calculation was designed to exclude revenue recognized in March if it was not expected to be ongoing revenue. See PX-30 at § 1.01.
32. Mr. LoCascio testified that the earn-out provision looked at three buckets of revenue. "One is the contracts that were going to be long-term contracts and signed paper for like a year, [LivePerson was] going to pay one time that revenue. [Second, i]f they were going to be looked at as proof of concepts, or tests - we knew sometimes there's a 50/50 chance of these things becoming full-time, long-term recurring contracts - we were going to give 50 percent." Finally, "one-time fees" were very minimal "because they don't recur." (Tr. 686.)
33. Mr. LoCascio testified that LivePerson would not "count things . . . if a customer is going to cancel with us, because it will not continue on, it will not recur." Mr. LoCascio also stated that "a customer can cancel any time that he wants to, and if they come to us and tell us they're canceling for contractual reasons or they want to stop paying us and they don't want to continue on in a one-year deal or two-year deal, then we look at that as canceled revenue." (Tr. 691-92.)
34. Mr. Freishtat agreed that it would be reasonable to define recurring revenue as revenue that is predictable, stable and can be counted on in the future with a high degree of certainty. Mr. Freishtat also agreed that LivePerson sought such recurring revenue in the acquisition with Proficient. (Tr. 161-62, 268-69.)
35. The Merger Agreement itself excludes from the earn-out calculation any revenue from former Proficient customers "that have indicated to [LivePerson] in writing that they intend to cancel their contract . . . ." (PX-30 at § 1.01.) It draws no distinction between customers who indicate that they are not renewing their contracts at the end of their term, like canceling a magazine subscription at the end of a subscription term, and those customers who terminate their contracts before the term of the contracts had otherwise expired. In either event, if a customer indicated its intent not to continue the contract before the end of March, 2007, LivePerson would be assured that the revenue would not be continuing, and the language of the Merger Agreement covered both situations. While Mr. Freishtat contended that revenue was not to be eliminated for "locked up" customers who did not have cancellation for convenience provisions in their contracts, the Merger Agreement itself drew no such distinction. (Tr. 104-10, 121-22.) Nor did Mr. Freishtat ever communicate this understanding of the meaning of the term "cancel" to LivePerson during the merger negotiations. (Tr. 122, 207-08.)
36. LivePerson and Proficient understood "cancel" to mean the stopping of ongoing revenue from a customer contract. Stephen Hufford, the former Executive Vice President of Proficient, testified that a fair definition of "cancel" would be "the taking of an affirmative step to stop a contract." (Tr. 566.) John Huntz, a former member of the Proficient Board of Directors, testified that "cancellation is something that is a proactive event on behalf of the customer, to take an action to cancel an existing agreement." (Tr. 524.) Michael Kovach, the Senior Vice President and Corporate Controller for LivePerson, testified that he determined which customers had terminated their contracts by way of a "cancellation notice," so dubbed because "any stoppage of recurring services is a cancellation of that ongoing revenue stream for us." (Tr. 918-19.)
37. In 2006, LivePerson had contracts that were automatically renewable and that required that an affirmative step be taken by the customer in order to stop LivePerson's services. (SF 33.) These included contracts with Allstate, H&R Block, and CorCell. (DX-20 at § 5; PX-10 at § 9; PX-2 at 9.)
38. LivePerson routinely used the term "cancel," "non-renew" or other indications of cancellation interchangeably, both internally and in communications with Proficient, to refer to contracts that would not continue. (Tr. 782; DX-108 at PL000021; DX-125 at PL000065; DX-126 at PL000067.) Mr. Dicso testified that when he used the terms "cancel" and "not renewed," there was no difference in his mind as to what those terms meant. (Tr. 782.) Internal documentation indicates that LivePerson used the terms "cancellation" and "termination" interchangeably within the context of H&R Block's cancellation notice. (DX-193 at LP0003736.)
39. Mr. Dicso testified that he had written "cancel" in connection with the Allstate and H&R Block contracts in an earn-out calculation prepared for March, 2007, because "[Allstate and H&R Block] gave [LivePerson] notice that they were not intending to continue using the service at the end of the term" and Mr. Dicso considered them "cancellations." (Tr. 797; DX-161.)
40. Mr. Kovach testified that upon receiving notices of cancellation, as in the case of Allstate, H&R Block, and CorCell, somebody from the Accounting Department, usually Ms. Clark, Mr. Kovach's accounting manager, would handwrite a "CL" on the notice. The document would then be placed in a sequential log of LivePerson's cancellations. Mr. Kovach stated that it was the policy and practice in effect at LivePerson from at least 2005 to keep a cancellation log and to log similar notices of termination. (Tr. 920-22.)
41. At no point did Mr. Freishtat and his colleagues at Proficient ever question or challenge LivePerson's use of the word "cancel" to signify a customer's decision to terminate the contractual relationship, or dispute LivePerson's running tally of the earn-out provided in the bi-weekly or monthly earn-out update spreadsheets, each of which excluded revenue from "cancelled" or "non-renew customers." (Tr. 574, 692, 747, 784-87.)
42. Thus, the credible evidence establishes that the Merger Agreement excluded revenue from former Proficient customers who indicated to LivePerson that they would not be continuing their contracts at the end of an automatic renewable term.
43. Allstate indicated to LivePerson in writing prior to the end of March, 2007 that it intended to "cancel" its contract, as that term is used in the Merger Agreement. Therefore, it was appropriate to exclude Allstate's March, 2007 revenue from the earn-out calculation, as stated in the Earn-Out Notice.
44. The July 14, 2005 Services Agreement between Proficient and Allstate provides that the "Agreement shall apply and remain in effect for a term that commences on [July 14, 2005], and extends for a period of 90 days following the Launch Date (the "Term"), unless earlier terminated pursuant to the terms hereof, or extended by both parties agreeing to such extension." (PX-3 at § 1.)
45. The terms of the Allstate contract were extended four times. The final extension, Amendment #4, dated April 28, 2006, set forth an initial annual term ending April 30, 2007. (DX-20 at § 1.)
46. Amendment #4 to the Allstate contract set forth an automatic renewal provision as follows:
After expiration of the Initial Annual Term, the Agreement will automatically renew for additional 12 month terms unless either party notifies the other party in writing of its intent to not to [sic] renew the Agreement at least 45 days prior ...