Chambers puts
Cisco options raise eyebrows
by Sarah Cohen
Updated 10:51 AM EST, May-20-2002
Renowned for its M&A savvy, Cisco Systems Inc. is a model for corporate buyers. But observers say one of its acquisition tactics is not only risky, but also calls into question whether the networking giant properly disclosed past deals to the U.S. Securities and Exchange Commission.
In a March quarterly filing, San Jose, Calif.-based Cisco disclosed that it has entered "put" and "call" contracts potentially requiring it to purchase four startups in its venture capital portfolio.
Put options let investors sell a specified amount of stock at a set price within a designated time. In dealmaking, acquiring companies occasionally use puts to eventually sell securities back to the target.
But in Cisco's case the options require it to buy a startup in which it has a stake within a specified time if the company reaches certain technology and sales "milestones."
The four startups have "put options enabling them to require Cisco to acquire the remaining interests not owned by Cisco, subject to the fulfillment of various conditions, including the achievement of specified technology and other milestones," the company said in the filing.
Two of these companies are Hammerhead Networks Inc. of Billerica, Mass., and Navarro Networks Inc. of Plano, Texas. Cisco agreed May 2 to acquire them for a combined $258 million. A third, San Jose-based storage equipment maker Andiamo Systems Inc., holds a put requiring Cisco to pay up to $2.5 billion by July 2004 assuming it meets certain goals. Cisco would not identify the other purchase.
As part of its contract with Hammerhead and Navarro, which were founded in early 2000, Cisco had call options to acquire the companies at a set stock price. Cisco has a standing call on Andiamo.
Cisco, Hammerhead and Navarro declined to say if the companies exercised their puts or calls as part of the acquisition. Cisco also would not confirm if its dealmaking included put options in the past.
"If a transaction was considered material prior to March, Cisco would have had to disclose it," a company spokeswoman said in an e-mail. "Most of Cisco's acquisitions have not been considered material."
A search of Cisco's SEC filings turned up no previous mention of acquisition-related puts. Cisco's detailed disclosures regarding its investments in Hammerhead, Navarro, Andiamo and the unnamed startup is out of character. Company watchers say it is an effort to assuage criticism that its financial reporting is inadequate.
The Cisco spokeswoman indicated the company is trying to shore up its disclosure.
"In the spirit of providing additional transparency in reporting financials, Cisco is providing more details surrounding commitments and contingencies, which includes spin-ins, certain privately held investments, real estate commitments, etc.," she wrote.
If Cisco did previously use puts deemed material under SEC rules, it should have disclosed them in past financial reports, said Dennis Taylor, a senior attorney with Houston-based securities fraud law firm Shepherd, Smith & Bebel. In 2000 alone, Cisco spent $12 billion on 24 acquisitions, which collectively amount to 70% of its revenues that year. In 1999 the company made 18 acquisitions.
According to Brian Lane, a partner with Gibson, Dunn, the SEC Staff Accounting Bulletin of 1999 instructs companies to use "qualitative measures," as well as quantitative ones in assessing materiality. The "beginning point for quantitative" assessment of a material transaction is 5% of revenues, he added.
The SEC guidance has made materiality even more stringent, with the result that companies must now disclose all "transactions that would influence investors' decision-making," said Robert Willens, a tax and accounting analyst with Lehman Brothers Inc.
Disclosure questions aside, why did Cisco opt to use the calls and puts?
The put agreements are "unusual," said Russell Hansen, a partner with Gibson, Dunn & Crutcher LLP. Analysts called put options a vestige from the days when technology valuations were high, M&A was competitive and networking equipment makers found it necessary to protect their stakes in startups from competitors.
Tom Taulli, an analyst with Newport Beach, Calif., investment bank NetCap Ventures Inc., said put options were evidence of the clout sellers wielded during the tech bubble. The instruments were "a way to bridge the differences between buyers and sellers."
In effect, puts and calls were a way to lock in a prospective acquisition and shield it from other potential buyers. "The put option in essence says, 'I will let you, Cisco, invest in this company,'" said Steve Kamman, an analyst with CIBC World Markets. "The company will take the risk of developing this product. And if the company succeeds, you have to buy it."
Although that strategy might have seemed sound in early 2000 when the telecommunications sector was hot, times have changed. Telecom equipment sales have plummeted, and the valuation of gear providers has fallen almost 100%. That means Cisco could have dramatically overpaid for Hammerhead and Navarro.
"When making a forecast for a put option, a buyer might predict a 30% or 40% decline in value, but who would have imagined a 99% decline?" Taulli said of the telecom slump.
Cisco did not state in its 10-Q when it originally financed Hammerhead and Navarro. But sources speculate that Cisco may have made the investments in early 2000, when the startups were founded, and that the parties immediately negotiated the options.
"It seems Cisco purposely did not lay all the facts on the table in its 10-Q filing," said an M&A lawyer who spoke on condition of anonymity. "In the case of three of the four unnamed acquisition targets, Cisco does not talk about the timing of the investments, which suggests it is avoiding the topic of valuation."
Cisco, which already owned 11.1% of Hammerhead, paid $173 million for the rest of the company, which makes Internet protocol software. Hammerhead has 85 employees, which means Cisco is paying more than $2 million per employee for Hammerhead.
The networker had a 14% stake in Navarro and is spending $85 million to roll up the company, which makes chips for data switches. Navarro was founded in March 2000 and has 25 employees. That amounts to more than $3.4 million per Navarro employee.
But those deals are peanuts compared with Cisco's put-call agreement with Andiamo. Even in the relatively healthy storage networking sector, Cisco may end up overpaying for the company. "The purchase price for the remaining interest [in Andiamo] would be based upon a valuation to be determined by applying a multiple to the actual revenue generated from sales of the company's products during a specified three-month period, on an annualized basis," Cisco said in its filing.
Since early 2001, valuations have fallen 50% for stronger storage companies and 90% or more for weaker providers. What's more, if Cisco exercises its calls or Andiamo exercises its puts, the networker is committed to another $100 million investment in the storage startup.
"[Cisco] Investors talking about undisclosed put options would raise bad publicity," Taylor said. "It's a general rule — financial statements must reflect transactions that impact a company's financial status." |
