Business hasn't been this bad in a decade,

Broadcom Corporation

(Nasdaq:BRCM) CEO Henry T. Nicholas III told

Nor is its image exactly brilliant in Israel these days. Nicholas has made the trip to Israel in an effort to restore the company's good name, tarnished by revelations regarding its purchase of Israeli startup VisionTech in November 2000, ostensibly for almost $800 million.

The deal got good press when first announced. But later stories turned less complimentary when the accounting behind the figures was disclosed. The value of the deal was inflated by the allocation of options to customers of Broadcom, VisionTech and of other startups Broadcom bought in exchange for purchase commitments. But Broadcom's CEO comes out swinging in defense of the Israeli company. Nicholas said VisionTech and its manager, Amir Morad, had been forced to grant the allocation to customers as part of the deal. Moreover, he adds, Morad had decided to grant warrants for Broadcom shares to VisionTech workers out of his own pocket.

Broadcom has meanwhile been hit by class-action suits. One claim raised is that the purpose of the allocation-for-orders mechanism was to grant Broadcom customers substantial discounts without revealing them in its profit and loss statement or in appended documentation. In other words, it was a mechanism for Broadcom to boost orders and sales, which naturally boosted its share price. As one lawsuit put it, Broadcom was buying its own revenues.

Insofar as is known, something over five million Broadcom shares out of the 7.96 million shares Broadcom allocated for the purchase of VisionTech wended their way to customers, instead of to VisionTech shareholders. The deal was reportedly worth almost $800 million, but the value of the shares allocated to customers was no less than $500 million. VisionTech wound up with less than three-eighths of the compensation.

Why? Thing is, when asking about the procurement plans of potential customers of startups he's thinking of buying, Nicholas explains "They always tell you they'll buy millions worth of products." But you can't count on statements like that, he says. Words are cheap. Hence the Broadcom mechanism of assuring how much stuff they will buy.

Broadcom didn't want to have to rely on VisionTech's advanced technology or design wins with almost every serious manufacturer of converters in the market. "We wanted the customers to have a stake in our success. We wanted VisionTech to be able to bring us two or three contracts with top-tier customers. Each contract incorporates not only a share in VisionTech's success, but also large performance penalties if the contract is not carried out," Nicholas explains.

All negotiations over warrants and orders were carried out at the level of the CEO. "You can ask Malcolm Miller, CEO of Pace Micro Technology," Nicholas says. Moreover, he says the deal structure was created with the help of leading accounting firm Ernst & Young, and Broadcom is far from being the only corporation using such mechanisms. Motorola division General Instruments has the same transaction structure in place with nine cable companies, he says.

Another item he reveals is that Broadcom officers were involved in all stages of negotiating the warrants-orders deals with potential VisionTech customers. Nicholas won't get into the roles played by VisionTech vs. Broadcom people, or the proportions between the amount of warrants they received compared with the size of their orders.

Overstating the negative

The most important thing, Nicholas says, is that everything has been perfectly above-board, and did not make any misrepresentations to shareholders and investors. Nicholas' philosophy is that when reporting to investors, a company should "overstate the negative and hold back associate positives". And he adds that in buying VisionTech, Broadcom not only bought its technology but also commitments from its customers to make substantial purchases, thus generating value for shareholders.

Shareholders thought Broadcom had bought only technology, but they didn't' have to know that the technology cost only $250 million, he explains. They didn't have to know the company had paid $500 million for customer orders. If the market thinks Broadcom overpaid for VisionTech, it can always bring down Broadcom's share price. If it does, well,investors be in for a nice surprise when the orders start to stream in, Nicholas says. The company prefers to under-promise and over-deliver.

The problem is that Broadcom is paying for the orders. Using warrants that may or may not be vested, it is still buying revenue using a currency that dilutes its shareholders. The structure epitomizes the massive, unrestrained use technology companies made of their shares and warrants for shares in recent years. Nicholas sees it differently: running a slush fund is not buying revenues, he says, and the company decided to view the VisionTech customers as though they were investors. What is the difference? he asks. Customers also contributed a great deal to the company, more than any strategic investor would, he says.

Well, one could surmise that a difference might lie in the nature of the deal-beast. Why should a potential strategic investor want to put millions into VisionTech in exchange for a small equity stake, when it could get a bigger equity stake just by buying products? True, vesting the warrants depends on honoring the purchase contract, which involves paying money to Broadcom. But in the end, these customers got more than VisionTech's investors without taking any of the risk.

Theoretically, if the vesting price is low enough (and Nicholas admits it's pretty low) - it might pay for a company to buy VisionTech products just to vest the warrants and obtain a major financial gain.

Some companies settle for giving out toaster ovens

Taken alone, the figures are astounding. Broadcom is paying $500 million worth of its shares to customers, assuming all are vested. The company boasts that it's never financed more than 2% of the orders volume by way of allocating warrants. What kind of sales is Broadcom expecting VisionTech to generate? So far the whole Broadcom group is selling no more than $1.5 billion a year.

True, Nicholas admits, but sales are climbing by more than 100% a year. He says that within a few yars, that sum won't look so big. Meanwhile the deals have assured that every converter and decrypter these customers produce for the next four years will incorporate VisionTech products. He foresees very large future sales, although he won't specify numbers. But even the most optimistic of prophets wouldn't think that sales would soar to a degree justifying a $500 million gift to buyers.

Maybe $500 million won't seem so hefty in a few years. But meanwhile, as Nicholas said himself, business is not good.

The worst in a decade

How bad is business anyway? "I'm only as good as my customers," Nicholas says. If


(NYSE:MOT), Broadcom's largest customer, is issuing two warnings in six weeks, this says something about the situation. But, Nicholas qualifies, relative to its competition Broadcom's situation has never been better.

The problem isn't with Broadcom or its technology, Nicholas says. It's that the company's customers are in bad shape. "The speed at which the situation deteriorated has been significant."

Intel Corporation


Cisco Systems

(Nasdaq:CSCO), Motorola and

3Com Corporation

(Nasdaq:COMS) have all issued warnings and may not buy what they were supposed to buy.

Some people say the problem is just an inventory bubble caused by over-ordering that will end when the inventory is gone. "I don't believe that's the case," Nicholas says. "The crisis could be a year or could be two years. What I care about right now is my market share," he insists, even if the market isn't growing by 25% each quarter any more.

One of Broadcom's strongest advantages over its rivals lies in its ability to enter new markets and generate income starting from zero market share. Broadcom achieved something no other chipmaker ever did, he says: it grew faster and purchased 18 companies and managed to finance the acquisitions without hurting profits.