Nishan Founder: VCs Screwed Me

One of the founders of Nishan Systems -- acquired by McData Corp. (Nasdaq: MCDTA) for $83 million in cash this summer -- has filed a lawsuit charging that two of Nishan's venture capital backers, certain Nishan executives, and McData cheated him and other holders of the startup's common stock out of their fair share of the proceeds from the deal.

Aamer Latif, who was president and CEO of Nishan from its founding in 1998 until 2002, says in his lawsuit that ComVentures, Lightspeed Venture Partners, and others conspired to make the terms of the McData acquisition more favorable to Nishan's preferred shareholders -- in other words, themselves -- rather than its common shareholders. [Disclosure: Lightspeed Venture Partners is an investor in Light Reading Inc., publisher of Byte and Switch.] Latif, who was a member of Nishan's board of directors, held 7.3 million shares of Nishan common stock.

"Nishan and certain of its officers and directors... individually, and in combination, defiled the corporate trust by, among other things, first illegally purchasing votes to ensure the consent of certain shareholders to, then misallocating the proceeds of, a merger agreement that disproportionately favors the defendant shareholders," says Latif's complaint.

Latif filed his original lawsuit in Santa Clara County Superior Court on Sept. 11, 2003, less than a month after McData announced plans to buy Nishan. McData said it would pay $83 million in cash and assume $2 million in debt, a price tag notably under the $100 million-plus investors had pumped into Nishan (see McData Sweeps Up Nishan, Sanera). Latif, represented by San Francisco law firm Sagy Law Associates, filed an amended complaint on Oct. 10. The news of his suit was first reported this Sunday by the The Mercury News of San Jose, Calif.

The lawsuit names as individual defendants Roland Van der Meer, partner with ComVentures; Gill Cogan, general partner with Lightspeed; Robert Russo, CEO of Nishan; and John McGraw, who was appointed interim CEO of Nishan after Latif departed in May 2002.ComVentures' Van der Meer sent Byte and Switch the following statement: "Nishan's Board of Directors acted consistent with the highest ethical, moral, and legal standards. Nishan's merger with McData was in the best interests of Nishan, its employees, and the common shareholders. The employees have been retained by an excellent parent company and the common shareholders all made money on their shares. In contrast, the preferred investors lost millions of dollars on the final outcome. The accused board members and investors intend to vigorously defend against the plaintiff's baseless claims." He also notes that the judge assigned to the case, Judge William J. Elfving, denied Latif's attempt to obtain a temporary restraining order on Sept. 15, 2003.

Neither Cogan nor Russo responded to requests for comment. McGraw could not be reached.

McData is also named in the suit as a defendant. Latif accuses the Fibre Channel switch vendor of offering Nishan's departing management team "unusually high severance payments, totaling over $3.1 million, with the only apparent goal of obtaining their proxy vote in favor of the Merger." In addition, according to the lawsuit, McData offered a 50 percent retention bonus to Nishan employees who promised to vote their common shares in support of the deal.

Asked to comment, a McData spokeswoman says: "We are aware of the allegations in the complaint and will defend against them, but beyond that can't comment further since it is ongoing litigation."

Latif claims that ComVentures, Lightspeed, and their allies worked to minimize the return to Nishan's common shareholders at every turn. For example, McData's initial term sheet of July 17 proposing the Nishan deal included a specific provision that $5 million be distributed to the common shareholders. But the revised term sheet submitted by Nishan deleted any specific consideration for common shareholders, Latif's lawsuit alleges.Moreover, ComVentures and Lightspeed plotted to enhance their stake in the company when Nishan was in critical need of funding, according to Latif.

In March 2003, Nishan was "under a pressing need to raise additional cash," yet the two VC firms "created an environment that prevented the Company from seeking funding from outside investors," Latif alleges in his complaint.

Instead, in what appears to be an especially greedy move, Latif's lawsuit details $5.5 million in bridge loans proposed by Lightspeed and ComVentures in June and August 2003 that guaranteed a return to the investors of three times the amount of their investment (plus interest) in the event of a merger or sale of the company. Latif's complaint notes that the VCs proposed $2.5 million of the bridge loan on August 1 -- after McData's initial acquisition offer had already been received.

"The opportunity to participate in the bridge loan was restricted to Lightspeed and ComVentures and a handful of shareholders (including a common shareholder) they hand-picked, although other qualified shareholders had expressed unsurprising interest in sharing in its bounty," says Latif's complaint, under the heading of "The Unconscionable Bridge Loan."

According to the lawsuit, McData is paying a total of approximately $90 million for Nishan -- with only $4 million going to the common shareholders. Meanwhile, about $59 million of that total goes to the preferred shareholders (which include the company's VCs); $16 million to bridge loan investors including Lightspeed, ComVentures, and other preferred shareholders; $2.5 million to Credit Suisse First Boston Corp., which acted as financial adviser to Nishan in the deal (and is named as a defendant in Latif's lawsuit); $1.1 million to McGraw; and $10 million in retention and severance payments to Russo and other employees.In addition to the financial shenanigans, Latif says in his lawsuit that in the midst of the McData negotiations Russo, who was named Nishan's CEO in November 2002, was charged with sexual harassment by a Nishan employee.

"Such conduct plainly does not support the payment of a $1.1 million severance package," says the lawsuit, which alleges that McGraw and other board members "chose to treat Russo leniently so as to ensure his support for the McData deal."

Latif is asking the court to require the defendants to return the proceeds from the McData transaction that they "unjustly received" to the common shareholders, and he is seeking compensatory and punitive damages.

One suspects, though, that the raw rancor exhibited in this dispute will live on regardless of how the finances are ultimately settled.

Todd Spangler, US Editor, Byte and Switch