0000891618-01-501974.txt : 20011128 0000891618-01-501974.hdr.sgml : 20011128 ACCESSION NUMBER: 0000891618-01-501974 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20010331 FILED AS OF DATE: 20011107 FILER: COMPANY DATA: COMPANY CONFORMED NAME: GADZOOX NETWORKS INC CENTRAL INDEX KEY: 0001084722 STANDARD INDUSTRIAL CLASSIFICATION: ELECTRONIC COMPONENTS & ACCESSORIES [3670] IRS NUMBER: 770308899 STATE OF INCORPORATION: DE FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: 1934 Act SEC FILE NUMBER: 000-26541 FILM NUMBER: 1777066 BUSINESS ADDRESS: STREET 1: 5850 HELLYER AVENUE CITY: SAN JOSE STATE: CA ZIP: 95138-1004 BUSINESS PHONE: 4083606005 MAIL ADDRESS: STREET 1: 5850 HELLYER AVENUE CITY: SAN JOSE STATE: CA ZIP: 951381004 10-K/A 1 f76028a3e10-ka.txt AMENDMENT NO. 3 TO FORM 10-K DATED MARCH 31, 2001 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-K/A (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED MARCH 31, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-26541 GADZOOX NETWORKS, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0308899 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number)
MICHAEL PARIDES PRESIDENT AND CHIEF EXECUTIVE OFFICER 5850 HELLYER AVENUE SAN JOSE, CA 95138 (Address of principal executive offices including Zip Code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 360-4950 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, $0.005 PAR VALUE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $101,115,958 as of May 25, 2001, based upon the closing price on the NASDAQ National Market reported for such date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose. The number of shares outstanding of the Registrant's common stock on June 18, 2001 was 34,062,214 shares. --------------------- DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Proxy Statement for its 2001 Annual Meeting of Stockholders (the "Proxy Statement") to be filed with the Securities and Exchange Commission are incorporated by reference to Part III of this Annual Report on Form 10-K Report. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- GADZOOX NETWORKS, INC. FORM 10-K INDEX
PAGE ---- PART I.................................................................. 2 Item 1. Business.................................................... 2 Item 2. Properties.................................................. 19 Item 3. Legal Proceedings........................................... 19 Item 4. Submission of Matters to a Vote of Security Holders......... 20 PART II................................................................. 20 Item 5. Market for Registrant's Common Equity and Related Stockholder Matters......................................... 20 Item 6. Selected Financial Data..................................... 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risks....................................................... 51 Item 8. Financial Statements And Supplementary Data................. F-1 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 52 PART III................................................................ 52 Item 10. Directors and Executive Officers of the Registrant.......... 52 Item 11. Executive Compensation...................................... 52 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 52 Item 13. Certain Relationships and Related Transactions.............. 52 PART IV................................................................. 53 Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K......................................................... 53
PART I In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements that relate to future events or future performance such as the sufficiency of our capital resources to fund continuing operations; statements relating to the transition of the Storage Area Network, or SAN, industry to 2-gigabit-per-second speeds; our commitment to continue to devote substantial resources to product research and development and to develop new products with greater capabilities and that support new industry protocol standards, including development and deployment of the Slingshot 4218 Fibre Channel fabric backbone switch; timing of first shipments of the Slingshot 4218; our commitment to continue to work with industry leaders to promote SAN architecture and develop new products; our intentions to enter into additional distributor and reseller agreements in the U.S. and internationally; our intentions to continue to develop reusable elements; our intentions to continue sponsoring educational seminars; the percentage of our fiscal 2002 sales that will be derived from new products; our intentions to expand our sales and marketing operations; anticipated future levels of general and administrative expenses; and the evolution of SAN capabilities and the market for SAN products. In certain cases you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intends," "potential" or "continue" or the negative of such terms or other comparable terminology. These statements are only predictions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including but not limited to our ability to raise sufficient capital to enable us to continue to operate our business; market acceptance of the Company's new products and the speed at which customers adopt current and new products for SANs; the ability and willingness of our OEM and distribution channel partners to buy and sell our products; our ability to develop, introduce, ship and support new products and product enhancements; growth rates of the market segment within which the Company participates; competition in the Company's industry and the timing of new technology and product introductions; the ability to retain and hire skilled personnel and the risks outlined under "Part II -- Risk Factors" and elsewhere in this Form 10-K. All forward-looking statements included in this document are based on information available to us on the date hereof and we assume no obligation to update any such forward-looking statements. ITEM 1. BUSINESS OVERVIEW We are a provider of hardware and software products that enable the creation of networks made up of computers and data storage devices which have become known as storage area networks, or SANs. Our SAN products are based on Fibre Channel technology, a set of specifications designed to enable computing devices, such as computers and storage devices, to rapidly exchange large amounts of data. We have designed our products to leverage the capabilities of Fibre Channel technology to enable companies to better manage the growth of mission-critical data by overcoming the limitations of the traditional small computer system interface, or SCSI, which is a captive storage architecture. We expect that a substantial majority of our net revenues for fiscal 2002 will be derived from sales of new products currently under development or evaluation, including the Slingshot 4218. If sales from new products are lower than expected or if we are unable to raise additional capital, including through a draw down under our equity line financing agreement, we will be required to make a significant reduction in operating expenses and capital expenditures in fiscal 2002 to ensure that we will have adequate cash reserves to fund operations through the end of fiscal 2002. Our SAN products include (1) the Capellix 3000 chassis switch, a switch that can be configured to perform multiple functions by adding hardware that is scalable from 6 to 32 ports; (2) the Capellix 2000 arbitrated loop switch, an 8-port switch that is extendable to 11 ports, designed for the entry-level switch market; (3) the Slingshot 4218 switch, a 2 gigabit 18-port Fibre Channel fabric switch (announced in April 2001) currently being evaluated by a number of OEMs and resellers; (4) the Gibraltar managed hub designed 2 to provide centralized management of a SAN and (5) the Ventana SAN management software application which provides monitoring and control of SAN devices. We began shipments of our SAN products, in commercial quantities, in October 1995. Our primary customers included original equipment manufacturer or, OEM customers, and distribution channel partners. Our major current OEM customers include, among others, Hewlett-Packard Company, and Compaq Computer Corporation. We have a two-tier distribution channel comprised of distributors and resellers. Our major distribution customers currently consist of Bell Microproducts, Inc., Consan (a Gates/Arrow Company) and Tech Data Corporation. We believe that the SAN infrastructure created by our network products forms the foundation for a new data management architecture. Just as the infrastructure created by local area networks, or LANs, formed a platform for the development of client-server computing, we believe that the SAN infrastructure has the potential to enable the development of a distributed data management architecture. We plan to leverage our technological expertise, our market knowledge and the strength of our partnerships to drive the development of this architecture and create new opportunities for our business. We were incorporated in April 1992 in California as Gadzoox Microsystems, Inc. In May 1997, we changed our name to Gadzoox Networks, Inc., and in August 1997, we reincorporated in Delaware. In July 1999, we sold 3,500,000 shares of common stock to the public in our initial public offering. Our principal executive offices are located at 5850 Hellyer Avenue, San Jose, California 95138, and our telephone number is (408) 360-4950. Our corporate web site is located at www.gadzoox.com. The Gadzoox logo and Gadzoox(R) are registered trademarks of our company. Gibraltar(TM), Capellix(TM), Reflex(TM), SANtools(TM), Slingshot(TM), Ventana(TM), IntraCom(TM), Nomad(TM) and PerfectPort(TM) are trademarks of our company. This Form 10-K contains other trademarks and tradenames of other entities. INDUSTRY BACKGROUND Growth Of Enterprise Data The volume of data generated in today's business environment continues to grow at a significant rate. This growth is fueled by a number of factors, including: - the emergence and rapid growth of data-intensive applications such as e-commerce, on-line transaction processing, web-serving, digital video and other multimedia applications and enterprise resource planning; - the increasing demand for more comprehensive disaster recovery tools which can be deployed across greater distances; - the increasing importance of digital information as a strategic business asset; - advances in storage technology and the resulting decline in the cost of storage capacity; and - a trend toward distributing data in the enterprise client-server environment. Traditional Captive Storage Architecture The growth of the amount of enterprise data has resulted in a corresponding need to manage, share, back-up and make data widely accessible. This need has traditionally been addressed by connecting individual high-performance computers, known as servers, to dedicated storage devices. This approach results in a "captive" storage architecture where storage devices are connected to only one server, and not to any of the other servers utilized by an enterprise. These connections are made through the use of the SCSI technology. Traditional captive storage architecture has several significant limitations, including: - Capacity Constraints. SCSI technology cannot typically support more than 15 individual disk drives. In general, to add additional storage capacity, additional servers must be added, which is costly and inefficient. 3 - Performance Constraints. The bandwidth, or rate at which data can be transmitted, of commercially available SCSI technology is fixed at 40 or 80 megabytes per second. Accordingly, the addition of a new storage device may not result in a proportional increase in performance because the available bandwidth may be fully utilized by the amount of data already flowing between the server and the existing storage devices. Further, the addition of new storage devices may actually degrade performance as more devices compete to utilize available bandwidth. - Lack Of Management. SCSI technology does not have any inherent capability to manage connections, storage or data. As a result, servers are burdened with management tasks. This is cumbersome because there is no centralized monitoring and control. This is also inefficient because server bandwidth is spent managing data and not serving clients, generating a need for more servers. Because of this lack of centralized management, we believe the cost of managing storage exceeds the cost of the storage devices themselves. - Lack Of Availability And Disaster Tolerance. In general, a SCSI device can only be accessed by its dedicated server. If the server becomes unavailable for any reason, such as a breakdown of the server or a disaster affecting the entire data center, data on its connected storage devices becomes inaccessible. This lack of fault and disaster tolerance makes the enterprise vulnerable to server or data center failures. Because the SCSI standard typically limits the distance between servers and storage devices to 25 meters, redundant storage devices in remote locations are generally not practical or cost-effective. As a result, sustained data availability in a captive storage architecture following a system failure or disaster is difficult to achieve. - Lack Of Efficient Transmission Of Data Between Storage Devices And Client Applications. A SCSI device can only be connected between storage devices and servers. This tasks the server with providing the interconnect between the storage device and the application utilizing the data. This is inefficient because server bandwidth is spent transmitting data. - Lack Of Sufficient Distance. SCSI devices are typically limited to just a few meters of connection distance, depending on the speed of the SCSI device. This leads to problems where large data centers need to connect storage to servers, or in campus environments where buildings may share storage devices. Development Of Fibre Channel In 1994, the American National Standards Institute, or ANSI, approved the Fibre Channel standard as an open standard technology specifically for high performance, input/output intensive environments, such as server-storage connectivity. Commercially available Fibre Channel products today offer over 1-gigabit-per-second of bandwidth. The industry is expected to transition to 2-gigabit-per-second speeds in 2001. Multiple Fibre Channel links of 10 kilometers, or in certain instances 80 kilometers, may each be interconnected to enable long distances between servers and storage devices. Fibre Channel technology also enables hundreds, theoretically thousands, of storage devices and servers to be interconnected. The Need For A New Storage Architecture Despite the greater bandwidth and capacity offered by Fibre Channel technology, it alone does not address the data management, data availability and disaster tolerance issues resulting from the growth of enterprise data. A new storage architecture comprised of a new model for connecting storage devices with servers and a foundation for distributing data management applications is needed. The Need For A New Connection Between Sans And Local And Wide Area Networks, Or Lans And Wans Through the popularity of the Internet and the emergence of e-business systems, companies have come to rely on electronic data to conduct business. While the use of electronic data has streamlined business processes to reduce operating costs and expanded markets to increase revenue for many businesses, it has also 4 increased their vulnerability to system failures or site disasters. To minimize these risks, companies are implementing disaster tolerance systems that copy or "mirror" data from the company's primary SAN site to additional SAN locations to help ensure continuous availability of data. Although localized SAN installations based on Fibre Channel have provided solutions for specific server application needs, the absence of long distance connectivity capabilities has posed a barrier for large enterprises and service providers that need to interconnect remote SAN sites for the purpose of data replication and restoration. By connecting SANs to LANs or WANs, users can leverage the existing infrastructure of local and wide area networks to transmit data from one SAN site to another without incurring the cost and time of installing a new dedicated long distance SAN infrastructure. Managed Storage In An Environment Of Personnel Constraints And High Storage Growth As more and more applications and data move online with global requirements of 24 hours a day, 7 days a week availability, the systems to support these requirements need to change and become more efficient. The proliferation of distributed systems has resulted in many enterprises with hundreds or even thousands of servers and storage devices. This, combined with the rapid growth of storage in many enterprises, creates an unmet demand for storage management. Trained personnel to manage data day-to-day are often not available and backup remains too cumbersome. Physical storage needs to be moved, protected and allocated in a more dynamic and efficient manner. THE GADZOOX SOLUTION We sell hardware and software products that create SANs for the intelligent management of enterprise data. To address limitations of traditional captive storage architecture, we pioneered the development of the SAN by leveraging the capabilities of Fibre Channel technology to create a new network architecture designed to enable multiple storage devices to be connected to multiple servers. We deploy products to provide new ways of clustering storage devices, making the management of data and the addition of new storage devices more efficient. Additionally, we provide advanced management capabilities to make storage easier to manage and protect. We believe the combination of our technical innovation and our market vision has influenced and will continue to influence the evolution of the SAN market. We developed some of the first SAN devices and introduced products that are designed to manage data from within a SAN without relying on servers. Our products include hubs with intelligent diagnostics, a chassis switch based on the Fibre Channel Arbitrated Loop protocol, or FC-AL, a fixed-port FC-AL stackable switch, and the recently announced Slingshot 4128, a Fibre Channel fabric switch which is currently being evaluated by a number of OEMs and resellers. Utilizing the proven principles of centralized network management for LANs, we were also the first to deliver management network devices and management software for SANs. These devices are designed to centralize the monitoring, diagnosis and control of a SAN and address the limitations of traditional captive storage architectures in the following ways. Capacity Scalability Our hub, switch and SAN management products are designed to allow users to scale servers and storage capacity independently to meet their individual needs. Our products help users realize Fibre Channel technology's ability to connect hundreds of storage devices or subsystems to multiple servers. This is more cost-effective than the traditional captive storage architecture, which requires businesses to purchase more than one server to facilitate the addition of storage devices. Increased Performance Our hub and Capellix family of switch products are designed to provide access to data at speeds exceeding 1 gigabit per second. Our Capellix chassis switch has greater port capacity (scalable from 6 ports to 32 ports) and a faster switching backplane than the 8-port and 16-port SAN switches available from other 5 SAN vendors. Our Slingshot switch product has the highest port density in its class, and is designed to provide access to data at 2-gigabit-per-second speeds. This enables higher performance and more cost-effective scaling because more devices, manufactured by us or our competitors, can be connected through a single switch than can be connected through existing switches. Our products leverage the multiple server/multiple storage topology of SANs to allow multiple users simultaneous access to stored data over independent paths within the SAN. This permits faster access to data by more users than possible in traditional captive storage architecture. Manageability Our management software products are designed to provide centralized monitoring and control of storage and networking devices in a distributed SAN environment. For example, our proprietary management software features and Ventana SAN Manager software are designed to minimize downtime by monitoring, detecting, isolating and troubleshooting faults as they occur. Our products leverage the SAN environment to facilitate the sharing of storage resources, such as tape backup devices and disk arrays, or disk drives grouped together to provide added storage capacity. Our products also leverage the SAN environment to reduce the total cost of ownership of storage networks. We have designed our products to integrate with LAN management software tools, such as the Hewlett-Packard OpenView(TM), Computer Associates Unicenter(R) and IBM Tivoli(TM). We believe that centralized management results in a total cost of ownership model where the cost of data management is significantly less than the cost of the storage devices themselves. Data Availability And Disaster Tolerance Our products are designed to further enhance SANs by allowing network administrators to specify primary and secondary data transmission pathways known as failover links. SANs are substantially more fault tolerant than traditional captive storage architecture because access to storage devices on a SAN is independent of any single server. As a result, even if one or more servers fail, data stored on SAN storage devices is still accessible by other servers connected to the SAN. In addition, because Fibre Channel technology allows devices to be located farther apart physically than SCSI technology, storage devices on the same SAN can be placed in remote locations to increase disaster tolerance. Interoperability Our current products leverage the FC-AL protocol. This protocol is the most widely deployed Fibre Channel standard. As a result, our products are compatible with substantially all major Fibre Channel servers and storage subsystems. Additionally, our Capellix chassis product is highly interoperable with other products in the market due to (1) its ability to communicate to substantially all major Fibre Channel servers and storage subsystems; (2) its ability to interoperate with most hubs and switches manufactured by other SAN vendors; and (3) the ability of its chassis design to provide "future proofing" to allow for new printed circuit boards with new functionality to be easily added to the chassis. This interoperability allows customers to install our products into their existing networks to allow them to better preserve their investment in existing equipment and provide a path for upgrades. Our new product, the Slingshot 4218, which is currently being evaluated by a number of OEMs and resellers, is based upon the Fibre Channel fabric protocol, or FC-SW and has been designed to fully conform to the Fibre Channel Switch-2, or FC-SW-2 standard, which defines the standard method for fabric services in a multi-switch network. Modular Scalability The modular design of our products allow users to scale and upgrade the capabilities of their SANs as required. Our customers are able to meet their evolving storage and performance needs through the incremental installation or upgrade of switches and SAN management software features. 