Original URL: http://www.theregister.co.uk/2006/08/11/cisco_spinin/
Cisco's mushy 'spin-in' deals undermine acquisition heroics
Lucrative friends and family program
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.
Building to a Crescendo
Cisco's first acquisition occurred in September of 1993 when it bought networking start-up Crescendo for about $90m. Since 1993, Cisco has bought close to 110 companies.
Out of that 110, it would be tough to find a better buy than Crescendo.
Crescendo opened up the LAN (local area network) switch market to Cisco, and the company has since turned the Catalyst line of products acquired from Crescendo into a multi-billion dollar per year business. Beyond the hardware, Cisco also acquired some key talent when it bought Crescendo - namely Mario Mazzola, Luca Cafiero, Prem Jain and Buck Gee.
The case of Mazzola and his relationship to Cisco's Chambers is of particular interest to our tale.
According to our sources, Chambers, then a vice president of sales at Cisco, had the entire Crescendo team report directly to him, forming a tight bond with the group. As the Catalyst gear took off, the former Crescendo executives rose through Cisco's ranks and made Chambers look good on their way. Mazzola surged to the post of chief development officer, while Chambers went on to become CEO.
In 2001, Mazzola announced plans to retire from Cisco and an internal memo circulated to that effect, according to a BusinessWeek story titled "Cisco's Comeback" written in late 2003. The story, along with other press accounts, claims that Chambers begged Mazzola to "come back" to Cisco before he even left. Chambers proved persuasive, and Mazzola stayed.
Mazzola had been shepherding a group of about 30 engineers who were working on an extension to Cisco's switch product line. Those engineers and executives Gee, Cafiero and Jain would break off to form Andiamo. As stated before, the folks involved with Andiamo were turned into multi-millionaires by Cisco, although the company has maintained that Mazzola, still at Cisco, did not profit from the deal.
Our sources indicate that the Andiamo staff did not even leave Cisco's campus. They, in fact, maintained Cisco security badges through the spin-in process.
In 2005, stories broke saying that Cisco's storage brass - the Crescendo and Andiamo crew - had retired en masse. Mazzola, Cafiero and Jain departed as did Soni Jiandani, the VP of storage marketing, who reported to Cafiero. Ah, but the executives didn't really retire, they went off to form Nuova - then called Nuova Impressa - according to a report in Byte and Switch.
Already wealthy, this group of Cisco veterans had enough cash to self-fund Nuova, stopping greedy venture capitalists from diluting their shares. They also managed to leave Cisco's offices this time and set up a new office in Santa Clara.
Our sources indicate that Nuova Impressa - notice the Italian name again following Mazzola around - actually rebuffed Cisco's initial attempts at an investment. Such hesitation didn't last long though, as you can see by yesterday's announcement. Once again, the Crescendo and Andiamo crowd will be getting rich.
All is fair, right?
Given Cisco's tremendous success and huge cash hoard, you might question whether these spin-ins really hurt the company. (And there have been other spin-ins, although none as lucrative as Andiamo.)
According to our sources, the spin-ins are proving painful to Cisco's morale. We've been told that Cisco's board has reprimanded Chambers for the Andiamo deal and his apparent favoritism for Mazzola and his cronies. The wealth accumulated by the spin-in veterans has made other Cisco employees jealous beyond belief.
For example, one poster on a storage message board writes, "Of the two spin-ins I am familiar with, the guys in charge were very well connected internally within Cisco and had strong coattails to drag along the best talent. Being well connected is a must in order to get the right funding and most importantly to get yourself and your team a sweetheart deal that will pretty much guarantee riches."
Another person writes, "Most of the $20m kind of acquisitions will fall under the 'spin-in' category where Cisco was already invested in a start-up. In fact, a lot of the people in these companies are ex-Cisco. Given that Cisco's options aren't worth much, I believe this is the way Cisco rewards its key talent.
"In some cases at least, some of the companies do stuff that is no big deal technically, and clearly the work could have been done far cheaper inside than the acquisition price paid. That again fits with the 'need' to reward talent."
Such accusations seem to undermine the myriad stories glorifying Cisco's A&D strategy.
"How has Cisco succeeded where so many others have failed,?" asked US News in June's story titled "Cisco's Connections: The tech giant has mastered the art of acquisitions."
"Simply put, experts say, it has professionalized a process that other companies turn to only on occasion - usually out of greed or necessity."
The story goes on to cheer Cisco's ability to perform acquisitions quickly and to maintain talent after purchasing a firm. It quotes an "expert" saying, "They do very few wild and wooly acquisitions. Everything they do is strategic."
And, of course, spinning out and then spinning back in top talent could be considered strategic. Cisco's share price has languished over the past four years, making it tough to tempt workers with lucrative options packages. Under such conditions - hell, under any conditions - the offer of a spin-in must look attractive.
Cisco may pay a premium for the start-ups but it gets their gear and keeps the talent happy. Beyond that, Cisco allows the start-ups to work in an unfettered environment where they can possibly bring product to market faster than a team could do inside of Cisco.
Investors, however, may not see things the same way. After all, the Andiamo group started inside of Cisco, then "left" in January of 2001, received $84m four months later and then received $750m in 2004 while wearing Cisco security badges no less.
Could Cisco have crafted its own Fibre Channel product line for a fraction of that total? Of course. Could Cisco argue that the start-up's intellectual property belonged to Cisco since the start-up began at Cisco and, er, worked at Cisco? Yes. So why did shareholders essentially pay these guys hundreds of millions for products they already owned? And why is Cisco paying the same group again?
One could see Cisco's spin-in strategy as a creative and rather intelligent way of running its business. We can't think of any major IT players that use this spin-in method as effectively. So, perhaps it's a competitive advantage.
Still, the financial terms of the deals coupled with the repeating themes do seem disconcerting. As a giant with billions on hand, Cisco should have an incredible amount of leverage on its side. One wouldn't think that Cisco could avoid such oddball deals.
Chambers has long pushed to establish more consistency and efficiency across Cisco and has developed a model company in that respect. So, it's sad to see such waste and inefficiency from the A&D team.
Unless, of course, that's the plan.®