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Cisco's mushy 'spin-in' deals undermine acquisition heroics

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Analysis Forget trying to win the lotto. What you really want to do is sign up for Cisco CEO John Chambers' long-term "spin-in" plan.

It's not clear if Cisco invented the "spin-in" term, but it has popularized it. Over the past decade, Cisco has fired up a few spin-ins where employees break off from the company for about two years to run their own venture and then rejoin their mates once Cisco acquires the start-up. In a couple of cases, those employees holding options in these spin-ins have become very wealthy - a fact that seems to have been lost on Cisco investors but not on other, jealous staff.

The latest example of a Cisco spin-in arrived yesterday when the company announced a $50m investment in a mysterious hardware start-up called Nuova Systems.

The Nuova investment follows Cisco's spin-in template to perfection. Cisco has handed the start-up $50m now and opened up the possibility of providing Nuova another $42m in funding in the months to come. For its generosity, Cisco has secured an 80 per cent stake in Nuova, while some portion of Nuova's 76 employees hold the other 20 per cent.

Cisco's investment has also given it the right to purchase Nuova, and we guarantee that Cisco will exercise this "option." The estimated price for Nuova will fall somewhere between $10m and $578m, according to Cisco.

That's a heck of a range, right? Well, you ain't seen nothing yet, as Cisco's southern gentleman Chambers might say behind closed doors.

The absolute classic spin-in was Andiamo - a Fibre Channel switch maker that Cisco bought in February of 2004.

Andiamo came to life in January of 2001 and just four months later Cisco gave the company an $84m investment. Following that investment, Cisco received a 44 per cent stake in the start-up and, you guessed it, the right to acquire the company.

In August of 2002, Cisco decided to go ahead and acquire Andiamo. In a regulatory filing, Cisco revealed that the purchase price would fall somewhere between $0 and $2.5bn. That makes the Nuova range look like pinpoint accuracy.

Cisco never reveals its exact spin-in pricing formula but does say that part of the formula involves looking at a start-up's sales during a given quarter.

In 2004, Cisco finally completed the purchase of Andiamo, shelling out $750m. That massive windfall benefitted Andiamo's staff as well as 37 Cisco employees that were granted shares in the start-up.

As Byte and Switch put it at the time, "Cisco says that ownership stake consists entirely of Andiamo stock options granted to Andiamo's 270 employees, as well as to 37 Cisco employees who have been 'seconded' to the Andiamo project. This means that those 37 Cisco staffers are technically employed by Cisco, but they work full-time for Andiamo."

"Andiamo means 'let's go' in Italian, and it's been rumored that several senior Cisco executives were threatening to tell Cisco just that unless they received some kind of special compensation." (More on that later.)

Cisco recorded at least part of the Andiamo purchase as an R&D expense.

As a historical footnote, Cisco announced its first layoffs in company history in March of 2001, just as it prepared to invest in Andiamo. Cisco fired close to 11 per cent of its staff.

Paying a big price

The financial machinations behind Cisco's spin-ins are quite intriguing.

For example, it's hard to see how Cisco could justify a $700m purchase for Andiamo.

For one, Cisco did not complete that transaction during the boom days. It started the buy process in 2002.

Hardware start-ups typically sell for much less than software start-ups due to the different natures of the businesses. The hardware crowd has lower margins, more costs and tends to face industry-wide standardization at a fairly quick clip.

The last hardware purchase we can recall coming close to the Andiamo deal was Sun's go-go days buy of Cobalt for $2.0bn. Sun later took a $1.6bn charge to write down most of that, er, investment.

For a bit more perspective, look to this week's deal between Brocade and McData. Brocade picked up McData for $713m. With that purchase, Brocade receives a proven, mature Fibre Channel switch player. When Cisco bought Andiamo, it had little idea how well the start-up's products would do in the Fibre Channel market. To this day, Cisco won't disclose exactly how much Fibre Channel switch revenue it makes, although analysts peg the range being between $70m and $100m per quarter. And that's after five years of plugging away at the market.

And now you have Cisco estimating that it could pay up to $578m for Nuova. Few outsiders have any clue what the super-stealth start-up is up to that could command such a price. Our sources indicate that Nuova is hammering out a type of server virtualization system - a box with networking, storage and servers combined.

Cisco's server partners will want to pay attention here because it looks like the company is preparing for some direct competition. And McData and Brocade know only all too well what happens when Cisco backs a spin-in.

But the financial and market implications of the Nuova purchase are only part of the story. To get at all the meat we have to travel back to 1993.

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