6 Increased Network Stability Our proprietary Reflex feature is integrated in all of our Capellix switch products and is designed to automatically bypass faulty links and devices to help ensure network stability. Our proprietary PerfectPort feature is designed to increase the reliability of each Fibre Channel link to our switch products. This enhances the reliability of the SAN. In addition, the use of PerfectPort in each link enables all devices in the SAN to be interconnected without limitation in the number of network devices or the distance between SAN devices. Platform For Advanced Data Management Our products are designed to allow storage devices to share data without the intervention of a server. This feature creates a platform that helps enable third-party applications, such as serverless backup applications that allow backups to be performed over a SAN without a server. Serverless backup helps alleviate servers and local area networks of backup traffic so they can more effectively serve clients. GADZOOX STRATEGY Our objective is to continue to develop and deliver innovative storage network products. Key elements of this strategy include the following: Leverage Experience in Storage Area Networks We intend to introduce high-quality, cost-effective products and product enhancements to meet the needs of the evolving SAN market. Our engineers have significant technological experience in both storage and networking. Our insight into the potential of Fibre Channel technology stems from the knowledge base of several of our employees who were involved in the establishment of the original Fibre Channel standards. We believe our participation on Fibre Channel and related standards committees, such as the Storage Networking Industry Association (SNIA), the Internet Engineering Task Force (IETF), the National Committee for Information Technology Standards (NCITS), and the Fibre Alliance, will enable us to extend our influence in the Fibre Channel market and into other technologies as they are applied to SANs. We believe this technological expertise has been instrumental in developing our SAN architecture and introducing innovative products and we intend to continue to devote substantial resources to our product development efforts. We remain committed to advancing the standardization of SAN capabilities through our participation in industry standards organizations, trade groups and strategic partnerships. For example, we have led the way in the development of SANmark(TM) conformance tests with the Fibre Channel Industry Association. These tests provide a mechanism to verify that devices are conforming to industry standards that Gadzoox is helping to develop, such as the FC-SW-2 standard which is currently out for public review and should be published shortly. We fully employ the standards of the National Committee for Information Technology Standards and other open standards bodies in our Slingshot family of Fibre Channel fabric switch products. Today, our personnel hold elected leadership positions in several industry working groups, including FC-SW-2, SNIA Technical Council and the FCIA SanMark Technical Committee and actively participate in other industry working groups including; FC-MI, T11.3, IPFC and FCIP. These industry working groups are comprised of representatives from various companies within the industry and their objectives include such things as promoting SAN interoperability standards, product technical advancements, product feasibility demonstrations and technical peer reviews. Participation and leadership positions in these groups is important to the Company as it gives the Company increased visability within the industry and helps to demonstrate the Company's expertise and competence in the storage area networking space. Develop Products Consistent With SAN Evolution Recognizing that SAN architecture was a new storage connectivity paradigm, we targeted our initial product development efforts to the introduction of active hubs as the basic building block of SANs. As SAN architecture began to gain market acceptance, we introduced managed hubs and SAN management software to allow centralized monitoring and control in larger distributed environments. In September 1999, we first commercially shipped the Capellix 3000 chassis switch, designed to provide highly scalable switching 7 capabilities with port counts from 6 ports to 32 ports, without the need to change other elements of the SAN, such as servers and storage devices. In March 2000, we first commercially shipped the Capellix 2000 stackable switch, an 8-port or 11-port switch. In April 2001, we announced the Slingshot 4218, an open standards-based Fibre Channel fabric switch. The Slingshot is currently being evaluated by a number of OEMs and resellers. We expect to begin shipping this product during the quarter ending September 2001. By basing new products on open standards, the need to reengineer systems to accommodate non-standards-compliant products, such as existing Fibre Channel FC-SW products, is diminished. By focusing on developing products consistent with SAN evolution, we believe that we have been a significant factor in the emergence of the SAN market. As SAN architecture gains wider market acceptance, we intend to continue to introduce products designed to enable greater capabilities. Develop Data Management Architecture We plan to leverage the SAN infrastructure to continue to develop a new data management architecture. Although SAN architecture addresses a number of problems resulting from the growth of enterprise data, we believe that its role will continue to evolve over time. Similar to the way that LAN architecture evolved from a connectivity method for the sharing of data and printers into an infrastructure that enabled the advent of client-server computing, we believe SAN architecture holds the potential of enabling further changes in the way data is managed. By eliminating the dependency between individual servers and the access to storage, SAN architecture enables the removal of data management applications from each server and consolidation in the SAN. In doing so, server processing capacity can be applied to business critical applications while data management functions are distributed within the SAN infrastructure, thereby creating a distributed data management environment. We believe that the improvements in reliability and security resulting from a distributed data management environment can enhance overall data availability. Correspondingly, the elevated role of an intelligent SAN infrastructure can result in higher-value SAN product segments. To influence these evolutionary steps, we plan to work with industry standards organizations, OEM customers, distribution channel partners and strategic partners to develop, standardize and promote a distributed SAN-based data management architecture. Focus On Key OEM Customers And Expand Distribution We intend to continue to focus on our OEM customer and distribution channel relationships to develop new markets. Our major OEM and distribution customers currently consist of the following:
OEM CUSTOMERS DISTRIBUTION CUSTOMERS ------------- ---------------------- Hewlett-Packard Company Bell Microproducts, Inc. Compaq Computer Company Consan (a Gates/Arrow Company) Tech Data, Inc.
While our OEM customers have historically accounted for the majority of our net revenues, our success depends largely on sales to OEMs and, in part, on the successful creation of an open market channel through distributors and resellers. Approximately 12% of our net revenues for the quarter ended March 31, 2001 came from distributor and reseller partners and 88% from OEM customers. We have taken several actions to improve our distribution channel partners' abilities to sell our products at the end-user level, including expanding training and customer service capability and implementing new reseller and distributor programs. However our primary sales focus is on OEM accounts. We offer a comprehensive training and marketing support program to our partners through our Gadzoox Associates in Networking, or GAIN, program. We intend to enter into agreements with additional distributors or resellers, both in the United States and abroad, to increase our geographic coverage and address new vertical markets, however, we cannot assure you that we will be successful in these efforts or that our net revenues will increase if we are successful. 8 Working Closely With Strategic Partners And Industry Alliances We intend to work closely with leaders in the storage, networking and computing industries to develop new and enhanced SAN products. We believe that establishing strategic relationships with technical partners is essential to facilitate the efficient and reliable integration of their capabilities into SAN solutions. To this end, we have developed strategic relationships and industry alliances with leading technology companies including the following: ATL Products (data backup applications) Compaq Computer Corporation (storage management) Exabyte Corporation (data backup applications) Legato Systems, Inc. (data backup application) Tivoli Systems Incorporated (network management) Microsoft Corporation (server clustering and web-based management) Novell, Incorporated (server clustering, network management) Seagate Technologies, Inc. (storage device interface technologies) Sun Microsystems, Inc. (storage management architecture) Veritas Software Corporation (storage management architecture) Computer Associates (data backup application, network management) Lucent Technologies (Fibre Channel -- Internet Protocol standards) Employ Reusable Elements Our products incorporate reusable application specific integrated circuit, or ASIC, cores and firmware agents, or small software applications used to carry out specific functions. This allows us to accelerate time-to-market, reduce development costs and leverage interoperability with existing products. In December 2000, we discontinued our relationship with Vitesse Semiconductor Corporation, our previous supplier of ASICs and have formed a strategic and business partnership with LSI Corporation to assist in the design as well as manufacture of our proprietary ASICs. We intend to continue developing reusable elements and leveraging them in order to quickly respond to changes in market requirements. PRODUCTS We offer a comprehensive line of networking products consisting of SAN managed hubs, switches and management software. Our products are designed to address the needs of our existing and potential customers to enable the adoption and growth of SANs for a broad range of markets and applications. In fiscal 2001, approximately 74% of our revenues were derived from sales of our hub products and 26% from Capellix switch products. In fiscal 2000, 100% of our revenues were derived from the sale of our hub products. In fiscal 1999, substantially all of our revenues were derived from sales of our hub products. We expect that a substantial majority of our net revenues for fiscal year 2002 will be derived from sales of new products currently under development or evaluation, including the Slingshot 4218 Fibre Channel fabric switch. 9 Network Products Our line of network products currently includes a managed hub, chassis and stackable switches. Our products enable the cost-effective installation, scaling and extension of SAN capacity, performance and management capabilities. The following product listing summarizes the key features and benefits of our networking products: HIGH-END HUB Gibraltar C/XM First Commercial Shipment: February 1997 Description: Managed hub 10-port managed hub Benefits: Enables efficient scalability for enterprise environments Management via Ventana Fully FC-AL standards compliant FC-AL SWITCHES Capellix 3000 First Commercial Shipment: September 1999 Description: Multi-protocol chassis switch Modular chassis-based design scalable from 6 ports to 32 ports 28-Gigabit-per-second switching backplane Innovative storage switch technology Supports multiple Fibre Channel and networking protocols through protocol plug-in modules Benefits: High bandwidth backplane enables more effective scalability than 8-port or 16-port switches Designed to be integrated without reengineering or changes to existing devices Plug-in modules provide configuration flexibility Modular hardware and agent design offers upgradability and extensibility Management via Ventana communicates with most other vendors' commercially available hubs and switches, fully FC-AL standards compliant Capellix 2000 First Commercial Shipment: March 2000 Description: Stackable 8-port switch extends to 11-ports with plug-in module
10 Benefits: Plug-in module for port expansion Modular hardware and agent design offers upgradability and extensibility Management via Ventana communicates with most other vendors' commercially available hubs and switches FIBRE CHANNEL FABRIC SWITCH Slingshot 4218 First Commercial Shipment: Expected quarter ending September 2001, announced in April 2001 Currently under evaluation by OEMs and resellers Description: 18-port Fibre Channel Fabric Switch 1 gigabit or 2 gigabit speed, auto-negotiated port-by-port Open standards-based (FC-SW-2) Benefits: 18 ports in 1U chassis for high density, low footprint Enables heterogeneous SAN fabrics and interoperability with existing 1 gigabit devices Load sharing trunks to enable selectable bandwidth between switches Management via Ventana SANtools FX
Management Products Our modular, upgradable management products are designed to enable users to deploy management capabilities as required and enhance the ability to maintain compliance with future management standards. To minimize the requirement for multiple connections from managed hubs to a management console, our products employ our proprietary IntraCom proxy management system. Unlike other products that impose distance limitations or require multiple connections, our proxy management system is designed to enable a single managed "master" device to manage other "slave" devices over existing Fibre Channel links without impacting the flow of data. 11 The following product listing summarizes the key features and benefits of our management products: MANAGEMENT SOFTWARE Ventana SAN Manager and Ventana SANtools First Commercial Shipment: May 1997 Description: SAN management application monitors, detects, isolates and troubleshoots faults as they occur Benefits: Centralized network and data management, enhances data availability Designed to integrate into enterprise platforms such as OpenView(TM), Unicenter(R) and Tivoli(TM)
