MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with
"Selected Historical Financial Data" and our financial statements and related
notes thereto included elsewhere in this prospectus. This discussion contains
forward-looking statements that involve risks and uncertainties. Our actual
results could differ materially from those anticipated in the forward-looking
statements as a result of certain factors included in the risks discussed in
"Risk Factors" and elsewhere in this prospectus.
OVERVIEW
We are a Colorado-based software company that has been in the
application acceleration business since March 2001. We develop, manufacture and
market, worldwide, two software product lines: HyperWeb and HyperTunnel.
HyperWeb and HyperTunnel address the growing need for real-time application
acceleration and improved business communications over wired and wireless
networks. Our mission is to make our customers more efficient and profitable by
increasing the performance of their internal and external business applications
through deployment of application acceleration software that is cost effective,
easy to use and easy to install.
Our initial software product line HyperWeb was introduced in late 2001.
In January 2004, we introduced our second major product line, HyperTunnel.
Application acceleration is a subset of the software industry. Our
competition is largely small, private companies. As a result, we view the
industry in which we compete as emerging and not yet quantifiable in terms of
size or opportunity. There are few benchmarks to guide us in our development.
Since we do not know the full extent of the market for our products, we cannot
analyze our penetration. Being in the transitional stage of our development, we
focus on basic success metrics, such as revenue growth, expense management and
achieving business plan milestones. In recent months, prospective customers'
decisions concerning the purchase of our products has shifted from a
technology-based decision to a financial justification based decision. Sales are
taking more marketing time and resources, and customers are taking longer to
justify the business benefit of a purchase of our product. We expect this trend
to continue.
With little revenue and only one primary product to date, we have had
insufficient funds to build sales channels or launch any effective marketing
strategy. We have driven sales volume largely through personal relationships and
customers who find us on the Internet. Through the end of 2003, we had not spent
material sums on non-personnel/agent sales and marketing initiatives. In the
first six months of 2004, we made a marginal increase in marketing expenditures
which are expected to benefit future quarters. Many large customers have found
us through our website, satisfactorily tested the software and then bought the
product without our ever having met the customer in person.
We are currently in the process of developing a more strategic approach
to marketing. We have hired new sales leadership and we are in the process of
developing and launching new sales channels (through both agents and
partnerships). In addition, we intend to develop stronger relationships within
our existing customer base in order to cross-sell to other departments and to
offer new products to such customers. Within most of our customers, we have only
penetrated a single division or a single application leaving, we believe, many
sales opportunities with existing customers. In addition, all existing HyperWeb
customers are candidates to buy the more "enterprise-wide" HyperTunnel product.
In the first six months of 2004, we began expanding our distribution
capabilities by launching new sales channels. We have appointed additional
regional U.S. and international sales agents, launched a monthly per site
subscription model with a partner, signed recurring revenue agreements with
three ISP's (which have not contributed any material revenues to date) and
expanded the internal direct sales organization. With the proceeds of this
offering, we expect to broaden our U.S. and international distribution network
and expand our partnership and OEM channels. We are, therefore, in a transition
28
period, moving away from an opportunistic marketing strategy to one that is more
focused on several market channels and have hired experienced marketing
personnel to assist us in this regard.
We were formed and incorporated in February 2001, when we acquired
substantially all of the assets of Remote Communications, Inc., or RCI. We paid
$400,000 for the RCI assets which included assuming specified liabilities of
$46,597 and the issuance of a note in the amount of $353,403. RCI's assets
included various computer programs, source code and the expertise of RCI's
management. In December 2001, the RCI management team decided to end their
involvement with our company. Their departure had a short-term minor negative
impact on the company in terms of technological direction, but no significant
long-term impact, as the technological product development direction changed and
we engaged new research and development, or R&D, professionals.
KEY INDICATIONS OF FINANCIAL CONDITION AND PERFORMANCE
We have a limited operating history. As of June 30, 2004, we had an
accumulated deficit of approximately $5.1 million (which is net of $1.2 million
accumulated loss due to the termination of our subchapter S corporation status).
We have not been profitable in any of our three years of operations. We expect
to continue to incur significant sales and marketing, product development and
administrative expenses and, as a result, expect to continue to incur losses in
the foreseeable future.
RESULTS OF OPERATIONS
The following tables show our results of operations for the fiscal years
ended December 31, 2003 and 2002 and the six months ended June 30, 2004 and
2003, both in terms of dollars and in approximate percentages.
