Cisco's Creative Andiamo Options

As details emerge of Cisco Systems Inc.'s (Nasdaq: CSCO) plan to "acquire" Andiamo Systems Inc., it's clear that Andiamo was effectively a dummy company established to provide unique stock-option incentives -- which Cisco says could be worth as much as $2.5 billion in total -- to a small group of executives and engineers (see Cisco Buys Andiamo).

Cisco's entrance into SAN switching is obviously a good thing for the industry as a whole. Armed with the Andiamo switches, Cisco is poised to seriously shake up the status quo in the Fibre Channel switch market, which is currently dominated by Brocade Communications Systems Inc. (Nasdaq: BRCD) and McData Corp. (Nasdaq: MCDTA).

But its unorthodox arrangement with Andiamo continues to raise questions about why Cisco felt it was necessary to structure the deal the way it did. Why did Cisco form a separate company at all? Why were ordinary Cisco stock options not good enough incentives for those employees?

The answer, as best we can determine, is that Cisco was deeply concerned about losing certain top-flight execs unless it came up with some kind of alternative compensation scheme, seeing as Cisco's stock price had fallen precipitously from its mid-2000 highs. At the same time, Cisco was very likely finding it difficult, if not impossible, to recruit elite Fibre Channel engineers unless they too were given potentially lucrative stock options.

In a roundabout way, Cisco has said as much. The structure of the deal "allows Cisco and Andiamo to balance both the risks and rewards of new market entry, while preserving the benefits of an entrepreneurial venture," Ammar Hannafi, VP of strategy and business development, told analysts and reporters in a conference call Tuesday.

By "benefits of an entrepreneurial venture," we think Hannafi means "multimillion-dollar, dotcom-style stock payout."

Cisco has finally confirmed that it is the exclusive investor in Andiamo, a connection first reported by Byte and Switch more than a year ago (see Cisco’s Secret SAN Strategies Revealed). The supposedly independent, privately held startup has not received a penny of funding from any other entity or individual. To date, Cisco says it has invested $74 million in Andiamo through convertible debt, out of a total of $84 million in promised funding. That investment (plus an additional $100 million pledged through the closing of the Andiamo acquisition) gives Cisco about a 44 percent stake in the venture.

Who owns the other 56 percent of the "startup"? 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. According to this theory, Cisco structured the deal for Andiamo to make sure these executives -- which supposedly included Mario Mazzola, Cisco's chief development officer -- stayed in the family.

A Cisco spokesman says that neither Mazzola nor any other Cisco officer or board member has any financial interest in Andiamo. Only Andiamo's employees and the Cisco employees seconded to Andiamo do, the spokesman says.

In that case, who is going to hit the jackpot, if and when Andiamo's switches start beating the pants off Brocade and McData? (See Cisco's Sales Strategy Unclear.)

Cisco is still being extremely secretive about who Andiamo's employees are. The only ones it has publicly named so far are CEO Buck Gee and VP of marketing Jacqueline Ross. Cisco representatives said Gee was not available for an interview, and they declined to identify any other members of Andiamo's management team.

Gee was previously VP of marketing at Com21 Inc. (Nasdaq: CMTO), a cable modem maker. Prior to joining Com21 in November 1994, he was employed by -- guess who? -- Cisco, which in 1993 acquired the company he was working for at the time, Crescendo Communications. Mario Mazzola, incidentally, was president, CEO, and founder of Crescendo. Ross, meanwhile, previously served as VP of marketing at Marimba Inc. and Check Point Software Technologies Ltd. (Nasdaq: CHKP).

Cisco did tell us that Andiamo has hired engineers from Brocade, EMC Corp. (NYSE: EMC), Hitachi Data Systems (HDS), IBM Corp. (NYSE: IBM), and Nishan Systems Inc.

Of course, the bottom-line question is: How much are shares of Andiamo actually worth? Right now, that's unknown. According to the terms of the deal, Cisco will exchange shares of its common stock for Andiamo shares (those held by Andiamo's employees). The overall transaction, expected to close sometime in the first half of 2004, could be worth as little as zero and as much as $2.5 billion, although industry observers say the final price won't be nearly that high.

Cisco argues that the Andiamo spin-in is a better deal for everyone involved, including shareholders, than if it had arranged a more conventional acquisition. Why? Because the ultimate purchase price is tied to how much Andiamo gear Cisco can sell (during an unspecified three-month period hence). Therefore, Cisco says, it will get a fairer valuation than if it had purchased Andiamo without knowing the viability of its products.

But analysts point out that under this deal, Cisco may have an incentive to not aggressively market and sell Andiamo switches so that the purchase price remains lower. Cisco's Hannafi insists the deal is based on "mutual trust" between the two companies.

"If you look at the structure and the way it's been put together, it implied a lot of trust from Cisco on the development process and the entrepreneurial ability of the team at Andiamo, and similarly from Andiamo a trust in Cisco doing the right thing for its customers," he said.

Perhaps Cisco's next challenge will be to rally its sales channels to move products that will ultimately help line the pockets of the 300 or so engineers and executives associated with Andiamo.

In an interesting side note, on Tuesday Brocade announced that Mark Leslie, former chairman and a current director of Veritas Software Corp. (Nasdaq: VRTS), has retired from Brocade's board of directors. Veritas has been working very closely with Andiamo to develop virtualization and volume management features, and it's possible that Leslie -- or Brocade -- perceived a conflict of interest in his role on Brocade's board (see Brocade Names Paisley to Board and Veritas Puckers Up for Cisco).

— Todd Spangler, US Editor, Byte and Switch
http://www.byteandswitch.com