CUSTOMERS We began commercial shipment of our SAN products in fiscal 1996, and as of March 31, 2001, we had shipped products to over 97 organizations in 30 countries. OEM Customers Historically, we have focused on sales to OEM customers because we believed that they were most capable of influencing the development of the early SAN market. We continue to believe that by partnering with leading OEM customers, we will continue to be well positioned to introduce new products and develop new markets. We work closely with our OEM customers as we develop new products and rely on these OEM customers for market feedback. In fiscal 2001, Hewlett-Packard Company represented approximately 42% of our net revenues and Compaq Computer Corporation represented approximately 33% of our net revenues. In fiscal 2000, Hewlett-Packard Company represented 33% of our net revenues and Compaq Computer Corporation represented 17% of our net revenues. In fiscal 1999, Hewlett-Packard Company represented 42% of our net revenues and Compaq Computer Corporation represented 15% of our net revenues. We focus our sales and marketing efforts on OEM customers that manufacturer Unix and Windows NT servers and high-end disk and tape storage subsystems. OEM customers have been a key to our growth in the various stages of the emerging market and have represented a significant portion of our revenues. We believe that this is largely due to the ability of our OEM customers to deliver complete, factory-configured solutions, which are installed and serviced by their dedicated technical support organizations. Even as the technology of a given solution matures and becomes suitable to transition to an open market integration model, the evolutionary nature of the SAN market should enable us to continue to present our OEM customers with the opportunity to integrate and deploy new capabilities as they are developed. To help ensure the successful deployment of these capabilities, we plan to continue to strengthen our OEM customer relationships and focus on the advancements of technology and standards. Distribution Channel Partners As the SAN market has matured, we have developed a two-tier distribution channel that is comprised of distributors and resellers. Distributors and resellers enable us to pursue a number of vertical markets and applications, such as e-commerce, internet service providers, digital video, digital publishing, oil and gas exploration and medical imaging. Our major distribution channel partners consist of Bell Microproducts, Inc., Consan (a Gates/Arrow Company) and Tech Data Corporation. We maintain a two-tier distribution marketing program. Our Gadzoox Associates in Networking, or GAIN, program addresses the SAN market development challenges and opportunities. By providing our partners with a comprehensive set of sales tools and in-depth training in technology, products, interoperability 12 and applications, we believe that we can enhance their ability to identify sales opportunities and deploy solutions. As a result of lower-than-expected net revenues from distribution channel partners, we have taken several actions to improve sell-through at the end-user level, including expanding training and customer service capability and implementing new reseller and distributor programs. In addition to partner development activities, we also actively work on end-user education. With the goal of generating awareness and end-user demand for SAN solutions, we have participated in a number of seminars with partners, such as ATL Products, Inc., Compaq Computer Corporation, Chaparral Network Storage, Inc., Computer Associates International, Inc., Exabyte, Inc., Hewlett-Packard Company, Legato Systems, Inc., Microsoft Corporation, Novell, Inc., Veritas Software Corporation and XIOtech Corporation, Inc. We plan to continue these educational seminars in conjunction with our channel and strategic partners. In addition, during the fiscal year 2001, we launched a SAN Training and Certification program. We cannot assure you that these programs will be effective to increase sales into and through the distribution channel or to increase our net revenues. Historically, we have derived net revenues from a limited number of OEM and distribution channel partners, which subjects us to business risks. Furthermore, the inability or unwillingness of our distribution channel partners to resell SAN networking equipment, including full SAN solutions, would significantly reduce our net revenues which would harm our business. SALES, MARKETING AND CUSTOMER SERVICE Our sales and marketing strategy is focused on the development of the SAN market through relationships with OEM customers and distribution channel partners. OEM customers have demonstrated the ability to resell our SAN products due, in part, to the length of time they have been involved in the SAN marketplace and the strength of their internal technical, sales and marketing structures. OEM customers are able to sell full SAN solutions including servers, storage and SAN switches. Our distribution channel partners have participated in the SAN market for a shorter period of time and often do not have fully trained technical, sales and marketing staff. As a result, they are not as well positioned as our OEM customers to provide full solution sales. Additionally, distribution channel partners may not be able to effectively compete with OEMs. We believe that selling through both OEM and distribution channel customers will help the SAN market evolve and ultimately enhance our ability to address a large end-user base. However, our distribution channel partners must establish strong technical, sales and marketing capabilities to effectively perform in this marketplace. As of March 31, 2001, our sales and marketing organization consisted of a total of 67 people, including field sales representatives, systems engineers, applications engineers, product marketing, product management, channel marketing and marketing communications. Our field sales personnel are located in San Jose and Arcadia, California; Austin, Grapevine, Kingwood and Plano, Texas; Dawsonville, Georgia; Rolling Meadows, Illinois; Babylon, New York; Berkshire, England; North Point, Hong Kong and Munich, Germany. Customer Service Our customer service organization provides product and technical support to our OEM customers and distribution channel partners as well as warranty repair or replacement services. Through our indirect sales model and our partner training programs, we minimize the need for a large end-user support organization. We provide direct self-service support for our products through our website. As of March 31, 2001, our customer service organization included 6 full-time employees. We plan to augment our internal staff as required in the future. TECHNOLOGY We possess considerable experience in a wide variety of technologies, including Fibre Channel technology, local area network and wide area network technologies, routing technologies, core ASIC design, systems design and software design, which we utilize in designing and developing our products. 13 Fibre Channel And Other Networking Technologies Fibre Channel technology has been adopted by and is being supported by most major computer and storage device manufacturers, including International Business Machines Corporation, Sun Microsystems, Inc., Hewlett-Packard Company, Compaq Computer Corporation, Dell Computer Corporation, Seagate Technology, Inc. and EMC Corporation. There are two main industry standards for the Fibre Channel protocol; FC-AL and FC-SW. Based on the cost-effective nature and wide industry deployment of the FC-AL protocol, we elected to base the design of our initial hub and switch products on that standard. As the needs of the market evolve and as more third- party products are developed to interoperate with other protocols, including FC-SW, we plan to introduce products and modular enhancements that support these protocol standards. Fibre Channel standards continue to be enhanced and new industry standards are being developed. We intend to fully employ standards and introduce products and modular enhancements that support new protocol standards in areas such as SCSI technology, Infiniband, Ethernet, Gigabit Ethernet, asynchronous transfer mode (ATM), Fibre Channel FC-SW, DWDM and transmission control protocol/Internet protocol (TCP/IP). We believe that knowledge in Fibre Channel technology is critical in achieving and maintaining a leading market position. A number of our engineers have contributed to the development and standardization of Fibre Channel. Based on this experience, we believe we possess insight and understanding with respect to the capabilities and limitations of this technology. Core ASIC Design We design our own core ASICs and employ personnel with expertise in semiconductor process and design methods. Our proprietary ASICs are manufactured using complementary metal-oxide semiconductor, or CMOS, technologies. We have successfully designed proprietary ASICs with speeds exceeding 1 gigahertz. We discontinued our business relationship with Vitesse Semiconductor, Inc. in December 2000, our previous ASIC supplier, and have formed a strategic and business partnership with LSI Logic Corporation to assist in the design as well as manufacture of our proprietary ASICs. Our CMOS ASIC staff possess experience in ASIC architecture, design and testing. System Design We employ our own computer aided design (CAD) engineers and design our printed circuit boards, or PCBs. We believe our systems design team has experience in the containment of high-frequency electromagnetic interference, or EMI, which is inherent in high-speed networking devices. We also have expertise in chassis design, including design for manufacturability, testability, usability, reliability and low cost. Software We employ software engineers with experience in embedded firmware, distributed agents and graphical user interface technologies. The team has experience in programming for several microprocessors and operating environments. We have considerable experience in software implementation to support Fibre Channel protocol standards, such as Fibre Channel Physical Layer, or FC-PH, FC-AL, small computer system interface over Fibre Channel (FCP), Fibre Channel fabric loop attach, or FC-FLA, Fibre Channel general services, or FX-GS, and FC-SW. We have also demonstrated development capabilities in proprietary and standard SAN management protocols. Our team also possesses experience in the area of graphical user interface software and network management middleware. We employ personnel with expertise in a variety of application development environments and tools. Our graphical-user interface development efforts focus on the Microsoft Windows family of operating systems, as well as platform-independent applications, through the Java programming environment. 14 RESEARCH AND DEVELOPMENT Our research and development expenses were $29.4 million in fiscal 2001, $18.2 million in fiscal 2000 and $13.9 million in fiscal 1999. We believe that our research and development efforts are essential to our ability to develop and deliver innovative products that address the needs of the market and help evolve the capabilities of SANs. At March 31, 2001, we had 68 full time employees engaged in research and development. We recognize the need to integrate new and enhanced technologies into our products and to continue to extend the open SAN architecture. Research and development programs that we are currently involved in include 2-gigabit-per-second ASIC cores and transceivers, high availability clustering architectures, SAN management application programming interfaces (APIs), distributed SAN management agents and the integration of SAN, local area network and wide area network technologies. In addition to the development of proprietary core technologies, we plan to continue partnerships with other leading providers of SAN technologies, products and services to jointly develop architectures and industry standards. Our product development efforts may not result in commercially viable products, and our products may be made obsolete by changing technology or new product announcements by other companies. MANUFACTURING Contract Manufacturing Our manufacturing strategy focuses on the use of contract manufacturing for the material procurement, assembly, test, packaging, warehousing and shipment of our products to our customers. Based on its strength in the volume manufacture of high-speed data networking equipment, we selected Sanmina Corporation as our contract manufacturing partner. Using a contract manufacturer allows us to reduce costly investment in manufacturing capital and inventory warehousing. While our contract manufacturer manages material procurement for the majority of the components that are incorporated in our products, we continue to manage the evaluation and selection of certain key components. These components include our proprietary ASICs, power supplies, chassis and optical transceivers. In addition to the management of key components, our internal manufacturing expertise is focused on product testability, manufacturability and the transfer of products from development to manufacturing. Although we use standard parts and components for our products where possible, we currently purchase several key components used in the manufacture of our products from single or limited sources. Our principal single source components include ASICs, optical transceivers and power supplies. ISO 9001 In June 1999, we received ISO 9001 registration from SGS International Certification Services, Inc. ISO 9001 is an international set of quality assurance standards for companies involved in the design, development, manufacturing, installation and servicing of products or services. These standards are set by the International Organization for Standardization (ISO), an international federation of national standards bodies. To be recommended for ISO 9001 certification, a company must be audited by an ISO accredited auditing company and must meet or surpass the ISO standards. We believe that our customers value the processes, control and traceability that are required to achieve ISO 9001 certification. COMPETITION The competitive environment in the SAN market is still developing. We anticipate that the market for our products will continue to be highly competitive, continually evolving and subject to rapid technological change. New SAN products are being introduced by various server and storage providers as well as our current and future competitors, and existing products will be continually enhanced. We face competition primarily from other sellers of SAN hub and switch products, including, but not limited to, Brocade Communication Systems, Inc., McDATA Corporation, QLogic Corporation and Vixel Corporation, in the SAN switch market, and Emulex Corporation and Vixel Corporation, in the SAN hub market. Furthermore, although we 15 currently offer products that are complimentary to SAN software products offered by companies such as Legato Systems, Inc. and Veritas Software Corporation, they and other enterprise software developers may in the future compete with us. We also compete with providers of data storage solutions that employ traditional technologies, including SCSI-based technology such as, Adaptec, Inc., LSI Logic Corporation and QLogic Corporation. In addition, as the market for SAN products grows, we may face competition from traditional networking companies and other manufacturers of networking equipment. These networking companies may enter the SAN market by introducing their own products, acquiring an existing SAN infrastructure provider or by entering into alliances with an existing SAN provider. It is also possible that OEM customers could develop and introduce products competitive with our product offerings. We believe the competitive factors in the SAN market include the following: - product performance and features; - product reliability and interoperability; - price; - strength of customer relationships, including OEM and distribution channel partners; - ability to meet delivery schedules; and - customer service and technical support. Some of our current and potential competitors have longer operating histories, significantly greater resources and name recognition and a larger installed base of customers than we have. As a result, these competitors may have greater credibility with our existing and potential customers. They also may be able to adopt more aggressive pricing policies and devote greater resources to the development, promotion and sale of their products than we can to ours, which allows them to respond more quickly to new or emerging technologies and changes in customer requirements. In addition, some of our current and potential competitors have already established supplier or joint development relationships with divisions of our current or potential customers. These competitors may be able to leverage their existing relationships to discourage these customers from purchasing additional products from us or persuade them to replace our products with their products. Increased competition could result in pricing pressures, reduced sales, reduced margins, reduced profits, reduced market share or the failure of our products to achieve or maintain market acceptance. We may not have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully in the future. Additionally, we may not be able to compete successfully against current or future competitors and competitive pressures may materially harm our business. INTELLECTUAL PROPERTY Our success depends on our proprietary technology. We rely on a combination of patents, trademarks, and trade secrets, as well as confidentiality agreements and other contractual restrictions with employees and third parties, to establish and protect our proprietary rights. We currently hold six United States patents with respect to our SAN related technology that expire between 2013 and 2016. We also have five pending patents in the United States with respect to our technology and are seeking patent protection for certain aspects of technology in selected international locations. However, it is possible that patents may not be issued for these applications. All of our software products are copyrighted with our banners and notices. We have been granted registration of two trademarks in the United States. Despite precautions, third parties could copy or otherwise obtain and use our products or technology without authorization or develop similar technology independently. The measures we undertake may not be adequate to protect our proprietary technology and may not preclude competitors from independently developing products with functionality or features similar to our products. There can be no assurances that such precautions we take will prevent misappropriation or infringement of our technology. Failure to protect our intellectual property could materially harm our business. 16 It is possible that litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of our resources and could materially harm our business. From time to time, we have received, and may receive in the future, notice of claims of infringement of other parties' proprietary rights. Infringement or other claims could be asserted or prosecuted against us in the future, and it is possible that past or future assertions or prosecutions could harm our business. Any such claims, with or without merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause delays in the development and release of our products, or require us to develop non-infringing technology or enter into royalty or licensing arrangements. Such royalty or licensing arrangements, if required, may not be available on terms acceptable to us, or at all. BACKLOG At March 31, 2001, the backlog for our products was approximately $1.7 million. This backlog represents orders that are scheduled for delivery to customers during the quarter ending June 2001. This compares to backlog of approximately $5.1 million at March 31, 2000, for delivery to customers during the quarter ending June 2000. Typically, our OEM customers forecast expected purchases on a three to six month rolling basis, as compared to distribution channel partners which order as required with minimal order fulfillment time. All orders are subject to cancellation or delay by the customers with limited or no penalty. Therefore, our backlog is not necessarily indicative of actual sales for any succeeding period. EMPLOYEES As of March 31, 2001, we had 227 full time employees, of whom 68 employees were engaged in research and development, 50 were in engineering services, 67 were in sales and marketing, 23 were in manufacturing and 19 were in finance, administration and information services. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good. Our future performance depends in significant part upon the continued service of our key technical, sales and senior management personnel, none of whom is bound by an employment agreement requiring service for any defined period of time. The loss of the services of one or more of our key employees could have a material adverse effect on our business, financial condition and results of operations. Our future success also depends on our continuing ability to attract, train and retain highly qualified technical, sales and managerial personnel. Competition for such personnel is intense, and we may not be able to retain our key personnel in the future. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information regarding our executive officers as of June 29, 2001:
NAME AGE POSITION ---- --- -------- Michael Parides(1)........................... 42 President, Chief Executive Officer, and Director Wayne Rickard................................ 42 Senior Vice President, Research and Development Ronald von Trapp............................. 53 Vice President, Worldwide Sales David Eichler................................ 52 Vice President, Finance and Chief Financial Officer Clark Foy.................................... 37 Vice President, Marketing William Hubbard.............................. 57 Vice President, Manufacturing Steven Dalton................................ 42 Vice President, Engineering Kristin Strout............................... 34 Vice President, Human Resources