Years Ended December 31,
2003 2003 2002 2002
Revenues
License fees $ 787,541 80 % $ 596,905 92 %
Service and other 195,678 20 % 53,928 8 %
983,219 100 % 650,833 100 %
Operating expenses
Research and development-personnel 112,243 11 % 121,565 19 %
costs
Research and development-other 38,588 4 % 99,128 15 %
Amortization of capitalized software 214,194 22 % 187,181 29 %
Impairment of intangibles and 276,296 28 % - 0 %
capitalized software
Customer support 173,959 18 % 240,790 37 %
Sales-personnel costs 299,811 30 % 334,902 51 %
Sales-agent costs 226,561 23 % 276,456 42 %
Sales-other 20,912 2 % 61,524 9 %
Marketing expenditures 32,984 3 % 125,263 19 %
Rent 92,616 9 % 137,675 21 %
Depreciation 90,177 9 % 70,475 11 %
General and administrative-personnel 804,025 82 % 616,669 95 %
costs
General and administrative-other 95,643 10 % 288,973 44 %
2,478,009 252 % 2,560,601 393 %
Operating loss (1,494,790 ) -152 % (1,909,768 ) -293 %
Interest expense, net 345,395 35 % 162,637 25 %
Other income (1,276 ) 0 % (52 ) 0 %
Preferred dividends (15,503 ) -2 % - 0 %
Net loss available to common shareholders $ (1,854,412 ) -189 % $ (2,072,353 ) -318 %
29
Six Months Ended June 30,
(unaudited)
2004 2004 2003 2003
Revenues
License fees $ 100,824 49 % $ 408,005 83 %
Service and other 105,560 51 % 82,312 17 %
206,384 100 % 490,317 100 %
Operating expenses
Research and development-personnel costs 108,489 53 % 72,891 15 %
Research and development-other 9,881 5 % 17,773 4 %
Research and development-product management 105,327 51 % - 0 %
Amortization of capitalized software 60,977 30 % 107,039 22 %
Impairment of intangibles - 0 % - 0 %
Customer support 68,144 33 % 103,371 21 %
Sales-personnel costs 185,699 90 % 184,578 38 %
Sales-agent costs 63,162 31 % 190,541 39 %
Sales-other 1,457 1 % 9,790 2 %
Marketing expenditures 39,147 19 % 34,761 7 %
Rent 46,508 23 % 46,508 9 %
Depreciation 38,564 19 % 44,947 9 %
General and administrative-personnel costs 332,610 161 % 282,294 58 %
General and administrative-other 157,631 76 % 89,625 18 %
1,217,596 590 % 1,184,116 241 %
Operating loss (1,011,212 ) -490 % (693,799 ) -141 %
Interest expense, net 536,909 260 % 141,758 29 %
Preferred dividends 48,040 23 % - 0 %
Other income (1,200 ) -1 % - 0 %
Foreign exchange loss/(gain) 9,489 5 % (13,068 ) -3 %
Gain on settlement (440,999 ) -214 % - 0 %
Net loss available to common shareholders $ (1,163,451 ) -563 % $ (822,489 ) -168 %
Restatement of Financial Statements
The December 31, 2003 and 2002 financial statements reflect a change in
the reporting of warrants issued to placement agents related to the sale of
debt, the accounting for the conversion feature included in the notes issued in
2002 and 2003, and the accounting for the settlement of liability to RCI. The
settlement of RCI was previously reported in the year ended 2003 and has been
changed to be reported in the first quarter of 2004. The value ascribed to the
warrants issued to the placement agency was previously accounted for as a
reduction of shareholder's equity and has been changed to be recorded as debt
issue costs and amortized as interest expense over the life of the debt. The
Company valued the beneficial conversion on debt issued and recorded this as
interest expense. In addition, the Company reclassified Series A Preferred Stock
to equity and reclassified the related dividends out of
30
interest and into equity. The following is a summary of net income and earnings
per share to reflect the changes described above.
