In a surprise merger of chip startups, network processor firm Bay Microsystems Inc. is snatching up Parama Networks Inc., a vendor sporting a single-chip, add/drop multiplexer (ADM). (See Bay Micro Acquires Parama.)

Concurrent with the acquisition, Bay is announcing a funding round of $8.4 million. That pays for Parama -- specifics aren't being disclosed -- with change left to bolster Bay's channel partnerships as the company tries to branch beyond U.S. government sales, says Bay CEO Chuck Gershman.

The deal, set to close later this month, would seem to leave Parama's investors without much return, as the company raised $41 million, including a $7 million round last year (see Parama Networks Closes $7M Round).

But it appears Parama's backers, a group including Azure Capital Partners, CrossBridge Venture Partners, Menlo Ventures, Network Angel Capital, and Sprout Group, picked up a piece of Bay in the deal. "Bay very likely will do an IPO in the next six to eight quarters, so that's when the investors will see their returns," says Hemant Bheda, Parama's CEO.

Originally a systems vendor, Parama raised a $31 million Series A in 2001 but decided a chip roadmap was a more practical way to go. The company's one-chip ADM came to market last year (see Parama Intros 'ADM on a Chip' and ADMs Get Smaller, Cheaper).

Parama didn't sell out of desperation, Bheda says. Rather, the company drew interest from U.S. government agencies but needed a boost to get the business.

"We had an exciting opportunity in front of us with government-related business, and to capitalize on that we needed to show strength, either by raising megabucks or by finding a partner," Bheda says. "We could have gone for a year or so [without more funding], but it was time to call the play."

Bay plans to use Parama's technology -- including developmental work that overlapped Bay's research -- to create compact next-generation boxes, something along the lines of the small multiservice provisioning platforms, or micro-MSPPs, that have come into vogue (see Micro MSPPs Are Big and The Micro MSPP Flight Plan). That's not to say Bay is getting into MSPPs, but the goal is similar: shrinking equipment "from a chassis-based [architecture] to that 1U or 2U form factor," Gershman says.

Considering the complexity of Bay's and Parama's chips, it's not likely the two will be glommed into one Frankenstein device. Rather, according to Gershman, they will work together inside these pizza-box systems.

In terms of technology, Bay picks up Parama's expertise in next-generation Sonet, including technologies such as generic framing procedure (GFP) and virtual concatenation (VCAT) that can be used to pack packet traffic into Sonet pipes efficiently (see Why Sonet Chips Are Sexy).

The deal also represents growth beyond a single product, as Bay so far has staked its success on the Montego network processor and variations thereof, competing at the 10-Gbit/s level against the likes of Applied Micro Circuits Corp. (AMCC) (Nasdaq: AMCC), EZchip Technologies, Intel Corp. (Nasdaq: INTC), and Sandburst Corp. A focus on Asynchronous Transfer Mode (ATM) scored Bay some U.S. government work that's paid off well; Bay claims it's the first high-end network processor operation to reach profitability, a milestone the company has been forecasting since 2003 (see Bay's ATM Chip Heads Into Battle and Startups Spout Bravado at NPC West).

The U.S. government accounts for 70 percent of Bay Micro's sales, which Gershman says are a lot more than $10 million per year. Government work has led to spotty revenues for other companies -- Foundry Networks Inc. (Nasdaq: FDRY) being one example (see War Fogs Foundry's Numbers). But Gershman claims Bay has its fingers in next-generation network projects likely to last several years (see Bay Wins 40G Job).

That's given Bay some job security and a steep revenue ramp. Revenue for the first quarter "was more than all of 2004, and our Q2 revenues have already exceeded our Q1 revenues," Gershman says.

Not all of Parama's 20 employees will be joining the 45 at Bay, although which employees will stay is yet to be decided. One employee knows for sure he'll be leaving: Bheda says he won't make the transition to Bay and is taking some time off before deciding on his next venture.

— Craig Matsumoto, Senior Editor, Light Reading