--------------- (1) Member of the audit committee. Michael Parides has served as our President, Chief Executive Officer and as a director of Gadzoox since September 2000. In January 2000 Michael joined the Company as Vice President of Advanced SAN 17 Solutions and Customer Service and was promoted in June 2000 to Chief Operating Officer. From June 1999 to January 2000, Mr. Parides was the Group Vice President of the Storage, Computer Systems, Software and Documents Management businesses at Dataquest/Gartner Group, a market research company. From November 1997 to June 1999, Mr. Parides was an independent consultant. From September 1996 to November 1997 he served as Vice President of Marketing of the Workstation, System and Server Division at Quantum Corporation, a storage systems company, or Quantum. From June 1995 to September 1996 Mr. Parides was the Vice President of Marketing, Consumer Desktops at IBM, a computer and software company. Mr. Parides holds a B.S. in electrical engineering from Rutgers University and an MBA from Duke University. Wayne Rickard joined us in April 1996 initially as our Vice President of Research and Development and General Manager at our Placentia, California facility. In January 1999 Mr. Rickard was promoted to Senior Vice President of Research and Development. In June 2000 Mr. Rickard was promoted to Chief Technical and Strategic Officer and has been serving in this capacity since that time. From September 1981 until joining us in April 1996, Mr. Rickard worked at Emulex Corporation, a data networking company, where he last served as senior director of engineering from April 1994 through April 1996. Mr. Rickard holds a B.S. in electrical engineering from California State University, Fullerton and an M.B.A. from Pepperdine University. Ronald von Trapp joined us in October 2000 as Vice President of Worldwide Sales. From August 1999 to September 2000, Mr. von Trapp was Vice President of Worldwide Sales at Vixel Corporation, a SAN switch company. From October 1997 to July 1999, Mr. von Trapp served as Vice President Worldwide Sales and Marketing for Mylex Corporation, a RAID storage systems company. From February 1997 to September 1997, he served as Vice President North American Sales for Maxtor Corporation, a storage systems company. From October 1988 to July 1996, Mr. von Trapp was Director of North American Distribution Sales for Quantum. Mr. von Trapp attended California State University, Fullerton. David Eichler joined the Company in May 2001 as Vice President of Finance and Chief Financial Officer. From January 1999 to May 2001, Mr. Eichler was Vice President of Finance and Administration and Chief Financial Officer for Alliance Semiconductor Corporation, a memory semiconductor company. Mr. Eichler served as Vice President of Finance and Chief Accounting Officer for Adobe Systems Inc., a software company, from December 1997 to December 1998. From March 1994 to November 1997, Mr. Eichler was Senior Vice President of Finance and Administration and Chief Financial Officer for Hyundai Electronics America, a semiconductor, computer and storage systems and telecommunications systems company, and served on the board of directors for three subsidiary companies. Mr. Eichler also held a number of senior financial management positions with Tandem Computers Inc., a fault-tolerant, mini-computer company. Mr. Eichler holds an MBA from the University of California, Los Angeles, a B.S. in accounting from Northeastern University and is a certified public accountant. Clark Foy joined the Company in June 2000 as Vice President of Marketing. From June 1997 to June 2000, Mr. Foy served in a number of senior management positions at Quantum, including Vice President of Marketing, Director of Strategic and Technical Marketing and Product Team Leader in the High-End Storage Division, as well as Director of Strategic Planning for the Hard Disk Drive Group. From July 1994 to May 1997, Mr. Foy held a number of management positions with Compaq Computer Corporation, a computer systems company, including Manager of Product Strategy and Planning, Manager of Business Unit Strategy and Planning, and Manager of Business Planning for the Desktop PC Division. Mr. Foy holds an MBA from Northwestern University and a B.S. in business administration from Miami University of Ohio. William Hubbard has served as Vice President of Manufacturing since September 1997. From May 1995 to July 1997, Mr. Hubbard served as Vice President, Manufacturing for Gregory Associates, a contract manufacturing company. From March 1994 to May 1995, Mr. Hubbard was Vice President of Operations for Hughes LAN Networks, a supplier of local area networking equipment. Mr. Hubbard holds a B.S. in manufacturing technology from Montana State University and an M.S. in Management Science and Engineering from Worchester Polytechnic Institute. Steven Dalton joined us in January 2000 as our Vice President of Development. From October 1998 to January 2000, Mr. Dalton served as the Vice President of Engineering, Americas for Force Computers, Inc. 18 From February 1997 to October 1998 Mr. Dalton was Vice President of Product Development for Auspex Systems, Inc., or Auspex, a developer and manufacturer of network attached storage devices. From March 1995 to September 1996, Mr. Dalton served as Vice President of Engineering of Auspex and in September 1996, he was promoted to President and Chief Technical Officer, in which capacity he served until February 1997. Mr. Dalton holds a BSET degree from California Polytechnic State University and is currently enrolled in the MBA program at Golden Gate University. Kristin Strout joined the Company in February 2001 as Vice President of Human Resources. From October 1998 to May 2000, Ms. Strout served as Regional HR Planning Director, Asia Pacific for Lucent Technologies, a telecommunications company. From January 1996 to September 1998, Ms. Strout was Director and Senior Management Consultant at GML Consulting Limited, a human resource and management consulting company based in Hong Kong. Between May 1992 and January 1996, Ms. Strout was Human Resources Consultant with HR Strategies, a human resources consulting company. Ms. Strout holds a B.A. degree in Psychology from Stanford University. ITEM 2. PROPERTIES Our corporate headquarters and engineering facility of approximately 65,000 square feet is located in San Jose, California. We lease this facility pursuant to a lease agreement that expires in November 2005. Additionally, the Company is subleasing approximately 8,000 square feet of adjacent space which expires in January 2002. Our research and development facility of approximately 20,000 square is located in Irvine, California. We lease this facility pursuant to a lease agreement that expires in April 2005. Our international sales offices are located in executive suites in London and Munich. We lease these facilities pursuant to lease agreements that expire in July and August 2001 respectively. We expect to renew these leases shortly. We also lease approximately 11,000 square feet in San Jose, California pursuant to a lease that expires in January 2002. We vacated this facility in October 1998 when we moved to our corporate headquarters facility. We sublease this facility to multiple tenants on terms that are co-terminous with our lease expiration date of January 2002. In May 2000, we entered into an agreement for a term of seven years to lease an additional 73,000 square feet in a new building adjacent to our existing corporate headquarters beginning August 2001. In March 2001 we entered into an amendment of that lease pursuant to which the landlord of the building agreed to seek a replacement tenant for the premises at equal or higher rent and similar terms. If the landlord is successful in doing so, or we are able to find a replacement tenant on terms acceptable to the landlord, the landlord will release us of our obligation with respect to this building effective as of the commencement of the replacement lease. In connection with the amendment, we issued to the landlord warrants to purchase 50,000 shares of our common stock at a price of $3.00 per share. The company has agreed to issue the landlord a warrant to purchase an additional 50,000 shares of our common stock if it is successful in finding a replacement tenant. ITEM 3. LEGAL PROCEEDINGS On June 6, 2001, a putative securities class action, captioned Cooper v. Gadzoox Networks, Inc., et al., Civil Action No. 01-CV-5309-RO, was filed against us, three of our former officers and Credit Suisse First Boston Corporation and BancBoston Robertson Stephens, Inc., two underwriters in our initial public offering, in the United States District Court for the Southern District of New York. The complaint alleges violations of Section 11 of the Securities Act of 1933 ("Securities Act") against all defendants, a violation of Section 15 of the Securities Act against the former officers, and violations of Section 12(a)(2) of the Securities Act and Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5., promulgated thereunder) against the underwriters. The complaint seeks unspecified damages on behalf of a purported class of purchasers of common stock between July 19, 1999 and December 6, 2000. As of June 18, 2001, various plaintiffs have filed similar actions asserting virtually identical allegations against at least 45 other companies. To date, there have been no significant developments in the litigation. As of June 26, 2001, we have received two substantially identical lawsuits, and anticipate that additional related lawsuits may be brought against us with substantially 19 identical allegations to the Cooper lawsuit. We further anticipate that all such lawsuits will eventually be coordinated or consolidated with one another. We intend to defend the lawsuits vigorously. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock has been quoted on the Nasdaq National Market under the symbol "ZOOX" since our initial public offering on July 19, 1999. Prior to this time, there was no public market for our stock. The following table sets forth the high and low closing sales prices per share of our common stock as reported on the Nasdaq National Market for the periods indicated. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. As of June 18, 2001 there were 312 holders of record of our common stock. The following table set forth, for the periods indicated the high and low closing sales prices on Nasdaq National Market for our common stock.
SALE PRICE ----------------- HIGH LOW ------- ------- Fiscal 2002: Third Quarter (through November 6, 2001).................. $ 1.240 $ 0.920 Second Quarter............................................ $ 3.190 $ 0.99 First Quarter............................................. $ 3.650 $ 1.500 Fiscal 2001: Fourth Quarter............................................ $ 5.062 $ 1.468 Third Quarter............................................. $ 6.750 $ 2.093 Second Quarter............................................ $14.125 $ 6.968 First Quarter............................................. $46.750 $13.687 Fiscal 2000 Fourth Quarter............................................ $72.125 $37.500 Third Quarter............................................. $86.625 $43.563 Second Quarter (from July 20, 1999)....................... $97.125 $53.875
In April 2000, we issued an aggregate of 239,444 unregistered shares of our common stock to the former stockholders of SmartSAN Systems, Inc. ("SmartSAN") in connection with the merger of SmartSAN with one of our wholly owned subsidiaries. The issuance was except from registration pursuant to Section 4(2) of the Securities Act of 1933 and Regulation D based on the representations by the former stockholders of SmartSAN that they did not have a present view towards a distribution of the shares and there was no general advertisement conducted in connection with the issuance of the shares. In May 2001, we sold 5.6 million shares of our common stock to three investors for net proceeds of approximately $14.5 million. The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933 and Regulation D based upon the representations of each of the investors that it was an "accredited investor" as defined under Regulation D and that it was purchasing such shares without a present view towards a distribution of the shares. In addition, there was no general advertisement conducted in connection with the sale. In August 2001, we sold 5.0 million shares of our common stock to three investors for net proceeds of approximately $7.5 million. The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933 and Regulation D and that it was purchasing such shares without a present view 20 towards a distribution of the shares. In addition, there was no general advertisement conducted in connection with the sale. In connection with the May 2001 sale of common stock, the Company issued a warrant to purchase 168,000 shares of common stock to its financial advisor for its assistance in the investor search. The warrant is immediately exercisable at $4.14 per share, is nonforfeitable and expires three years from the date of grant. In March 2001, we entered into an amendment agreement for a leased facility. In connection with the amendment, we issued to the landlord a warrant to purchase 50,000 shares of our common stock at a price of $3.00 per share. The warrant is immediately exercisable, are nonforfeitable and expire three years from the date of grant. Each warrant issuance was exempt from the registration pursuant to Section 4(2) of the Securities Act based upon representation of each of the warrant holders that it was an "accredited investor" as defined under Regulation D and that it would be purchasing such securities without a present view towards a distribution of the securities. In addition, there was no general advertisement conducted in connection with either warrant issuance. ITEM 6. SELECTED FINANCIAL DATA You should read the selected financial data set forth below in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our Financial Statements and the Notes thereto included elsewhere in this report. The statements of operations data for the years ended March 31, 2001, 2000, and 1999, and the balance sheet data at March 31, 2001 and 2000, are derived from, and are qualified by reference to, the audited Financial Statements and Notes thereto appearing elsewhere in this report. The statements of operations data for the years ended March 31, 1998 and 1997, and the balance sheet data as of March 31, 1999, 1998 and 1997, are derived from, and are qualified by reference to, financial statements not appearing in this report. Historical results are not necessarily indicative of results that may be expected for any future period. The change in accounting policy relating to sales to distributors in the year ended March 31, 2001, has impacted the year over year compatibility of the selected financial data.
YEAR ENDED MARCH 31, --------------------------------------------------- 2001 2000 1999 1998 1997 -------- -------- -------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Net revenues....................................... $ 33,290 $ 47,931 $ 24,821 $ 9,811 $ 823 Cost of revenues................................... 32,131 26,128 18,638 7,898 483 -------- -------- -------- -------- ------- Gross margin..................................... 1,159 21,803 6,183 1,913 340 -------- -------- -------- -------- ------- Operating expenses: Research and development......................... 29,368 18,223 13,928 7,178 2,168 Sales and marketing.............................. 23,982 11,638 5,765 2,974 1,126 General and administrative....................... 7,992 4,285 1,649 1,774 902 Amortization of acquired intangible assets....... 3,842 -- -- -- -- In-process research and development costs........ 4,900 -- -- -- -- Impairment of long lived assets.................. 17,829 -- -- -- -- Restructuring and other expenses................. 2,513 -- -- -- -- Amortization of deferred compensation............ 608 1,285 547 -- -- -------- -------- -------- -------- ------- Total operating expenses....................... 91,034 35,431 21,889 11,926 4,196 -------- -------- -------- -------- ------- Loss from operations............................... (89,875) (13,628) (15,706) (10,013) (3,856) Interest income, net of interest expense........... 2,332 3,267 (226) 373 259 Sale of electronic test equipment rights, net...... -- -- -- -- 1,508 -------- -------- -------- -------- ------- Net loss before cumulative effect of accounting change........................................... $(87,543) $(10,361) $(15,932) $ (9,640) $(2,089) Cumulative effect of accounting change............. (5,300) -- -- -- -- -------- -------- -------- -------- ------- Net loss........................................... $(92,843) $(10,361) $(15,932) $ (9,640) $(2,089) ======== ======== ======== ======== =======
21
YEAR ENDED MARCH 31, --------------------------------------------------- 2001 2000 1999 1998 1997 -------- -------- -------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Basic net loss per share before cumulative effect of change in accounting principle................ $ (3.13) $ (0.53) $ (3.23) $ (2.41) $ (0.59) Cumulative effect of change in accounting principle........................................ (0.19) -- -- -- -- -------- -------- -------- -------- ------- Basic net loss per share........................... $ (3.32) $ (0.53) $ (3.33) $ (2.41) $ (0.59) ======== ======== ======== ======== ======= Weighted average shares used in computing basic loss per share(1)................................ 28,006 19,731 4,789 3,995 3,551 ======== ======== ======== ======== ======= Pro forma amounts with the change in accounting principle related to revenue applied retroactively Net revenues..................................... N/A 39,823 24,568 9,811 823 Net loss......................................... N/A (13,169) (13,169) (9,640) (2,089) Basic net loss per share......................... N/A (.67) (.67) (2.41) (0.59)
MARCH 31, ---------------------------------------------------- 2001 2000 1999 1998 1997 -------- --------- -------- -------- ------- (IN THOUSANDS) BALANCE SHEET DATA: Cash, cash equivalents, and short-term investments..................................... $ 10,939 $ 73,449 $ 12,202 $ 4,624 $ 7,067 Working capital................................... 11,785 81,295 15,912 6,385 6,895 Total assets...................................... 34,487 103,496 28,598 14,942 8,825 Long-term obligations, less current portion....... 403 1,292 15,057 1,426 16 Total stockholders' equity........................ 20,421 86,790 5,659 8,169 7,820
--------------- (1) See Note 2 of Notes to the Financial Statements for an explanation of the determination of the weighted average common and common equivalent shares used to compute net loss per share. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion in conjunction with our Financial Statements and the Notes thereto included elsewhere in this Form 10-K. NOTE REGARDING FORWARD-LOOKING STATEMENTS In addition to historical information, this discussion contains forward-looking statements that relate to future events or our future performance such as statements relating to the sufficiency of our capital resources to fund continuing operations; our commitment to continue to devote substantial resources to product research and development; our intentions to expand our sales and marketing operations; the percentage of our fiscal 2002 sales that will be derived from new products and anticipated future levels of general and administrative expenses. In certain cases you can identify forward-looking statements by terminology such as "may", "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intends," "potential" or "continue" or the negative of such terms or other comparable terminology. These statements are only predictions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including but not limited to our ability to raise sufficient capital to enable us to continue to operate our business; market acceptance of the Company's new products and the speed at which customers adopt current and new products for SANs; the ability and willingness of our OEM and distribution channel partners to buy and sell our products; our ability to develop, introduce, ship and support new products and product enhancements; growth rates of the market segment within which the Company participates; competition in the Company's industry and the timing of new technology and product introductions; the ability to retain and hire skilled personnel and the risks outlined under "Risk Factors" and elsewhere in this Form 10-K. All forward- 22 looking statements included in this document are based on information available to us on the date hereof and we assume no obligation to update any such forward-looking statements. OVERVIEW We are a provider of hardware and software products for storage area networks, or SANs. Our SAN products are designed to leverage the capabilities of Fibre Channel technology to enable enterprises to better manage the growth of mission-critical data by overcoming the limitations of the traditional captive storage architecture. We sell our SAN products through leading OEMs, including Hewlett-Packard Company and Compaq Computer Corporation. We also sell our products through distribution channel partners such as Bell Microproducts, Consan (a Gates/Arrow Company) and Tech Data Corporation. We were founded in April 1992 and initially developed electronic test equipment. Since October 1995, we have focused on developing Fibre Channel network products that address the needs of the SAN market. Since our inception, we have incurred significant losses, and as of March 31, 2001, we had an accumulated deficit of $132.3 million, and for the fiscal year ended March 31, 2001, our net loss was $92.8 million. We have not, and may never, achieve profitability on a quarterly or annual basis and anticipate that we will incur net losses for the foreseeable future. We expect to continue to incur significant sales and marketing, product development and administrative expenses, and as a result, we will need to generate significant net revenues to achieve and maintain profitability. We expect that a substantial majority of our net revenues for fiscal 2002 will be derived from new products currently under development or evaluation, including the Slingshot 4218. If sales from new products are lower than expected or if we are unable to raise additional capital, including through a draw down under our equity line financing agreement, we will be required to make a significant reduction in operating expenses and capital expenditures in fiscal 2002 to ensure that we will have adequate cash reserves to fund operations through the end of fiscal 2002. In April 2000, we completed the acquisition of SmartSAN Systems, Inc., a California corporation ("SmartSAN") which was accounted for under the purchase method of accounting. We acquired all of the outstanding shares of SmartSAN by issuing 239,433 shares of common stock and assuming options to purchase 108,376 additional shares (which numbers reflect the effect of the exchange ratio applied to the outstanding SmartSAN shares and stock options at the time of the acquisition). Total consideration was as follows (in thousands): Value of stock issued and options assumed................... $23,625 Merger and other related costs paid in cash................. 1,169 ------- Total consideration......................................... $24,794 =======