December 31,
2003 2002
Net loss as previously reported $ (1,303,945 ) $ (2,022,051 )
RCI settlement (440,999 ) -
Warrant interest expense and beneficial conversion (109,468 ) (50,302 )
feature
Accretion of preferred stock dividends (15,503 ) -
Reclass of interest expense 15,503 -
Net loss available to common shareholders as $ (1,854,412 ) $ (2,072,353 )
restated
Basic and diluted loss per common share as $ (1.00 ) $ (1.69 )
originally reported
RCI settlement (0.34 ) -
Warrant interest expense and beneficial conversion (0.08 ) (0.04 )
feature
Accretion of preferred stock dividends (.01 ) -
Reclass of interest expense .01 -
Basic and diluted loss per common share as restated $ (1.42 ) $ (1.73 )
Revenues: Fiscal 2003 compared to fiscal 2002: The 32% increase in
license fees revenues from 2002 to 2003 reflects the growing acceptance of our
initial product, HyperWeb, and the results of our limited initial marketing and
selling efforts. Also, in 2003 37% of license fees revenues were derived from
existing customers who had purchased HyperWeb in 2002 for a particular
application or for a limited number of users. In 2003, these customers expanded
their license by adding more users and/or sought additional applications for the
product. Support and other revenues primarily represent a 12 month maintenance
contract on sales where the revenue is recognized over the term of the support
agreement. The increase is a result of more maintenance agreements accompanying
license sales (over 90% of all licensees purchase a maintenance plan that is
usually 20% to 30% of a license sale) and subsequent year renewals of
maintenance. Approximately 60% of our 2002 customers have renewed for a second
year of maintenance service. None of the increase in revenue is attributable to
an increase in list prices. Additionally, we do not anticipate that projected
revenue growth will result from increases to our list prices.
In 2002, our top three customers accounted for 57% of the total revenues
during the year. In 2003, the top three accounted for 34% of total revenues. In
both 2003 and 2002, approximately 64% of revenues were from U.S. customers. Our
non-U.S. based customers have discovered us almost exclusively from an Internet
search or by word of mouth. During the years 2002 and 2003, we had a single
part-time sales agent in the United Kingdom and did very little marketing
outside of the U.S.
First six months of 2004 compared to first six months of
2003: Revenues in the first six months of of 2004 were $284,000 (or 58%)
lower than the first six months of 2003 (or $490,317) due to:
º •
º the transition to our new sales management team and other business
development personnel changes (consistent with our new strategy) which
delayed our ability to close sales;
º •
º certain sales agents who are no longer active with the company and the
resulting time spent by our new sales management in cultivating new
sales agent relationships;
º •
º the delays in implementing our new marketing strategy-in the first six
months of 2004, our limited finances have not yet permitted a broad
expansion of our marketing; and
31
º •
º the fact that three of our four senior executives have focused
primarily on fundraising and the initial public offering process
during the first six months of 2004, substantially limiting the time
being devoted to business development activities.
Industry reports lead us to believe that worldwide information
technology spending will increase slightly in 2004 as compared to 2003. The
demand for our products depends on continued growth in the Internet and
corporate network traffic, the ability to develop and maintain strong
relationships with indirect channel partners, our ability to expand or enhance
our product offerings and our sales and marketing efforts. Growth in service
revenues is dependent upon continued sales of maintenance agreements and license
renewals. Our future viability will be directly affected by the acceptance of
HyperTunnel by existing and new customers.
We experience some seasonality in our revenues. Typically the summer
months of July and August and the month of January, after the December and
year-end holidays, are very slow for technology sales in North America and
Europe. This usually impacts results in the first and third calendar quarters.
Research and development expenses: This consists primarily of
compensation related to the cost of engineering personnel, third party
consultants, prototype expenses related to the design, development, testing and
enhancement of our software products, facilities costs and hardware and software
used in the design, development and support of our products. This expense
category is the non-capitalized portion of these costs. The following section
details our policy regarding which research and development, or R&D, expenses
are capitalized. The reduction in expenses from 2002 to 2003 is the result of a
less expensive personnel mix and a larger percentage of costs capitalized in
2003 as we were developing the HyperTunnel product line. We expense all R&D
expenses as incurred once the product line is in general release.
In 2004, we intend to add application specific transformations such as
quality of service, or QoS, and high speed network enhancements to HyperTunnel.
We intend to invest in excess of $2 million over the next 12 months for such
enhancements. Such spending will constitute a significant increase over our
current annual R&D expenditures. We may be subject to risks and delays caused by
hiring new personnel, management of an increased number of third-party
consultants and the increased testing and quality control needed for a larger
level of activity.
In the first six months of 2004 we formalized our product management
function. We hired new staff and allocated existing resources to this
initiative. This function strategically manages the product through development,
testing and taking the product to market. We had this need due to the new
product line and future R&D plans.
Amortization of capitalized software costs: This category represents
the write-off of previously capitalized software development costs. It includes
the same types of expense categories as in R&D costs above.
For software costs, both internally developed and purchased from third
parties, we follow the following accounting policies:
Pre-Feasibility Stage: We expense costs incurred to establish the
technological feasibility of a software program as they are incurred. For these
purposes, technological feasibility is considered achieved when all planning,
designing, coding, and testing has been sufficiently completed such that we can
produce the program to meet its design specifications.
