In NetApp, Inc. v. Cinelli, the Delaware Chancery Court found that the seller in a business acquisition was clearly liable for breach of contract and fraud. Although the fact of the plaintiff’s damages wasn’t in doubt, the amount of those damages was murkier. This article summarizes why the court found one expert’s damages theory wasn’t supported by the evidence at hand.
NetApp, Inc. v. Cinelli, C.A. No. 2020-1000-LWW (Del. Ch. Aug. 2, 2023).
The case involved a data management company that acquired a cloud-based software company for $35 million. After the deal closed, the buyer discovered that the seller had improperly recorded internal software use as revenue in its financial statements, substantially inflating its revenue.
The buyer sued the seller for breach of contract and fraud. After trial, the court entered judgment in favor of the plaintiff, finding that the defendant had breached multiple representations in the merger agreement. For example, the seller falsely claimed that its financial statements complied with Generally Accepted Accounting Principles and reflected bona fide transactions.
The remedy for breach of contract or fraud under Delaware law is based on the parties’ reasonable expectations. The court explained that damages are measured “by the amount of money that would put the plaintiff in the position it would have held if the defendant’s representations were true.”
The seller argued that damages should be measured by the difference between the company’s “as-represented” value (the $35 million purchase price) and its “actual” value if revenue had been reported accurately. The seller’s expert determined that the company’s actual value was $30.4 million, based on a combination of several income- and market-based methods. The difference between these amounts was $4.6 million of estimated damages.
In contrast, the buyer argued that damages “should address the future cash flows it planned to generate from the acquisition, irrespective of the purchase price.” The buyer’s expert first calculated the plaintiff’s expectations using the acquired company’s projected cash flow plus “synergistic cash flow.” The buyer’s anticipated synergies included increasing sales of the acquired software using its larger sales force and leveraging complementary products.
The expert estimated that the present value of the plaintiff’s expected cash flows was $86.2 million. Then he adjusted the projections for the present value of cash flows attributable to improper internal billings ($48.5 million). The difference between these amounts was $37.7 million of estimated damages.
The seller’s damages estimate was ultimately accepted. The court acknowledged that potential synergistic value between two previously separate businesses is “often a driving factor in business combinations.” However, the uncertainties of integrating two businesses “may result in an overvaluation of synergies, which can take longer to capture than anticipated — if they are captured at all.”
The court found no evidentiary basis for making a responsible estimate of lost synergistic cash flows. Although mathematical certainty isn’t required, the buyer’s anticipated synergistic cash flows were “aspirational” and assessing whether the buyer reasonably expected to realize those synergies would be a “theoretical exercise.”
The court also noted that the buyer’s revenue team didn’t review the company’s valuation model, and that its expert simply adopted the buyer’s assumptions without testing its calculations or assessing their reasonableness. Moreover, the buyer discontinued sales of the acquired software four months after closing, even though the product performed as expected. So, awarding damages above the purchase price would amount to a “windfall.”
Plaintiffs hoping to recover damages based on expected synergies should have market-based evidence to back up their claims. Courts tend to be skeptical of these damages, so it’s important to demonstrate that a plaintiff’s expectations are realistic.
Contact our team today if you have questions about Fraud Damages Based on Speculative Synergies.