The allocation of the total consideration to the fair value of acquired assets and liabilities is as follows (in thousands): Fair value of net assets acquired and liabilities assumed... $ (778) Acquired intangible assets and goodwill..................... 20,672 In-process research and development......................... 4,900 ------- $24,794 =======
At the time of the acquisition, we allocated approximately $4.9 million of purchased in-process research and development costs. Other acquired intangible assets, including goodwill, developed technology and other intangible assets of approximately $20.7 million are being amortized over their estimated useful lives of five years on a straight-line basis. Gadzoox amortized approximately $3.8 million for fiscal year ended March 31, 2001. In the fourth quarter ended March 31, 2001, we abandoned the Geminix(TM) product line and other technology acquired in the SmartSAN acquisition. As a result of this abandonment, management decided that, based on an updated analysis of the acquisition, remaining goodwill and intangibles, totalling approximately $16.8 million, had become impaired and were written off in the fourth quarter of fiscal 2001. 23 We currently derive substantially all of our revenues from sales of a limited number of products within the same product line. During fiscal 1999, substantially all of our net revenues were derived from sales of our hub products, some of which are no longer sold. We commenced commercial shipment of our Capellix switch products during the quarter ended December 31, 1999. While sales of Capellix during the quarters ended December 31, 1999 and March 31, 2000, were approximately 28% and 47% respectively, of net revenues, the majority of our net revenues in fiscal 2000 were generated from sales of our hub products. During fiscal 2001, approximately 74% of our revenues came from sales of hub products and approximately 26% from Capellix switch products. We expect that net revenues from switch products will account for a substantial majority of our total net revenues for the foreseeable future. The percentage of our net revenues derived from switch sales may vary significantly from quarter to quarter. Additionally, we expect that a substantial majority of our net revenues for fiscal 2002 will be derived from new products currently under evaluation or development. We may not be successful in our efforts to diversify our product base. Also, we may not be successful in the adoption of our new products, in particular our Fibre Channel fabric backbone switch, the Slingshot 4218 product, or the adoption of other products currently under development. Additionally, even if our customers adopt the Slingshot 4218 or other future products, we cannot assure you that our net revenues will increase. We depend on a few key customers. In fiscal 2001, approximately 81% of our net revenues came from Hewlett-Packard Company, Compaq Computer Corporation and Bell Microproducts, Inc., with Hewlett-Packard and Compaq Computer each accounting for 10% or more of our net revenues. In fiscal 2000, approximately 72% of our net revenues came from four customers with sales to Hewlett-Packard Company, Compaq Computer Corporation, Bell Microproducts, Inc, and Tokyo Electron Limited each accounting for more than 10% of our net revenues. In fiscal 1999, approximately 84% of our net revenues came from sales to five customers with sales to Hewlett-Packard Company and Compaq Computer Corporation each accounting for more than 10% of our net revenues. While we are seeking to diversify our customer base and expand the portion of our net revenues which are derived from sales through various channels, we anticipate that our operating results will continue to depend on volume sales to a relatively small number of OEM customers and distribution channel partners. We may not be successful in our efforts to diversify our customer base. We believe net revenues derived from OEM customers and distribution channel partners will continue to fluctuate for the foreseeable future. During fiscal 2001, approximately 19% of our net revenues were derived from distribution channel partners and resellers. During fiscal 2001, net revenues derived from distribution channel partners were significantly lower than net revenues derived from OEM customers. Although we have taken several actions to improve our distribution channel partners' abilities to sell our products to end-users, we cannot assure you that demand for our products through the distribution channel will increase. If we are unable to increase sales through our distribution channel partners, our net revenues may continue to decline, and our business could be harmed. During the fourth quarter of fiscal 2001, we changed our accounting method for recognizing revenue net of appropriate reserves for sales returns when merchandise is shipped to distributors, to recognize revenue and related gross margin when the product is shipped by the distributor to an end-user. The cumulative effect of this change in accounting policy in fiscal 2001 was an increase in our net loss by $5.3 million. This change in accounting policy was made effective April 1, 2000. We believe this change is preferable as it better recognizes the substance of demand for our products due to changes in the market place during fiscal year 2001, and will accordingly better focus Gadzoox on, and allow investors to better understand, end-user demand trends for its products. We continue to record revenue from product sales to OEMs upon shipment and we provide an allowance for product returns based on our management's estimates. Allowances for estimated sales returns are provided at the time of revenue recognition. Our past product return experience may not be indicative of future product return rates. Our gross margins are affected by, among other factors, fluctuations in demand for our products, the mix of products sold, the mix of sales channels through which our products are sold, the timing and size of customer orders and product implementations, new product introductions both by us and by our competitors, product obsolescence, warranty and repair costs, changes in our pricing policies and those of our competitors, 24 component costs, and the volume manufacturing pricing we are able to obtain from our contract manufacturer. We recognize higher gross margins from sales to distribution channel partners. As a result, a decrease in sales to these customers will have a greater impact on gross margins than a decrease in sales to other customers. Although we enter into general sales contracts with our customers, none of our customers are obligated to purchase any amount of our products pursuant to these contracts. We rely on our customers to submit purchase orders for specific quantities of our products. All of our sales contracts contain provisions regarding the following: - products and pricing; - order dates, rescheduling and cancellations; - warranties and repair procedures; and - marketing and/or sales support and training obligations. Our OEM contracts generally contain additional provisions regarding product technical specifications, labeling and boxing instructions and other customization instructions. Several of our OEM sales contracts contain favored pricing provisions, as well as confidentiality provisions. Two of our OEM sales contracts provide the OEM the right to manufacture our product in the event of a material default we are unable to cure within a specified time period. Our contracts with our distribution channel partners generally contain additional provisions for stock rotation, which provide for a right of return for 10% to 15% of the value of purchases during the prior three months, to be offset with an immediately deliverable order in an amount equal to or greater than the stock to be rotated. Following our change in revenue recognition for distributors, revenue is only recognized when product is sold by the distributor to an end-user, and stock rotation rights are not expected to materially impair future revenues. We currently outsource substantially all of our manufacturing to Sanmina Corporation, a third-party manufacturer. Our agreement with Sanmina Corporation provides for two months of rolling purchase orders and rolling forecasts for the nine months immediately following the purchase order period. Purchase prices are negotiable throughout the three-year contract period. We are liable for materials that Sanmina Corporation purchases on our behalf that we cannot use, cannot be cancelled before receipt or are unique parts otherwise unusable by Sanmina Corporation. The agreement restricts our ability to reschedule orders and allows us to cancel existing orders subject to penalties of up to the total purchase price. Sanmina Corporation provides warranties on workmanship and pass-through warranties on component parts. Sanmina Corporation purchases most of the key components used to manufacture our products. We obtain some of these key components, such as our application specific integrated circuits, or ASICs, from sole sources, and other components, such as power supplies and chassis, from limited sources. If we inaccurately forecast demand for our products, Sanmina Corporation may be unable to provide us with adequate manufacturing capacity. In addition, Sanmina Corporation may not be able to obtain adequate supplies of components to meet our customers' delivery requirements. Alternatively, excess inventories may be accumulated by Sanmina Corporation for our account. In order to reduce the costs of sales, we relocated our manufacturing operations from Sanmina Corporation's manufacturing facility in Santa Clara, California to its manufacturing facility in Guntersville, Alabama during the second half of fiscal 2000. Additionally, we may consider moving the outsourced manufacturing to other new locations or to a new contract manufacturer. These relocations could be time consuming and expensive and there can be no assurance that such moves would not disrupt the manufacturing of our products. Such disruptions could cause us to lose net revenues and damage our customer relationships. 25 RESULTS OF OPERATIONS The following table sets forth financial data for the fiscal years indicated as a percentage of net revenues:
YEAR ENDED MARCH 31, ------------------------ 2001 2000 1999 ------ ----- ----- SUMMARY OF OPERATIONS DATA: Net revenues................................................ 100.0% 100.0% 100.0% Cost of revenues............................................ 96.5 54.5 75.1 ------ ----- ----- Gross margin................................................ 3.5 45.5 24.9 ------ ----- ----- Operating expenses: Research and development.................................... 88.2 38.0 56.1 Sales and marketing......................................... 72.0 24.3 23.2 General and administrative.................................. 24.0 8.9 6.7 Amortization of acquired intangible assets.................. 11.5 -- -- In-process research and development costs................... 14.7 -- -- Impairment of long lived assets............................. 53.5 -- -- Restructuring and other expenses............................ 7.5 -- -- Amortization of deferred compensation....................... 1.8 2.7 2.2 ------ ----- ----- Total operating expenses.................................... 273.5 73.9 88.2 ------ ----- ----- Loss from operations........................................ (270.0) (28.4) (63.3) Interest income, net of interest expense.................... 7.0 6.8 (0.9) ------ ----- ----- Net loss before cumulative effect of change in accounting principle................................................. (263.0) (21.6) (64.2) Cumulative effect of change in accounting principle......... (15.9) -- -- ------ ----- ----- Net loss.................................................... (278.9)% (21.6)% (64.2)% ====== ===== =====
YEARS ENDED MARCH 31, 2001, 2000 AND 1999 Net Revenues Net revenues declined by $14.6 million to $33.3 million in fiscal 2001, or 30% from $47.9 million in fiscal 2000. The decrease in revenues during fiscal 2001 was primarily due to lower sales of our Gibraltar hub product line due to decreased demand for hub products generally and slower than anticipated adoption of our Capellix switch products. During fiscal 2000, net revenues were $47.9 million, an increase of 93% over fiscal 1999 revenues of $24.8 million. Net revenues for fiscal 2000 and 1999 increased over the respective prior year periods primarily due to a broadening of our product line, additions of new OEM customers and increased sales through distribution channel partners. In fiscal 2000, we began commercial shipments of our Capellix 3000 and Capellix 2000 switch products, however the majority of our net revenues during this period were generated from sales of older hub products. During fiscal 1999 we began selling our Gibraltar 6-port hub and Denali(TM) switch. Sales to OEMs during fiscal 2001 represented approximately 81% of our revenue and sales to distributors represented approximately 19% of our revenue, with sales to Hewlett-Packard Company and Compaq Corporation accounting for approximately 75% of our net revenue. Sales to OEMs and distributors during fiscal 2000 represented approximately 59% and 41%, respectively, with sales to Hewlett-Packard Company, Compaq Corporation, Bell Microproducts, Inc and Tokyo Electorn Limited, accounting for approximately 72% of our net revenues. The significant increase in the percentage of our revenue derived from sales to OEMs in fiscal 2001 as compared to fiscal 2000 resulted primarily from our decision to focus on sales to OEM customers. The decision to focus our sales efforts primarily on OEM customers in fiscal 2001 was made because we believe OEM customers will order higher volumes than distributors, sales to OEM customers tend 26 not to be subject to return pressures, we believe we will experience less collectibility issues with respect to our accounts receivables with OEMs, sales to OEMs require less time and effort on the part of our sales force as compared to sales to distributors and sales to OEM customers requires little or no specialized support or training. In fiscal 1999, approximately 67% of our net revenues came from three customers with sales to Hewlett-Packard, Compaq Computer Corporation and Digital Equipment Corporation each accounting for more than 10% of our net revenues. During fiscal 2001, approximately 26% of our revenue was generated by the sale of our Capellix switch products and approximately 74% from the sale of hub products compared to 25% and 75% in fiscal 2000, respectively. In fiscal 1999, 100% of our revenues were derived from the sale of our hub products. Revenues by geographic area during fiscal 2001 were 72% from North America, 25% from Europe and 3% from Asia. During fiscal 2000, these percentages were approximately 70% from North America, 19% from Europe and 11% from Asia and in fiscal 1999, 64% from North America, 17% from Europe and 19% from Asia. Net revenues during fiscal years 2001, 2000 and 1999 may not be indicative of future results. In fiscal 2002, we expect that a substantial majority of our net revenues will come from the sale of new products currently under evaluation or development, including our Fibre Channel fabric backbone switch, the Slingshot 4218. We cannot assure you that we will be able to develop and introduce the Slingshot or other new products successfully and in the time frame we expect or that these products will be adopted by our OEM and distribution channel partners, or that significant net revenues would be derived if so adopted. See "Part II -- Risk Factors -- We have limited product offerings and our business may suffer if demand for any of these products declines or fails to develop as we expect" and "-- Our business will suffer if we fail to develop and successfully introduce new and enhanced products that meet the changing needs of our customers." Gross Margins Gross margins decreased in absolute dollars by $20.6 million, or 95%, during fiscal 2001 compared to fiscal 2000. As a percentage of sales, gross margins declined from 45.5% in fiscal 2000 to 3.5% in fiscal 2001. The decrease in gross margin during fiscal 2001 compared to fiscal 2000 was primarily due to: - increased reserves for excess and obsolete inventory in fiscal 2001 -- we wrote off approximately $2.5 million of unsellable material and increased our reserves for excess and obsolete inventory by approximately $10.6 million based on the forecasted demand for the next 12 months. We establish these reserves when we believe our products are not saleable during the next 12 months based on projected current demand. We believe that reserving for excess inventory that we do not expect to use or sell within a normal operating cycle of 12 months is reasonable given product life cycles, historical experience and the current economic environment. Of the $10.6 million reserve for excess or obsolete inventory during fiscal year 2001, approximately $7.0 million relates to our Capellix 3000 switch product, $2.0 million relates to our Capellix 2000 switch product, $0.9 million relates to hub switches and $0.7 million relates to other excess or obsolete inventories. These reserve amounts increased in fiscal 2001 because demand for our products slowed faster than we had anticipated. While we have established excess inventory reserves for the majority of our Capellix 3000 inventory and some of our Capellix 2000 inventory and hub products, the Company continues to sell these products despite little demand and, consequently, to date we have not scrapped this inventory. At some future date, we anticipate that we will formally scrap the remaining inventory with respect to these products; - production cancellation penalties of $1 million as a result of lower than expected revenues; - a change of product mix from sales of hub products to switch products as we decided to focus on selling switch products exclusively beginning in the quarter ended March 31, 2001 -- during fiscal 2001, approximately 26% of our revenue was generated by the sale of our Capellix switch products and approximately 74% from the sale of hub products compared to 25% and 75% in fiscal 2000, respectively; and 27 - lower sales volumes to distribution channel partners, for which gross margins are typically higher than OEM customers during fiscal 2001 approximately 19% of our net revenues were derived from sales to distributors and resellers compared with approximately 30% in fiscal 2000. Between fiscal 2000 and fiscal 1999 the gross margin increased by $15.6 million. As a percentage of net revenues, the gross margin increased from 25% of sales