Post-Feasibility/Pre-Release Stage: We capitalize costs incurred
following technological feasibility but prior to commercial release and record
them at cost. These costs are not applied against revenues generated during that
period.
32
Post-Release Stage: Commencing with commercial release of the
program, we amortize costs that have accumulated in the R&D account over the
program's expected useful life and we expense as incurred all additional
software costs.
Our internal software development costs include application and tool
development, translation, testing and localization costs incurred in producing
software and associated documentation to be licensed to customers. We also may
contract with third parties to develop and test software that will be licensed
to customers. In addition, from time to time we may choose to purchase source
code or product rights from third parties to be integrated with our software.
As of December 31, 2003, we had unamortized capitalized costs (in
accordance with the above criteria) associated with HyperTunnel of $373,000.
Because HyperTunnel was released in January 2004, we had not commenced
amortization of these capitalized costs at December 31, 2003. We are in the
process of amortizing our capitalized costs of HyperWeb on a straight-line basis
over three years and anticipate these unamortized capitalized costs of $35,000
to be fully amortized as of December 31, 2004.
We expense R&D costs relating principally to the design and development
of products (exclusive of costs capitalized) as they are incurred. We expense
the costs of developing routine enhancements as R&D costs as incurred because of
the short time between the determination of technological feasibility and the
date of general release of related products. The reduction from the first six
months of 2004 (compared to 2003) is a result of earlier capitalized costs
becoming fully amortized in 2003.
Impairment of intangibles: We evaluate all of the carrying values of
our assets to determine the reasonableness of continued capitalization. We
review the facts and circumstances of our business which may indicate that the
carrying values of our assets may be impaired. We use future undiscounted cash
flows to determine whether the carrying value of the asset is recoverable. If
the carrying value is less we recognize an impairment loss based on the excess
carrying amount of the asset over the respective fair value.
During 2003, we determined that certain acquired intellectual property
and trademark and patent costs, which were previously capitalized, no longer had
any value to us and thus were written off. These assets arose primarily as a
result of the purchase of the assets of RCI and initial trademark and patent
costs incurred in 2001 and early 2002. The amount written off in 2003 was
$85,000.
In addition we incurred an impairment expense in 2003 as a result of the
abandonment of a version of HyperWeb with particular new feature functionality.
In 2003 we were simultaneously developing HyperTunnel and an updated version of
HyperWeb. In July 2003, we abandoned the development of a version of HyperWeb
with particular new feature functionality and used our limited resources to
complete development of our new product, HyperTunnel. As a consequence, we
recorded an impairment of $191,000, representing all previously capitalized
costs relating to the development of the updated version of HyperWeb.
Customer support costs: This includes personnel costs which relate to
post-sales support of our products. All of our support resources are currently
based in our Greenwood Village, Colorado, office. We plan to open European and
Asia/Pacific based support operations, perhaps with a partner, to support our
increasing international business. Currently our staff works varying shifts to
meet support requirements from different time zones. These are primarily in the
areas of customer support under maintenance agreements and other post sale
technical support, which may include telephone/web support, next business day
advance replacement and access to all software updates and upgrades. The
reduction in these costs from 2002 to 2003 was a result of a more optimal but
reduced staffing mix in this area. The cost of services in the first six months
of 2004 were lower by approximately 34% compared to the corresponding period in
2003 because we delayed the hiring of additional technical
33
and customer service support due to slower than expected sales. See "General and
administrative" below.
Sales and marketing: Through 2003, we targeted sales efforts at
enterprises with a focus on reaching the corporate information technology
organization managers responsible for the performance of mission-critical
applications and maintenance of network performance in the enterprise. We have
also maintained a website and have agreements with the Google and Yahoo! keyword
search engines that direct those curious about compression and acceleration
solutions to our website. Our agreement with Google is a standard agreement that
is terminable by either party at any time. We pay Google its standard fees,
which included a $5.00 initial setup fee and cost-per-clicks charge which varies
at our option. Our agreement with Yahoo!, through its subsidiary Overture
Services, Inc., is also a standard agreement that is also terminable by either
party at any time. We pay Overture its standard fees, which included a $50.00
setup fee, $20.00 minimum monthly fees and click fees that vary at our option.
We have spent $12,000 with Google and Overture over the last two years. The
amount spent can be increased or decreased based on various search criteria
offered by Google and Overture and the periodic volume generated through the
search engines. Other than attending conferences and limited public relations,
we have done no meaningful marketing. To date, sales efforts have been comprised
of mostly Colorado-based employees and agents and a single United Kingdom based
agent. Historically we have had no presence in the Asia/Pacific region.
