The Inside Story Of A $1 Billion Acquisition That Caused Cisco To Divorce Its Closest Partner, EMC

Tech giant EMC said last week that it's ending its wildly successful joint venture with Cisco, known as VCE.

This is the most recent - and most serious - step in the slowly unfolding divorce between the partners.

EMC is buying out most of Cisco's stake of VCE, which combines VMware, EMC, and Cisco products into an all-in-one computer. Plug it in and you've instantly grown your data center. (EMC owns 80% of VMware.)

VCE systems are very popular. The company is on track to generate $2 billion a year, up from $1 billion in 2012, VCE says.

Cisco will retain a 10% stake but will no longer be a joint partner running the company.

This is the inside story of how that partnership dissolved after VMware paid $1.26 billion to buy a tiny startup called Nicira in 2012.

From close partners to bitter rivals

The story begins long before VMware bought Nicira. A few years earlier, Nicira founder Martin Casado invented a technology called "software-defined networking" (SDN) that changes how networks are built and managed.

SDN takes the fancy features out of the network hardware and puts them into software. This makes networks easier to build and cheaper to operate. Companies still need to buy network hardware, but they need less of it, and less expensive varieties.

Cisco currently dominates this $50 billion-a-year network market, owning about half of it. SDN is a huge disruption to that business. (Cisco has since launched its own SDN product to compete with VMware.)

However, Cisco could have prevented this disruption - and its war with its former partner - by buying Nicira itself. CEO John Chambers had every opportunity (and was reportedly urged) to put together a bid that Nicira couldn't refuse, sources told us.

But, our sources say, he was betting the bidding war for Nicira was a bluff - so he lost the chance to buy it.

Inside a $1 billion bidding war

Here's the story multiple sources have told us.

During a meeting with a large Cisco customer, that customer told Chambers that Cisco should buy Nicira.

The network industry, including Cisco, was already aware of Nicira. Casado, Nicira's co-founder and CTO, had been giving away the SDN software he created in grad school as a free and open source project, known as OpenFlow.

When Nicira was still in stealth mode in 2011, an industry organization formed around OpenFlow called the Open Networking Foundation. Its founding members were a who's who of the largest cloud and telecom providers like Deutsche Telekom, Facebook, Google, Microsoft, Verizon, and Yahoo.

Shortly afterwards, all the big networking giants, including Cisco, joined that foundation in order to be involved in (and perhaps control) its activities.

Casado was becoming famous in this circle of influential tech giants. When Nicira officially came out of stealth in 2012, the whole network world, especially Cisco, knew about it. We even called it the "least stealthy startup" when it formally launched.

Urged by his big customer to buy Nicira, Chambers asked his chief strategy officer at the time, Ned Hooper, to start acquisition talks, a source told us. Accordingly, someone from Hooper's team quietly started the talks.

Nicira's board and investors were not surprised to hear from Cisco. Nicira had already raised about $50 million from folks like Ben Horowitz of Andreessen Horowitz, Lightspeed Venture Partners, and NEA. VMware founder Diane Greene was also an angel investor.

When Cisco approached, Nicira turned to top Valley deal maker, Frank Quattrone to shop the startup around.

There was a lot of interest from a lot of big tech players. We heard some of the interested companies included Oracle, Citrix, F5, Microsoft, and IBM. EMC was in the mix separately, as was VMware.

Multiple offers came in, ranging from $200 million to under $600 million, we were told.

Cisco offered $750 million, in a mostly stock transaction that looked like $1 billion on paper. However, it would have been worth about $600 million to Nicira's preferred stockholder investors, sources told us.

Cisco's offer wasn't bad

Cisco's offer wasn't exceptionally low given that Nicira had just come out of stealth. But the highest bid came from VMware.

As these things happen, word leaked to Chambers that he wasn't the highest bidder and that EMC was involved in the winning bid.

Around this time, Hooper left the company. So Chambers told Cisco's newly promoted chief strategy officer, Padmasree Warrior, to go make the Nicira deal happen.

New to the job, Warrior made the smart political move of calling Cisco's star engineer Mario Mazzola to ask his opinion on Nicira's worth, and to get his support on whatever deal she would put together.

Mazzola advised Warrior not to pay more than $800-ish million for Nicira, our source says. Some people say he sensed the possibility of another spin-in deal and indicated then that he could build Cisco a SDN product for around $800 million.

Chambers had to decide to up his offer and grab this huge-threat startup - or not.

It's important to remember that Quattrone - the dealmaker shopping Nicira around - had just orchestrated HP's $11 billion buy of Autonomy, which was considered quite high at the time. (The Autonomy acquisition became a problem for HP, with HP CEO Meg Whitman admitting that HP paid too much for it, lawsuits and a lot of other fall-out.)

So Chambers wondered if Quattrone was playing him, trying to get him to pay more for the startup than he should, a source tells us.

Chambers also pondered which companies could actually pay $1 billion for this startup. He knew VMware might want it. It had already been competing with Cisco in some small ways. But VMware was only generating about $1 billion a quarter at the time. It had never made an acquisition this big before, and it wouldn't do so without the backing of its majority stakeholder, EMC.

Chambers didn't think EMC would let VMware declare war on Cisco because of their valuable partnership. ("Joe would never screw me," our source paraphrases Chambers as saying. Joe is Joe Tucci, EMC's CEO.)

He decided that this was all a bluff. And Cisco told Quattrone it wouldn't up its bid.

So Nicira went to the highest bidder, VMware, and the deal closed almost immediately, over the weekend, sources tell us. VMware ultimately paid $1.05 billion cash, plus another $210 million in stock.

On Monday, July 23, 2012, Chambers discovered he lost the deal to VMware. He "was furious," several sources told us.

He couldn't believe that close partner EMC had allowed VMware to become one of Cisco's biggest competitors.

A 2012 deal has big repercussions today

Nicira's $1+ billion sale sparked a gold rush to fund other SDN startups and acquire them for millions, too.

Cisco turned to Mario Mazzola and his dream team of engineers Prem Jain and Luca Cafiero to build a rival SDN product, investing $135 million and paying $863 million for the latest spin-in, the day they demonstrated the product.

That product is expected to do well for Cisco.

But Wall Street analysts worry the increased competition for Cisco could hurt its huge 60% profit margins.

Cisco has been slowly divorcing itself from EMC and VMware in big and little ways. It has since cozied up to big EMC rival NetApp. Those two companies now offer a similar product to what VCE offers. Cisco also took a small but significant stake in Parallels, a company that makes rival tech to VMware.

Meanwhile, EMC has run into its own tough times. After a reported mega-merger deal with HP and EMC fell through, Chambers was quick to publicly say he wouldn't buy EMC, either.

For its part, VMware just released its quarterly earnings reporting Nicira, now known by the product name NSX, is on track to become a $100 million business. It has more than 250 paying customers today and lots of new partnerships.

In response to this story, VMware sent us this statement:

"Networking virtualization is a core tenant of our software-defined data center strategy, and we are very pleased with the early traction we are seeing from VMware NSX. Our customers are embracing the NSX solution, not only to fundamentally change networking operations and economics, but to transform how they secure their data centers."

Cisco, EMC and Qatalyst Partners declined comment.