in fiscal 1999 to 45% in fiscal 2000. This increase was primarily due to the following: a greater percentage of our net revenues were derived from higher gross margin sales to distribution customers, a greater percentage of our net revenues were derived from sales of higher margin new products, such as the Capellix switch, and higher sales volumes which resulted in economies of scale and cost savings realized from our transition to Sanmina Corporation for contract manufacturing. Our gross margins could decrease if sales to distribution channel partners decrease, if sales of our newer products are not adopted by the marketplace, if sales volumes decrease due to lower overall demand and if the Company were to experience increased price competition. Research And Development Expenses Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to consultants and outside service providers, material costs for prototype and test units and other expenses related to the design, development, testing and enhancements of our products. We expense our research and development costs as they are incurred. Research and development expenses increased from $13.9 million in fiscal 1999, to $18.2 million in fiscal 2000, to $29.4 million in fiscal 2001. These increases were primarily due to additional research and development personnel, including the addition of our strategic research and development team and our two ASIC development teams primarily devoted to our development of new products including the Capellix and Slingshot families of switch products. In fiscal 2001 research and development expenses were approximately 88.2% of sales compared to 38.0% in fiscal 2000 and 56.1% in fiscal 1999. We believe that a significant level of investment for product research and development is required to remain competitive. Accordingly, we continue to devote substantial resources to product research and development efforts and expect that research and development expenses will continue to increase in absolute dollars. Sales And Marketing Expenses Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing, sales and customer engineering support functions, as well as costs associated with trade shows, promotional activities and travel expenses. Sales and marketing expenses increased by 106% to $24.0 million in fiscal 2001 from $11.6 million in fiscal 2000. Between fiscal 2000 and fiscal 1999 sales and marketing expenses increased by 102% from $5.8 million to $11.6 million. The increased spending in each of these years was primarily due to the hiring of additional sales and marketing personnel and the expansion of our sales and marketing efforts. During fiscal 2001, the increase in sales and marketing expense was primarily attributable to increased staffing and increased activities for the Capellix line, including joint seminar, tradeshow and advertising activities with key OEMs, alliance and distribution partners worldwide. We intend to expand our sales and marketing operations and efforts substantially, both domestically and internationally, in order to increase market awareness of our products and more effectively train and educate our distribution channel partners and end-users. However, we cannot be certain that any increased expenditures will result in higher net revenues. We believe that continued investment in sales and marketing is critical to our success and expect these expenses to increase in absolute dollars in the future. 28 General And Administrative Expenses General and administrative expenses consist primarily of salaries and related expenses for executive, finance, accounting, information technology, facilities and human resources personnel, recruiting expenses, professional fees and costs associated with expanding our information systems. General and administrative expenses increased by 87% to $8.0 million during fiscal 2001 from $4.3 million in fiscal 2000, and by 160% during fiscal 2000 from $1.6 million in fiscal 1999. The increase during fiscal 2001 and 2000 and between fiscal 2000 and 1999 was primarily attributable to increased personnel, additional expenses incurred related to the growth of our business, expansion of our facilities and information infrastructure and our operation as a public Company. We expect these expenses to increase in absolute dollars as we add personnel to replace the personnel the Company lost due to attrition in fiscal 2001 and as the Company expands its administrative infrastructure to support the other areas of the Company's business. Amortization Of Deferred Compensation In connection with the grant of stock options to employees, during fiscal 1999, we recorded deferred compensation within stockholders' equity of approximately $3.0 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. We recorded amortization of deferred compensation of $0.6 million, $1.3 million, and $0.5 million during fiscal years 2001, 2000 and 1999 respectively. At March 31, 2001, the remaining deferred compensation of approximately $0.4 million will be amortized as follows: $0.3 million in fiscal 2002 and $.1 million in fiscal 2003. The amortization expense relates to options awarded to employees in all operating expense categories. The amount of deferred compensation expense to be recorded in future periods could decrease if options for which accrued but unvested compensation has been recorded are forfeited. See Note 7 of the Notes to the Financial Statements. Amortization Of Acquired Intangible Assets In connection with the acquisition of SmartSAN Systems, Inc. ("SmartSAN") in April 2000, we amortized acquired intangible assets, including goodwill, developed technology and other intangible assets of approximately $20.7 million over their estimated useful lives of five years on a straight-line basis. For fiscal 2001, we amortized $3.8 million of goodwill and acquired intangible assets. During the fourth quarter of fiscal 2001, we wrote-off the remaining $16.8 million of goodwill and reported this as a separate line item on its Statement of Operation. See "Restructuring and Impairment Charges." In-Process Research And Development Costs In connection with the acquisition of SmartSAN, we expensed approximately $4.9 million of in-process research and development costs which represented approximately 20% of the purchase price. This amount represented the estimated fair value based on risk-adjusted cash flows related to the incomplete research and development projects. At the date of acquisition, the development of these projects had not yet reached technological feasibility, and the research and development in progress has no alternative future uses. Accordingly, these costs were expensed as of the acquisition dated. At the acquisition date, SmartSAN was conducting design, development, engineering and testing activities associated the development of next-generation Geminix products: SDM3000, RDM4000, and DDM5000, valued at $800,000, $1.1 million, and $3.0 million, respectively. The SDM3000 was a next-generation Fibre Channel to Fibre Channel router; the RDM4000 was being developed as a Fibre Channel to LAN/WAN remote domain manager; and the DDM5000 was scheduled to be the flagship distributed domain manager incorporating advanced storage virtualization. SmartSAN engineers had made significant progress on the projects as of the acquisition date, including design of the overall architecture, and in some cases, much of the development work. However, substantial integration and testing activities remained to develop the technologies into commercially viable products. 29 At the acquisition date, the technologies under development were approximately 80%, 65% and 25% complete, based on engineering man-month data and technological progress. SmartSAN had spent approximately $700,000 on the in-progress projects, and expected to spend approximately $2.5 million to complete all phases of the R&D projects. Anticipated completion dates ranged from 2 months for the SDM3000 to 12 months for the DDM5000, at which times we expected to benefit, and generate cashflows, from the developed technologies. In making its purchase price allocation, management considered present value calculations of income, an analysis of project accomplishments and remaining outstanding items, an assessment of overall contributions, as well as project risks. The value assigned to purchase in-progress technology was determined by estimating the costs to develop the acquired technology into commercially viable products, estimating the resulting net cashflows from the projects, and discounting the net cash flows to their present value. The revenue projection used to value the in-process research and development was based on estimates of relevant market sizes and growth factors, expected trends in technology, and the nature and expected timing of new product introductions by the Company and its competitors. The resulting net cash flows from such projects are based on management's estimates of costs of sales, operating expenses, and income taxes from such projects. The rates utilized to discount the net cash flows to their present value were based on estimated cost of capital calculations. Due to the nature of the forecast and the risks associated with the projected growth and profitability of the development projects, discount rates of 40% to 45% were used in the analysis. These discount rates were commensurate with the projects' stage of development and the uncertainties in the economic estimates described above. Restructuring And Impairment Charges During the fourth quarter of fiscal 2001, we executed our plan to focus more resources on the development of open-fabric switch technology products and to restructure our business operations. This resulted in the termination and abandonment of the Axxess(TM) and Geminix product lines, reduction of personnel and consolidation of all San Jose, California operations in one building. In connection with this restructuring, we recorded expenses of approximately $2.5 million and an additional expense of $17.8 million relating to the impairment of long term assets, primarily relating to the write-off of the remaining goodwill and acquired intangible assets that resulted from the SmartSAN acquisition which was completed in April 2000. After completing the SmartSAN acquisition, we realized that the IP router market was extremely competitive and would require significant additional funding to develop products and provide support. In March 2001, we changed our product strategy and refocused our efforts exclusively on the higher margin, open fabric switch market. Consequently, the product lines and technologies acquired in the SmartSAN acquisition were abandoned because they did not support open-fabric switch technology. As a result of this writedown of goodwill and acquired intangibles related to the Axxess and Geminix product lines, we eliminated approximately $350,000 of goodwill amortization in fiscal 2001. Inventory and Accounts Receivable Charges and Reserves In the quarter ended September 30, 2000, we noted that our inventory balance began to increase. During the same quarter we implemented a policy to create a reserve for inventory items considered to be excess or obsolete. Excess inventory is any inventory at a given balance sheet reporting date in excess of anticipated 12 month demand. In the quarters ended September 30, 2000, December 31, 2000 and March 31, 2001, we recorded additional inventory reserves of $6.8 million, $1.5 million and $2.3 million, respectively, for excess and obsolete inventory. These reserves were primarily related to our excess Capellix 3000 and hub products. During fiscal 2001, we scrapped approximately $2.5 million of inventory that had been reserved as excess or obsolete inventory. In addition, because of a deterioration in general economic conditions and, in particular, problems experienced by our distributors, in fiscal 2001 we wrote off approximately $400,000 of uncollectible accounts receivable and increased our reserve for doubtful accounts be approximately $200,000. See Note 9 of the Notes to the Financial Statements. 30 Interest Income, Net Of Interest Expense Interest income, net of interest expense, related to our debt and lease obligations, includes income from our cash investments, net of expenses related to our financing obligations. Interest income, net of interest expense, totaled $2.3 million in fiscal 2001, compared to $3.3 million in fiscal 2000 and interest expense, net of interest income, of $0.2 million in fiscal 1999. The decrease in interest income, net of interest expense, in fiscal 2001 was primarily the result of lower cash levels due to the higher operating loss as well as increased working capital and capital spending, offset in part by lower interest expense due to the repayment of the outstanding convertible notes to Seagate Technology, Inc. See Note 4 of the Notes to the Financial Statements. The increase of net interest income during fiscal 2000 compared to fiscal 1999 was primarily due to interest income earned from investment of the net proceeds received from the issuance of common stock from our initial public offering in July 1999, and by lower interest expense charged on the convertible note due to partial conversion of the note in connection with our initial public offering. This increase was partially offset by increased interest expense charged on higher capital lease obligations. During fiscal 1999 interest expense, net of interest income, was primarily due to accrued interest on the convertible note, as well as, interest expense charged on our capital lease obligations. Income Taxes As of March 31, 2001, we had approximately $108.3 million of federal and $26.9 million of state net operating loss carryforwards for tax purposes available to offset future taxable income. We also had Federal and state research and development tax credit carryforwards of approximately $3.1 million and $2.8 million respectively. Such net operating and research credit loss carryforwards expire at various dates beginning in 2001 through 2015. We have not recognized any benefit from the future use of loss carryforwards for these periods or for any other periods since inception because management's estimate of the realizability of the tax benefits of the loss carryforwards indicates that the underlying assumptions of future profitable operations contain risks that do not provide sufficient assurance for us to recognize such benefits currently. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have financed our operations primarily through private sales of common stock, convertible preferred stock, the issuance of a convertible note, equipment lease financings and an initial public offering of common stock. At March 31, 2001, we had approximately $10.9 million in cash and cash equivalents and $11.8 in net working capital, a decrease of $31.9 million in cash and cash equivalents and a decrease of $69.5 million in net working capital from the prior fiscal year. In fiscal 2001, the Company used $51.0 million in cash for operating needs, an increase of $37.5 million from fiscal 2000. This increase was primarily due to the higher than anticipated net loss as a result of lower sales of new and existing products and higher operating expenses coupled with higher working capital needs. Additionally, during fiscal 2001, we generated $23.1 million in cash from investing activities, primarily due to the net proceeds from the sale and purchase of short term investments of $30.6 million, offset in part by the purchase of capital equipment of $5.3 million and $2.2 million used for the purchase of long term investments and the acquisition of SmartSAN. Net cash used by financing activities during fiscal 2001 amounted to approximately $4.0 million. Approximately $5.1 million was used to pay the remaining balance due on the convertible note payable to Seagate Technology, Inc., other notes payable acquired from with SmartSAN and capital equipment lease obligations. Proceeds from the issuance of common stock in connection with employee stock option exercises and the employee stock purchase plan generated approximately $1.7 million in fiscal 2001. In fiscal 2000, we used $13.6 million in cash for operating needs, a decrease of 13% from $15.7 million used in fiscal 1999. This decrease was primarily due to a decrease in our net loss from $15.9 million in fiscal 1999 to $10.4 million in fiscal 2000. The $4.0 million net increase in inventory was primarily the result of 31 slower than anticipated demand for our Capellix switch products. The $11.2 million decrease in accounts receivable net is a result of lower revenues and improved collection efforts. We have recorded a reserve for doubtful accounts receivable as of March 31, 2001 and we expect to collect the net accounts receivable amount recorded in our books on March 31, 2001. In fiscal 2000, we used $2.8 million in cash from investing activities to acquire property and equipment. Additionally, we invested $30.6 million of the proceeds from our initial public offering during fiscal 2000 in short-term investments. In fiscal 2000, we generated $77.6 million in cash from financing activities including the sale of our equity, an increase of 212% from $24.9 million generated in fiscal 1999. This increase was primarily due to the sale of common stock in our initial public offering in July 1999. Additionally, we used debt and leases to partially finance operations and capital purchases and we plan to continue this practice. We expect to devote substantial cash resources to continue our research and development efforts, to hire and expand our sales, support, marketing and product development organizations, to expand marketing programs, to establish additional facilities worldwide and for other general corporate activities. We incurred a net loss in the year ended March 31, 2001 of $92.8 million and have an accumulated deficit of $132.3 million as of March 31, 2001. We have continuously incurred net losses from operations and used $51.0 million of cash in operations for the year ended March 31, 2001, and have working capital of $11.8 million as of March 31, 2001. In May 2001, we sold 5.6 million shares of our common stock in a private placement transaction for net proceeds of approximately $14.5 million. On June 28, 2001, we entered into an equity line financing agreement, or Equity Line, with Societe Generale pursuant to which we have the right to elect to sell and Societe Generale has the obligation to purchase up to $20 million of our common stock over a two year period ending June 28, 2003. In addition, under the terms of an agreement entered into with a placement agent we engaged in connection with the equity line, we are obligated to pay a fee to the placement agent equal to 2% of the funds we draw down under this equity line. Pursuant to the terms of the Equity Line, we, from time to time, during the two year period beginning on June 28, 2001, can elect to sell (which election is referred to as a draw down) a specific dollar amount of its common stock based upon the price and trading volume of its common stock during the thirty trading days prior to a draw down. The price per share and the actual number of shares sold by the us pursuant to each draw down will be determined by the price and volume of trading in the Company's common stock during the five trading days following the day that we notify Societe Generale of the draw down, provided that in no event will the price per share be less than the higher of $1.00 and the price set by us in our notice of election to make a draw upon the equity line. Under the terms of the Equity Line Agreement, we are obligated to sell at least $5.0 million of common stock to Societe Generale or pay a penalty equal to 6% of any portion of such $5.0 million minimum obligation which is not sold by us. We cannot sell more than 6,812,400 shares of common stock pursuant to the Equity Line without first obtaining stockholder approval. We are also obligated in connection with the Equity Line to file a registration statement registering the sale by Societe Generale of any shares sold by the Company. If this registration statement is not declared effective within 180 days of June 28, 2001, then Societe Generale shall have the right to terminate the Equity Line, in which event the Company shall be obligated to pay the penalty described above. The terms of the Equity Line limit our ability to draw down funds under this financing line. These limitations include, but are not limited to, the following, (i) the requirement that the price per share of the our Common