Expenses included in this category are the compensation costs of sales
and marketing personnel, commissions and incentives, agent fees, market research
costs, website expenses, partner association costs, public relations and
conference attendance.
From 2002 to 2003, the amount incurred in this category fell by 27%, or
$218,000 largely due to the following:
º •
º a reduction of $49,000 in compensation and agent fees as a result of:
(i) reducing the number of employees and agents, (ii) converting
compensation arrangements to more incentive based rather than fixed
base fees, and (iii) a reduction in marketing personnel costs;
º •
º lower travel and entertainment costs of $20,000 as a result of less
travel and no conference attendance;
º •
º elimination of fees paid to a public relations firm resulting in a
savings of $15,000;
º •
º costs of $57,000 incurred in 2002 to become a Siebel Systems, Inc.
partner and attend various Siebel events, which were not incurred in
2003; and
º •
º initial website development costs incurred in 2002 of $27,000 which
were not incurred in 2003.
For the first six months of 2004 compared to the first six months of
2003, there was a 31% reduction in expenses in this category largely
attributable to:
º •
º the reduction in sales agent fees due to fewer producing sales agents
and changes to sales agent compensation to low or no fixed amounts and
more commission based;
º •
º greater sales travel cost in the first quarter of 2003; and
º •
º lower commissions because of lower sales levels.
Sales and marketing expenses represented a disproportionate share of
revenues due to the start-up nature of our business in 2002 and 2003. In 2004,
we are implementing a new strategic sales and marketing plan. In March, 2004 we
hired a new executive to lead this area. In June and July 2004 we made other
additions to our sales organization. We expect that the remainder of 2004 will
be spent identifying new sales channels, building deeper relationships with
existing customers, developing new agents and partnerships, identifying OEMs to
distribute our products, launching new marketing
34
initiatives and adding a greater emphasis on international opportunities. As a
result, we expect to spend in excess of $4 million over the next 12 months on
sales and marketing, an increase of more than 650% over 2003 levels. We
anticipate that 75% of the sales and marketing budget will be expended on people
related activities (payroll, agent fees and commissions) and 25% on non-people
related activities (advertising, public relations, collateral, conference
attendance, partner fees, etc). We will continue to invest in appropriate sales
and marketing campaigns and therefore expect sales and marketing expenses in
absolute dollar expenses to increase in the future. We plan to work toward a
target of sales and marketing expenses being in the range of 25% to 35% of
revenues, but we do not expect to achieve this during the next two years.
General and administrative expenses: General and administrative
expenses consist primarily of employee compensation for executives and
administrative personnel, office costs such as telecommunications, legal and
accounting fees. We treat costs relating to raising equity as a reduction to
share capital and as such they are not included in this category.
From fiscal years 2002 to 2003 the amount incurred in this category was
flat but there were major changes between the two years as follows:
º •
º an increase in costs associated with the Chief Executive Officer
transition in the amount of $31,000. We hired a new Chief Executive
Officer in the fourth quarter of 2003. During this time the former
Chief Executive Officer became the Chairman of the Board and remained
on the payroll;
º •
º an increase in payroll expense recorded for stock-based compensation.
In 2003, as described in more detail in the financial statements, we
recorded an expense for stock options granted to employees in the
amount of $139,000;
º •
º in 2003 we recorded an entry to reflect the fair value of the
agreement made between our founder and our new Chief Executive
Officer. Our founder agreed to grant the new Chief Executive Officer
107,143 of his shares of common stock in the Company, for which we
recorded a compensation expense of $113,000. This was a non-cash
entry;
º •
º in early 2003 we reduced executive compensation expenses in the human
resources and finance area as we focused on sales and new products.
This resulted in a savings of $165,000 compared to 2002. The previous
human resources executive (and current board member) continued to
provide interim support to us. We retained a new Chief Financial
Officer in December 2003;
º •
º in 2003 we enjoyed a lower rent expense as a result of moving our
corporate office to a less expensive location. This resulted in a
savings of $45,000 compared to 2002; and
º •
º in 2003 we had lower legal expenses compared to 2002 in the amount of
$66,000. This was a result of capitalizing certain legal costs for
patents in 2003 and higher costs in 2002 as a result of certain debt
offerings, formation activities and matters related to the acquisition
of RCI's assets.
In the first six months of 2004 general and administrative expenses were
higher than in the first six months of 2003 by approximately $120,000. This was
largely due to:
º •
º the costs of the new Chief Executive Officer. In 2003, our founder
served as Chairman and Chief Executive Officer. In October 2003, the
positions were split and we hired a new Chief Executive Officer. This
resulted in additional compensation expense of approximately $124,000;
º •
º in 2004 we incurred additional costs due to hiring a new CFO and
additional compliance and audit fees as we prepared for a public
offering of our securities. This resulted in additional costs of
approximately $44,000; and
35
º •
º a reduction in costs in 2004 due to: a $22,000 reduction as the
Company eliminated full time human resources positions, and a $28,000
reduction in fees paid to third-party business consultants.
We expect to incur greater administrative costs in the future as we
comply with recently enacted laws and regulations affecting public companies,
including increased accounting and legal fees, complying with the provisions of
the Sarbanes-Oxley Act of 2002 and other current and future rules and
regulations required by the SEC, the American Stock Exchange and the Financial
Accounting Standards Board, or FASB. In addition, we will have greater costs
related to our Audit and Corporate Governance Committee and certain types of
insurance policies as a result of being a public company. There may be other
additional costs, which could be substantial, as a result of our becoming a
public entity.
General and administrative expenses represented disproportionate
percentages of revenues in 2002 and 2003 due to the start-up nature of our
business. If we are successful in implementing our sales and marketing plan, our
general and administrative expenses should continue to decline as a percentage
of revenue.
Interest expense: We incurred interest expense on loans from
convertible and other debt, a loan from our founder, imputed interest on
warrants issued in connection with debt offerings, imputed interest on the
conversion feature of our debt, a note payable to RCI and a line of credit. In
2002, the convertible debt was in existence for a partial year, resulting in a
higher interest charge in 2003. The line of credit was not in existence in 2002.
The interest charge was higher by approximately $395,000 in the first six months
of 2004 compared to 2003 due to our higher levels of debt, the higher number of
warrants issued with the resulting imputed interest charge, imputed interest on
debt conversions, costs recorded to reduce the conversion price of certain
warrants and the amortization of the costs incurred in selling the 2004 notes.
The following is a breakdown of the interest expense for the first six
months of 2004:
Cash Interest Paid (received)
Line of Credit and Credit Cards $ 4,337
Interest Received on Short-term investments (734 )
Non-cash Interest Expense Accrued
Founder's Loan 4,018
Ed Peats Short-term Loan 2,274
Bridge Loans 63,829
Loan Fee Amortization
2003 Bridge Loans 14,288
2004 Bridge Loans 104,500
Value of Debt Warrants Issued 110,735
Bridge Loans Issued with conversion price at less than fair market value 48,000
Warrants Issued with an exercise price at less than fair market value 150,800
Value of Detachable warrants 34,862
$ 536,909
Gain on settlement of RCI note: We purchased certain assets from
Remote Communications, Inc., or RCI, in March 2001. The purchase price (net
after certain liabilities of RCI was paid by us in the form of a promissory note
upon closing of the transaction) was $353,000 to be paid in March 2004. Part of
the sale agreement called for certain RCI officers to become our employees and
continue to develop the product offering. In late 2001, these employees
terminated their employment with us. At the time of leaving our company, in
addition to the promissory note, we established a reserve for certain
36
possible claims for compensation to these employees in the amount of $130,000.
We disputed certain claims by these employees and RCI.
In March 2004, we settled our dispute with RCI regarding the initial
purchase of assets in 2001. Under our settlement, we agreed to pay RCI $42,500
as settlement in full for all liabilities owing and any claims due under our
purchase agreement. Accordingly, in the financial statements for the quarter
ended March 31, 2004, we reduced the value of the note payable to RCI to
$42,500, reversed the previously accrued compensation to RCI officers and
recorded a gain on the settlement of this liability in the amount of $441,000.
Income taxes: We make no provision for income taxes because, since
inception, we have never been profitable. We have a net operating loss carry
forward available to offset future federal and state income tax expenses at an
amount that approximates our accumulated deficits. Our net operating loss carry
forward will expire in varying amounts from 2021 to 2023. The utilization of the
net operating loss carry forward as an offset to future taxable income is
subject to the limitations under U.S. federal income tax laws. One such
limitation is imposed where there is a greater than 50% change in ownership of
our company.
OFF BALANCE SHEET TRANSACTIONS
We are not party to any off balance sheet transactions. We have no
subsidiaries or equity ownership in any other entity. We have no guarantees or
obligations other than those which arise out of normal business operations to
customers, i.e., a sale of software, which is covered by customer agreements
limiting, in part, our liability.