Stock remain higher than a specified minimum price during the five trading days following the Company's election to draw upon the Equity Line, (ii) the absence of any material adverse change in the business or financial condition of the Company, (iii) the continued effectiveness of the registration statement covering the sale of shares by Societe Generale and the absence of any material omission or misstatement from the then current prospectus relating to the registration statement and (iv) the delivery of certain letters and reports from the Company's counsel and accountants. As a consequence, we may not be able to draw down a sufficient amount of funds under the equity line to fund our operations and, based on current market 32 conditions and our stock price, we will, in all likelihood, need to raise additional funds. Assuming we attempted to draw down funds and delivered such draw down notice to SG on September 5, 2001, based on the $1.46 average volume weighted average price of our common stock for the five trading days preceding September 5, 2001 and the 214,000 assumed average daily trading volume of our shares during the 30 trading days preceding September 5, 2001, based on the limitations on our ability to draw down funds under the equity line we would not be able to draw any funds under the equity line. The Equity Line prohibits Societe Generale from selling shares of the Company's Common Stock during the term of the Equity Line other than a number of shares equal to the amount of any draw down by the Company divided by 94% of the minimum selling price specified in the Company's draw down election. Consequently, Societe Generale may have the ability to sell substantially more shares of Common Stock following a draw down election than it is obligated to purchase in connection with the draw down, which may result in an immediate and significant drop in the Company's stock price and a significant increase in the number of shares issued by the Company pursuant to a draw down. Accordingly, the Company's use of the Equity Line for financing may result in substantial dilution to the Company's stockholders and a significant decline in the Company's stock price. We believe that our cash reserves, working capital and the funds available under the Equity Line agreement will be adequate to fund our operations through the end of fiscal 2002. However, as discussed above, the Company's right to sell shares under the Equity Line agreement is subject to a number of conditions and we may not be able to sell our shares of common stock under the Equity Line agreement when we wish or need. If we are unable to sell our shares of common stock under the Equity Line Agreement, we will be required to raise additional funds to continue to operate our business. Many companies in the high technology manufacturing industry have experienced difficulty raising additional financing in recent months. Additional financing may not be available to us on favorable terms or at all. Even if additional financing is available, we may be required to obtain the consent of our stockholders, which we may not be able to obtain. If additional financing is not available, we may need to dramatically change our business plan, sell or merge our business, or face bankruptcy. In addition, the issuance of equity or equity-related securities will dilute the ownership interest of our stockholders and the issuance of debt securities could increase the risk or perceived risk of the Company. Our cash needs depend on numerous factors, including market acceptance of and demand for our switch products, particularly new products currently under evaluation or development, including the Slingshot 4218, our ability to develop and introduce new products and product enhancements, prices at which we can sell our products, the resources we devote to developing, marketing, selling and supporting our products, the timing and expense associated with expanding our distribution channels, increases in manufacturing costs and the prices of the components we purchase and other factors. In fiscal 2002 a substantial majority of our revenues are expected to be derived from the sale of new products currently under evaluation or development, including the Slingshot 4218. We cannot assure you that we will be able to develop and introduce the Slingshot or other new products successfully and in the time frame we expect or that these products will be adopted by our OEM and distribution channel partners, or that significant net revenues would be derived if so adopted. See "Risk Factors -- We have limited product offerings and our business may suffer if demand for any of these products declines or fails to develop as we expect" and "-- Our business will suffer if we fail to develop and successfully introduce new and enhanced products that meet the changing needs or our customers." If we are unable to raise additional capital, including through a draw down under the Equity Line, or if sales from new products are lower than expected, we will be required to make a significant reduction in operating expenses and capital expenditures in fiscal 2002 to ensure that we will have adequate cash reserves to fund operations through the end of fiscal 2002. Additionally, we may do one or more of the following: - engage a financial advisor to explore strategic alternatives, which may include a merger, asset sale, or another comparable transaction; 33 - raise additional capital to fund continuing operations by private placements of equity and/or debt securities; and - form a joint venture with a strategic partner or partners to provide additional capital resources to fund operations. In addition to the foregoing, we are attempting to reduce our financial commitments and reduce future cash outflows by negotiating alternative terms with our suppliers. In addition, cost-cutting measures could include additional reductions in force. Further, we are working with our channel partners to increase revenues through new marketing programs and promotions, and are exploring potential additional sources of revenue. There can be no assurance that we will be successful in increasing revenues or reducing cash outflows. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 138, "Accounting for Certain Derivative Instruments and Hedging Activities," an amendment of SFAS No. 133, which is effective for all fiscal years beginning after June 15, 2000. SFAS No. 138 establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Because the Company does not currently hold any derivative instruments and does not currently engage in any material hedging activities, management believes that the application of SFAS No. 138 will not have a material impact on the Company's financial position or results of operations. In March 2000, FASB issued Financial Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation -- an Interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44 addresses the application of APB No. 25 to clarify, among other issues: (a) the definition of employee for purposes of applying APB No. 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequences of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. The Company's adoption of FIN 44 did not have a material impact on the Company's financial position or results of operation. 34 RISK FACTORS You should carefully consider the following risk factors and all other information contained in this Form 10-K. Risks and uncertainties, in addition to those we describe below, that are not presently known to us, or that we currently believe are immaterial may also impair our business operations. If any of the following risks occur, our business, operating results and financial condition could be seriously harmed. In addition, the trading price of our common stock could decline due to the occurrence of any of these risks. RISKS RELATED TO OUR BUSINESS AND FINANCIAL CONDITION WE HAVE INCURRED NET LOSSES IN EVERY FISCAL QUARTER SINCE OUR INCEPTION IN 1992 AND WE MAY NEVER BE ABLE TO ACHIEVE OR SUSTAIN PROFITABILITY. We have incurred net losses in every fiscal quarter since our inception in 1992, most recently a net loss of $9.2 million in our quarter ended September 30, 2001. We incurred a net loss in fiscal 2001 of $92.8 million and we had an accumulated deficit of $151.2 million as of September 30, 2001. If we are unable to increase revenue so that we achieve profitability, our operating results will suffer and the price of our common stock may fall. We expect to incur significant product development, sales and marketing and general and administrative expenses as we focus our business on the design, development, manufacturing and sales of fibre channel switching products, in particular our two-gigabit Slingshot product line. Our first Slingshot product only became commercially available in July 2001. Because we have switched the focus of our business to our switch products and continue to phase out our Gibralter hub product line, we do not expect to generate substantial revenue in the future from the sales of our hub products. In fiscal 2001, of our $33.3 million in total revenue, $24.6 million, or 74%, was attributable to sales of our Gibralter hub products, and only $8.7 million, or 26%, was derived from sales of our switch products. In the six months ended September 30, 2001, of our $11.6 million in revenue, $6.0 million, or 52%, was attributable to sales of our switch products and $5.6 million, or 48%, was attributable to our Gibralter hub products. To date, all of our revenue from sales of our switch products have been attributable to our Capellix product line. Our future operating results will depend on many factors, including the growth of the fibre channel switching market and market acceptance of our new switching products. We may never be able to achieve or sustain profitability. WE HAVE LIMITED WORKING CAPITAL AND WE WILL NEED TO RAISE ADDITIONAL FINANCING TO SUSTAIN OUR BUSINESS. We had only $15.1 million in working capital available as of September 30, 2001. We have never been profitable and we used $51.0 million of cash for operating activities in fiscal 2001, and approximately $17.0 million for the six months ended September 30, 2001. If we are unable to raise additional financing or if sales of our storage area network products are lower than we expect, we may be unable to sustain our business. Additional financing may not be available to us when and as required on commercially reasonable terms, if at all. In the event we are able to obtain additional financing, the issuance of equity or equity-related securities will dilute the ownership interest of our existing stockholders and the issuance of debt securities could increase the risk or perceived risk of our business. Issuance of debt securities could also impair our financial condition and interest payments could have an adverse effect on our results of operation. If we are unable to raise additional capital or if sales from our switching products are lower than expected, we will be required to make a significant reduction in operating expenses and capital expenditures in fiscal 2002 to ensure that we will have adequate cash reserves to fund operations through the end of fiscal 2002 and beyond. Additionally, we would be required to explore strategic alternatives, which may include a merger, asset sale or another comparable transaction or form a joint venture with a strategic partner or partners to provide additional capital resources to fund operations. If additional financing is not available, we may need to dramatically change our business plan, sell or merge our business or face bankruptcy. WE MAY NOT BE ABLE TO DRAW DOWN A SUFFICIENT AMOUNT OF FUNDS UNDER OUR EQUITY LINE FINANCING ARRANGEMENT TO FUND OUR OPERATIONS. The terms of our equity line financing agreement with Societe Generale, or SG, limit our ability to draw down funds under this financing line. As a consequence, we may not be able to draw down a sufficient amount 35 of funds under the equity line to fund our operations and we will, in all likelihood, need to raise additional funds. On June 28, 2001, we entered into an equity line with SG pursuant to which we have the right to sell to SG, and SG has the obligation to purchase, up to $20 million of our common stock over a two year period ending June 28, 2003. In addition, under the terms of an agreement entered into with Shoreline Pacific Institutional Finance (the institutional division of Financial West Group), the placement agent we engaged in connection with the equity line, we are obligated to pay a fee to Shoreline equal to 2% of the funds we draw down under this equity line. Under our equity line with SG, we can elect to sell a specific dollar amount of our common stock based upon the price and trading volume of our common stock during the 30 trading days prior to a draw down. Assuming the Company attempted to draw down funds and delivered such draw down notice to SG on October 22, 2001 and based on the $1.16 average volume weighted average price of our common stock for the five trading days preceding October 22, 2001 and the 140,793 assumed average daily trading volume of our shares during the 30 trading days preceding October 22, 2001, we would not be able to draw any funds under the equity line because our maximum draw down amount under these assumptions is $82,011 which is less than the minimum draw down amount permitted under the equity line. In addition, in the event our stock price is less than $1.00, we will not be able to draw down any funds under the equity line. Because our right to sell shares under the equity line agreement is subject to a number of conditions we may not be able to sell our shares of common stock under the equity line agreement when we wish or need. Consequently, we may not be able to raise sufficient capital under the equity line to fund our operations. In addition, in the event the equity line is terminated before we have drawn down at least $5 million, we will be required to pay a commitment fee of 6% of the amount of the $5 million not drawn down, up to a maximum fee of $300,000. This commitment fee will also become payable prior to the termination of the equity line if one of the following events occurs: - if a registration statement covering the shares purchased by SG under the equity line is not declared effective by December 25, 2001 or if this registration statement loses its effectiveness for 20 consecutive trading days or for more than 80 trading days in any twelve month period. - if we breach any material representation, warranty or covenant contained in the equity line financing agreement or the related registration rights agreement. - if we fail to issue stock to SG in accordance with the terms of the equity line financing agreement, fail to remove any restrictive legends on such stock, or otherwise fail to uphold our obligations under the equity line and such breach is not cured within 5 trading days after we receive notice describing the breach from SG. - if we sell all or substantially all of our assets, merge or consolidate with another company and we are not the surviving entity, or if we effect a transaction or series of transaction whereby more than 50% of our voting power is sold. - if our stock price trades below $1.00 for more than 30 consecutive trading days. IF WE DRAW DOWN UNDER OUR EQUITY LINE FINANCING ARRANGEMENT WITH SG, OUR STOCKHOLDERS WILL BE DILUTED, POTENTIALLY SUBSTANTIALLY, AND OUR STOCK PRICE COULD DECLINE SIGNIFICANTLY. SG MAY ENGAGE IN SHORT-SELLING ACTIVITIES THAT COULD RESULT IN DECLINES IN THE TRADING PRICE OF OUR COMMON STOCK WHICH COULD MATERIALLY ADVERSELY AFFECT OUR BUSINESS AND FINANCIAL CONDITION. Under the terms of our equity line with SG, we have the right to require that SG purchase shares of our common stock, subject to certain conditions. The shares of common stock that we sell to SG will be sold at a 6% discount to the daily volume weighted average price of our common stock during each day of the draw down period. If we were to draw down the entire $20,000,000 equity line at the minimum purchase price of $0.94, we would be required to issue 21,276,596 shares of our common stock, or 54.1% of our currently outstanding common stock, which would result in substantial dilution to our current stockholders. In addition, SG's subsequent resale to the public of the shares it purchases under the equity line may result in an immediate and significant drop in our stock price. Furthermore, SG may engage in short-selling activities with respect to our common stock which could also cause the trading price of our stock to decline. In addition, The 36 Nasdaq National Market has a continued listing requirement that the minimum bid price of our common stock must exceed $1.00 and if the minimum bid price of our common stock falls below this threshold for 30 consecutive days our stock could be delisted from The Nasdaq National Market. On November 6, 2001, the closing sales price of our common stock as reported by The Nasdaq National Market was $1.00. Note that in September 2001, The Nasdaq National Market announced that it was suspending the minimum bid requirement until January 2, 2001. If there is a significant drop in our stock price as a result of sales of our stock made under the equity line, short-selling activities by SG or otherwise, this could materially adversely affect our ability to raise additional funding and to attract and retain customers and distributors and quality personnel, which could lead to business failure. IF WE ARE UNABLE TO RAISE ADDITIONAL FINANCING, IF WE CONTINUE TO EXPERIENCE SIGNIFICANT LOSSES, AND IF OUR TRADING PRICE DECLINES, WE MAY NOT BE ABLE TO CONTINUE TO MEETING THE CONTINUED LISTING CRITERIA FOR THE NASDAQ NATIONAL MARKET, WHICH WOULD MATERIALLY ADVERSELY AFFECT OUR BUSINESS AND FINANCIAL CONDITION. If we were unable to continue to list our common stock for trading on The Nasdaq National Market, this would materially adversely affect business, including, among other things: - our ability to raise additional financing to fund our operations; - our ability to attract and retain customers and distributors; and - our ability to attract and retain personnel, including management personnel. In addition, if we were unable to list our common stock for trading on The Nasdaq National Market, many institutional investors would no longer be able to retain their interests in and/or make further investments in our common stock because of their internal rules and protocols. If institutional shareholders liquidated their holdings in our common stock and/or did not continue to make investments in our common stock, this would decrease the trading volume of our shares and would likely result in a lower price for our common stock. Continued listing on The Nasdaq National Market currently requires, among other things, that we have either stockholders' equity in excess of $10.0 million or that our net tangible assets exceed $4.0 million. The Nasdaq National Market is in the process of phasing out this net tangible assets test and, after November 1, 2002, we must meet the $10 million stockholders' equity requirement. As of September 30, 2001, our stockholders' equity was approximately $2.4 million and our net tangible assets were approximately $2.4 million. Consequently, as of September 30, 2001 we did not meet The Nasdaq National Market continued listing requirements for either the $10 million stockholder's equity test or the $4 million net tangible asset test. To date we have not received notice from The Nasdaq National Market regarding our failure to comply with this continued listing requirement. In May 2001 and August 2001, we sold an aggregate of 10,600,000 shares of common stock resulting in net proceeds of approximately $21.6 million. The net proceeds from May 2001 and August 2001 private placements are not currently reflected as stockholder's equity on our balance sheet because the shares sold in these transactions will be redeemable if the registration statements covering the resale of these shares are not declared effective by the SEC prior to 360 days after the date the shares were originally issued. Consequently, the proceeds from the sale of the shares are currently recorded outside stockholders equity as redeemable common stock. If the SEC declares effective the registration statements relating to the resale of shares of our common stock sold in these private placements, our stockholders' equity and net tangible assets will increase by approximately $21.6 million. However, we expect to incur additional losses in