CORPORATE GROUP AND SEGMENT INFORMATION
We are not, and never have been, part of any corporate group. We do not
have segment information because all of our activities are devoted to the
development and sale of software. We have no discontinued operations.
In fiscal 2003, 64% of our revenue came from the U.S., 33% from the
European Union and 3% from Asia/Pacific. Over the next 12 months we expect our
revenue from non-U.S. customers to increase as a percentage of revenues.
USE OF ESTIMATES AND CRITICAL ACCOUNTING POLICIES
This discussion and analysis of the financial condition and results of
operations is based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
In order to prepare these financial statements, we are required to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses and related disclosures of contingent assets and
liabilities. On an ongoing basis, we evaluate our estimates, including those
related to the valuation of long-lived assets, valuation allowances including
sales return reserves, allowances for doubtful accounts and other liabilities,
such as product warranty reserves. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances. Actual results may differ from these estimates under
different assumptions or conditions. Our accounting policies are described in
more detail in the notes to our financial statements included elsewhere in this
prospectus, which you should read in conjunction with this discussion. We have
identified the following as critical estimates employed in applying critical
accounting policies.
Revenues: We derive revenues from the following sources: software
license revenue and services revenue, which primarily consists of maintenance,
consulting and training. We recognize revenue in accordance with the Securities
and Exchange Commission's Staff Accounting Bulletin No. 101,
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"Revenue Recognition in Financial Statements," the American Institute of
Certified Public Accountants' Statement of Position, or SOP, 97-2, "Software
Revenue Recognition," as amended by SOP 98-9, "Modification of SOP 97-2,
Software Revenue Recognition, with Respect to Certain Transactions," and other
authoritative accounting literature. We determine fair value of each element in
multiple-element arrangements based on vendor-specific objective evidence, or
VSOE, for all items included in a new customer agreement. We maintain a price
lists for various regions where we have stated License and Maintenance rates and
terms. We base our assessment of VSOE for each element to the price charged when
the same element is sold separately. VSOE for maintenance is determined based
upon the customer's annual renewal rates. During the sales process we make
various proposals that illustrate the license fee component (License Fee
Revenue) and the optional maintenance component (Services Revenue). Customers
are not required to buy maintenance so they actually make dual buying
decisions-one for the license and one for the maintenance. The split between
these two categories is included in all of our executed customer agreements and
billings subsequently sent to them. We use the contractual split between these
two categories to allocate the fair value of each because we believe that it
represents the fair value. Any other fees or services as part of a sale are
extremely rare and in the cases where they have occurred, they have been
governed by a separate contract with a separate fee.
License fee revenue: For software license agreements that do not
require significant modification or customization of the software, we recognize
revenue when evidence of a non-cancelable, signed contingency-free agreement
exists, any acceptance testing is complete, delivery of the product has
occurred, the license fee is fixed or determinable and collection is probable.
In all other instances, we defer revenue. We record deferred revenue as a
current liability until all the elements to be delivered at a future date and
vendor specific evidence of acceptance have occurred.
We consider receipt of a customer purchase order to be persuasive
evidence of an arrangement. Sales through our distribution channels are
evidenced by agreements governing the relationship together with purchase orders
from the ultimate end customers. Delivery generally occurs when the customer has
received an electronic media copy of the software or where we have evidence that
the customer has downloaded the software from our website.
If a license agreement provides acceptance provisions that grant
customers a right of refund or replacement only if the licensed software does
not perform in accordance with its published specifications, we defer revenue
recognition until acceptance by the customer or lapse of the acceptance period.
Generally, license agreements have no such provisions and, as the likelihood of
non-acceptance is remote, we generally recognize revenue when all other criteria
of revenue recognition are met.
Typically, our software licenses do not include significant
post-delivery obligations to be fulfilled by us, and payments are due within
30 days from the date of delivery. For customers who pay license revenues as
monthly subscribers under a utility-based pricing model, and where the license
allows for payment terms of more than 12 months from the date of delivery, we
recognize revenue as payments become due assuming all other conditions for
revenue recognition have been satisfied.
Services revenue: Services, or maintenance, revenue is recognized
ratably over the term of the maintenance agreement, typically one year.
Consulting services generally do not involve significant modification or
customization of the licensed software. Consulting and training revenues are
usually charged on a time and materials basis and are recognized as the services
are performed. Revenue from fixed price contracts is recognized on a percentage
of completion basis, which involves the use of estimates. If we do not have a
sufficient basis to measure the progress towards completion, we recognize
revenue when the project is completed or when we receive final acceptance from
the customer. Revenue from agreements for supporting and providing periodic
unspecified upgrades to the
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licensed software is recorded as unearned revenue and is recognized ratably over
the support service period.
Allowance for doubtful accounts: We maintain an allowance for
doubtful accounts at an amount we estimate to be sufficient to provide adequate
protection against losses resulting from collecting less than full payment on
our receivables. Overdue accounts are reviewed, and an additional allowance is
recorded when determined necessary to state receivables at realizable value. In
judging the adequacy of the allowance for doubtful accounts, we consider
multiple factors including historical bad debt experience, the general economic
environment, and the aging of our receivables. A considerable amount of judgment
is required when we assess the realization of receivables, including assessing
the probability of collection and the current creditworthiness of each customer.
As of June 30, 2004 we have determined that no reserve is currently necessary
for doubtful accounts.
Expensing of employee stock options: We have adopted the disclosure
only provision of FAS 123 which permits us to disclose in notes to our financial
statements the pro forma net income (loss) and earnings per share that would
have resulted from the use of the fair value based method. The disclosure only
provisions allows us to disclose the pro forma effect on net income and earnings
per share of issuing options to employees rather than expensing them based on
the fair value of the options.
We recorded an expense of $139,000 for the 132,678 options granted to
employees in 2003. The expense represents the difference between the exercise
price of $3.50 at the date of grant and the estimated fair value of common
stock. This treatment is in accordance with APB 25.
Valuation of Long-Lived and Intangible Assets and Goodwill: As
required by SFAS 144, "Accounting for Impairment or Disposal of Long-lived
Assets," we regularly perform reviews to determine if the carrying value of our
long-lived assets is impaired. The purpose of the review is to identify any
facts or circumstances, either internal or external, which indicate that the
carrying value of the assets cannot be recovered. Such facts or circumstances
might include significant underperformance relative to expected historical or
projected future operating results or significant negative industry or economic
trends. If such indicators are present, we determine whether the sum of the
estimated undiscounted cash flows attributable to the assets in question is less
than their carrying value. If less, we recognize an impairment loss based on the
excess carrying amount of the assets over their respective fair values. If
quoted market prices for assets are not available, we estimate the fair value
based on the present value of expected future cash flows. The fair value of the
asset then becomes the asset's new carrying value.
RECENT ACCOUNTING PRONOUNCEMENTS
On March 31, 2004, the FASB issued an Exposure Draft, Share-Based
Payment, an Amendment of FASB Statements No. 123 and APB 25. The Exposure Draft
covers the accounting for transactions in which an enterprise pays for employee
services with share-based payments including employee stock options. Under the
Exposure Draft, all share-based payments would be treated as other forms of
compensation by recognizing the related costs generally measured as the fair
value at the date of grant in the income statement.
If adopted as proposed, we would record as an expense the fair value of
the options we have issued. Based on the number of options we have issued, this
proposed statement would substantially increase our net losses and accumulated
deficit by approximately $110,000 for the fiscal year ended December 31, 2003
and $276,000 for the first six months of 2004. If adopted, this pronouncement
would be effective for the fiscal year beginning January 1, 2005.
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MARKET AND CREDIT RISK
Financial instruments, which potentially subject us to concentrations of
credit risk, consist primarily of cash, cash equivalents, short-term investments
and accounts receivable. Our cash, cash equivalents and investments are
maintained with accredited financial institutions and investments are placed
with quality issuers. We believe no significant concentration of credit risk
exists with respect to these financial instruments. Cash and cash equivalents
consist primarily of cash on deposit with banks and money market instruments
that are stated at costs, which approximate fair market value. We have no
current investments in fluctuating net asset value investments.
Concentrations of credit risk occur from time to time as we record large
sales relative to our growing customer base. With respect to accounts
receivable, we perform ongoing credit evaluations of our customers. As of
June 30, 2004, approximately 41% of the accounts receivable balance was
comprised of a single customer. This customer is a historic slow payer and the
account is not in dispute. The customer is one of the five largest telecom
organizations in the European Union. Foreign currency exchange risk may be
exacerbated by slow paying non-U.S. customers.
Currently most sales are in the United States, Canada, Australia and
Europe. Our marketing plan is to target sales in Europe and Asia/Pacific in
2004. As a result, financial results could be affected by factors such as
changes in foreign currency exchange rates or weak economic conditions in
worldwide markets. Any strengthening of the U.S. dollar could make our products
less competitive in foreign markets. We currently have no foreign exchange
contracts, option contracts or other foreign currency hedging arrangements.
During 2003, we recorded foreign exchange gains on certain agreements for
customers where the license fee was denominated in Euros.
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