future quarters which would affect our ability to meet The Nasdaq National Market continued listing standards for the minimum stockholder's equity and minimum net tangible assets tests. Note that on March 31, 2000, our stockholders' equity was approximately $86.8 million and our net tangible assets were approximately $86.8 million. Furthermore, continued listing on The Nasdaq National Market requires that the minimum bid price of our common stock exceed $1.00. If the minimum bid price of our common stock is below the $1.00 threshold for 30 consecutive days, we will not meet The Nasdaq National Market continued listing requirement. The closing sales price of our common stock as of November 6, 2001 as reported by The Nasdaq National Market was $1.00. Please note however that in 37 September 2001, The Nasdaq National Market announced that it was suspending the minimum bid requirement until January 2, 2002. In addition to the potential material adverse affects to our business in the event our common stock was no longer listed for trading on The Nasdaq National Market, we would not be able to draw down any funds under our equity line with SG. WE MAY NOT BE ABLE TO REDUCE OUR OPERATING EXPENSES SUFFICIENTLY TO REDUCE OUR NET LOSSES AND SUSTAIN OUR BUSINESS. THIS MAY IMPAIR OUR ABILITY TO ATTRACT ADDITIONAL FINANCING. We incurred $91.0 million in operating expenses in fiscal 2001, and approximately $24.1 million in the six month period ended September 30, 2001. We may not be able to reduce our operating expenses sufficiently to reduce our net losses which were $92.8 million in fiscal 2001 and $18.5 million in the six month period ended September 30, 2001. In March 2001, we implemented a reduction of force decreasing our headcount by 27 employees. In August 2001, we implemented a second reduction of force decreasing our headcount by 16 employees. In October 2001, we implemented a third reduction in force decreasing our headcount by a further 31 employees. For the most part, each of the reductions in force were implemented on an across-the-board basis throughout our various departments. In the March 2001 reduction in force, 7 of the affected employees were terminated as a direct result of our decision to discontinue the Axxess product line. However, aside from the March 2001 reduction with respect to the Axxess product line, no reduction in force was targeted to a specific product line. In particular, of the 74 employees that were let go during these reductions in force, approximately 19 of the affected employees were in our sales and marketing department, 12 were in our operations department, 28 were in our engineering department and 5 were in our finance department. The remaining employees who were terminated were in administrative positions. We incurred approximately $339,000 in severance costs related to our March 2001 reduction in force, $288,000 in severance costs related to our August 2001 reduction in force and approximately $601,000 in severance costs related to our October 2001 reduction in force, all of which amounts have been fully incurred and paid to date. We are also attempting to reduce our financial commitments and reduce future cash outflows by negotiating alternative terms with our suppliers. In addition, future cost-cutting measures could include additional reductions in force. If we are unable to reduce our operating expenses sufficiently, we may not be able to reduce our net losses or sustain our business. This may impair our ability to attract additional financing on commercially reasonable terms or at all. Our ability to successfully reduce our operating costs could materially affect our quarterly and annual operating results. WE ONLY RECENTLY BEGAN SELLING FIBRE CHANNEL SWITCH PRODUCTS AND OUR ABILITY TO SUCCESSFULLY SELL OUR CAPELLIX AND SLINGSHOT SWITCH PRODUCTS IS DIFFICULT TO EVALUATE. CONSEQUENTLY, OUR OPERATING RESULTS WILL BE DIFFICULT TO FORECAST. In the quarter ended March 31, 2001, we decided to focus our business on selling fibre channel switch products, a segment of the storage area network market that we have not historically competed in. In fiscal 2001, of our $33.3 million in total revenue, $24.6 million, or 74%, was attributable to sales of our Gibraltar hub products and only $8.7 million, or 26% of our total revenue, derived from sales of our switch products. In the six month period ended September 30, 2001, of our $11.6 million in revenue, $6.0 million, or 52%, was attributable to our switch products and $5.6 million, or 48%, was attributable to our hub products. We plan to phase out our Gibralter hub product line and focus on our switch products. We only began selling our Capellix switch products in September 1999 and we expect much of our future revenue to come from sales of our two-gigabit Slingshot products, the first of which only became commercially available in July 2001. Because we do not have a substantial history in selling switch products and because of the rapidly evolving nature of the storage area network market generally, there is limited financial and operating data with which to evaluate our performance and prospects. Further, we plan our operating expenses based primarily on our revenue projections. Because most of our expenses are fixed in the short-term or incurred in advance of anticipated revenue, we may not be able to decrease our expenses in a timely manner to offset any unexpected shortfall in revenue. The revenue and income potential of our switch products is unproven and our historical performance is not likely to be indicative of future performance. If we do not achieve our expected revenue 38 growth, our operating results will be below our expectations and the expectations of investors and market analysts, which could cause the price of our common stock to decline. We may not be able to successfully penetrate the market for storage area network switch products, attract and retain original equipment manufacturer customers and distributors for these products or achieve or sustain profitability. You should consider our business and prospects in light of the heightened risks and unexpected expenses and problems we may face as a company that is focusing its business on selling products in a segment of the market different from its historical operations, a market segment that is rapidly evolving and intensely competitive. We also expect sales of our switch products to have lower margins, at least for the foreseeable future, than we have recently experienced with our hub products which could materially adversely affect our quarterly and annual operating results. We have been able to increase our margins on sales of our hub products as our costs to produce these products have decreased over time. In order to compete in the switch market we have had to reduce prices while our costs to manufacture these products have remained fixed. IF WE ARE UNABLE TO SUCCESSFULLY MARKET AND SELL OUR SWITCH PRODUCTS, OUR ABILITY TO SUSTAIN AND GROW OUR BUSINESS WILL BE SIGNIFICANTLY REDUCED AND OUR STOCK PRICE WILL LIKELY DECLINE. If we are unable to successfully penetrate the fibre channel switch market, our revenue will continue to decline, our net losses will increase, we will need to raise additional funding and we may not be able to sustain our business. In the six month period ended September 30, 2001, we recorded $11.6 million in total revenue compared to $18.9 million in total revenue from the six month period ended September 30, 2000, a decrease of 39%. The quarter ended September 30, 2001 was our first quarter during which we had our two-gigabit Slingshot switch product available and we recognized only $0.4 million of our $5.1 million in total revenue that quarter from the sales of two-gigabit Slingshot product. We do not have significant experience in developing, marketing, selling and supporting switch products. In contrast, many of our competitors do have this experience and many of our competitors have significantly greater financial, technical, marketing and administrative resources than we do. In addition, many of these competitors have pre-existing relationships with the primary original equipment manufacturers that we expect to sell our switch products to. Other factors that may affect the market acceptance of our switch products, many of which are beyond our control, include the following: - growth and changing requirements of the storage area networks product markets; - availability, price, quality and performance of competing products and technologies; - performance, quality, price and total cost of ownership of our products; and - successful development of our relationships with existing and potential original equipment manufacturing customers and distribution channel partners. We may not be able to compete successfully in the market for fibre channel switch storage area network products. Original equipment manufactures and other distribution partners may not adopt our Slingshot and Capellix switch products, and even if they do, we may not be able to generate significant revenue from the sale of these products to sustain our business. WE DEPEND ON SALES OF OUR STORAGE AREA NETWORK PRODUCTS TO A FEW KEY ORIGINAL EQUIPMENT MANUFACTURER CUSTOMERS TO GENERATE SUBSTANTIALLY ALL OF OUR REVENUE. IF WE WERE TO LOSE ANY OF THESE CUSTOMERS OR SALES OF OUR PRODUCTS TO ANY OF THESE CUSTOMERS WERE TO DECREASE SIGNIFICANTLY, OUR OPERATING RESULTS WOULD SUFFER AND OUR ABILITY TO SUSTAIN OUR BUSINESS COULD BE SIGNIFICANTLY IMPAIRED. We depend on a few key original equipment manufacturer customers for substantially all of our revenue. In the six month period ended September 30, 2001, of our $11.6 million in total revenue, $5.2 million or 45% was due to sales to Hewlett Packard and $3.3 million or 28% was due to sales to Compaq. In fiscal 2001, of our $33.3 million in total revenue, $14.1 million or 42% was due to sales to Hewlett-Packard and $11.1 million or 33% was due to sales to Compaq. In fiscal 2000, of our $47.9 million in total revenue, $14.1 million or 29% was due to sales to Hewlett-Packard, $8.1 million or 17% was due to sales to Compaq, $15.8 million or 33% was due to sales to Bell Microproducts and $5.8 million or 12% was due to sales to Tokyo Electron. The primary reason for the decline is revenue for each of our primary original equipment manufacturer customers in fiscal 39 2001 as compared to fiscal 2000 was attributable to decreased demand for our hub products and slower than anticipated adoption of our Capellix fibre channel switch products. In September, 2001, Hewlett-Packard and Compaq announced that they intend to merge the two companies. If the merger is successfully completed, the combined company may buy fewer of our products than if Hewlett-Packard and Compaq were purchasing storage area network products as separate companies. Although we intend to expand our original equipment manufacturer customer base, we anticipate that our operating results will continue to depend on sales to a relatively small number of original equipment manufacturers. We also expect that our decision to focus on sales of switching products will not change our historical pattern of selling only to a relatively small number of original equipment manufacturers. The loss of any of our key customers, or a significant reduction in sales to those customers, could significantly reduce our expected future revenue. Our agreements with our customers do not provide any assurance of future sales to those customers. For example: - our original equipment manufacturer and reseller agreements are not exclusive and contain no renewal obligation; - our original equipment manufacturers and resellers can stop purchasing and marketing our products at any time; and - our original equipment manufacturer and reseller agreements do not require minimum purchases. We cannot be certain that we will retain our current original equipment manufacturer customers or that we will be able to recruit additional or replacement customers. Many of our original equipment manufacturers carry or utilize competing product lines. If we were to lose one or more original equipment manufacturers to a competitor, our business, results of operations and financial condition could be significantly materially adversely affected and our ability to sustain our business could be significantly impaired. Any fluctuations in demand for our products from one or more original equipment manufacturer customers could materially affect our quarterly and annual operating results. IF WE ARE UNABLE TO INCREASE SALES OF OUR STORAGE AREA NETWORKS PRODUCTS THROUGH OUR DISTRIBUTION CHANNEL PARTNERS AND RESELLERS, OUR OPERATING RESULTS WILL SUFFER. Our distribution strategy focuses primarily on developing and expanding indirect distribution channels through original equipment manufacturers, distribution partners and resellers. We believe that expanding our sales through distribution partners and resellers is an important part of our strategy to increase sales of our switch products. The ability and willingness of our distribution partners and resellers to sell our products could materially affect our quarterly and annual operating results. Our failure to execute this strategy successfully could limit our ability to grow or sustain revenue. During fiscal 2001, approximately $6.3 million, or 19%, of our revenue was derived from sales to distribution partners and resellers. In the six month period ended September 30, 2001, approximately $2.9 million, or 25%, of our revenue was derived through these channels. As we attempt to expand our sales to distribution partners and resellers, we may increase our selling costs, as these parties generally require a higher level of customer support than our original equipment manufacturers. If we fail to develop and cultivate relationships with significant resellers, or if these resellers are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer. Even where we are successful in establishing a distribution or reseller relationships, our agreements with the third party will likely not be exclusive, and as a result, many of our distribution partners and resellers will carry competing product lines. We believe that distribution partners and resellers are extremely important influencers of end-user customer purchase decisions. Our distribution partners and resellers may not market our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. Our failure to successfully develop or manage our relationships with distribution partners and resellers could materially adversely affect our operating results. Historically, we have experienced difficulties in selling our products through distribution partners as compared to original equipment manufacturing customers. Our original equipment manufacturing customers have demonstrated the ability to resell our storage area network products due, in part, to the length of time they have been involved in this marketplace and the strength of their internal technical, sales and marketing 40 structures. Our distribution channel partners have participated in this market for a shorter period of time and often do not typically have fully trained technical, sales and marketing staffs. As a result, they are not as well positioned as our original equipment manufacturers to sell our products effectively. We may never be able to increase the sales of our products through distribution partners and resellers. If we are unable to effectively sell our products through our distribution channel partners and resellers, our net revenues may continue to decline and our business would be harmed. THE LENGTHY PROCESS REQUIRED TO MAKE SALES TO OR DEVELOP RELATIONSHIPS WITH ORIGINAL EQUIPMENT MANUFACTURERS AND DISTRIBUTION PARTNERS MAY IMPEDE OUR ABILITY TO INCREASE SALES OF OUR PRODUCTS. We rely on original equipment manufacturers and distribution channel partners to distribute and sell our products. As a result, our success is dependant on our ability to initiate, manage and expand our relationships with significant original equipment manufacturers and our ability to attract distribution channel partners that are able and willing to sell our products, as well as the sales efforts of these original equipment manufacturers and distribution channel partners. Our original equipment manufacturer customers typically conduct significant evaluation, testing, implementation and acceptance procedures before they begin to market and sell new technologies, including our products. Based on our experience with our larger original equipment manufacturer customers, this evaluation process is lengthy and has historically been as long as nine months. During the slowdown of the U.S. economy in general and the market for storage area network products in particular, in 2000 and the first nine months of 2001, the sales process has lengthened to some extent, in some cases as long as 12 months. Our sales process is complex and requires significant sales, marketing and management efforts on our part. The complexity of this process increases if we must qualify our products with multiple customers at the same time. In addition, once our products have been qualified, the length of the sales cycle of each of our original equipment manufacturers may vary depending upon whether our products are being bundled with another product or are being sold as an option or add-on. Sales to distribution channel partners may also require lengthy sales and marketing cycles. Additionally, to increase sales through the distribution channel, we have made significant investments in activities designed to improve sell-through at the end-user level and we may never see significant revenue resulting from these efforts. Any delay in the sales cycle could have an adverse effect on our operating results and financial condition. OUR OPERATING RESULTS FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE IF OUR RESULTS FAIL TO MEET INVESTORS' AND ANALYSTS' EXPECTATIONS. We have experienced, and expect to continue to experience, fluctuations in sales and operating results from quarter to quarter. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful, and that such comparisons cannot be relied upon as indicators of future performance. During the past three years, our operating results have varied significantly. Additionally, we began focussing our business on selling our switch products, which has not traditionally been our core business, only in the first half of calendar 2001, and we expect that our operating results may vary significantly in the future as we attempt to penetrate this market segment. Our quarterly and annual operating results are likely to continue to vary significantly in the future due to a number of factors described below and elsewhere in this "Risk Factors" section, many of which are outside of our control. The primary factors that may cause our quarterly net revenues and operating results to fluctuate include the following: - changes in general economic conditions and specific economic conditions in the computer storage and networking industry; - increases in the prices of the components we purchase; - our ability to maintain quality manufacturing standards for our products; - our ability to maintain, increase or quickly decrease the contract production of our products at expected prices; and - the mix of distribution channels through which our products are sold. 41 Accordingly, you should not rely on the results of any past periods as an indication of our future performance. It is likely that in some future periods, our operating results may be below expectations of public market analysts or investors. If this occurs, our stock price may decline. OUR ORIGINAL EQUIPMENT MANUFACTURERS HAVE UNPREDICTABLE ORDER PATTERNS, WHICH MAY CAUSE OUR REVENUE TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER. Our original equipment manufacturer customers tend to order sporadically, and their purchases can vary significantly from quarter to quarter. Our original equipment manufacturers generally forecast expected purchases in advance, but frequently do not order as expected and tend to place purchase orders only shortly before the scheduled delivery date. We plan our operating expenses based in part on revenue projections derived from our original equipment manufacturers' forecasts. Because most of our expenses are fixed in the short term or incurred in advance of anticipated revenue, we may not be able to decrease our expenses in a timely manner to offset any unexpected shortfall in revenue. These order habits may cause our backlog to fluctuate significantly. Moreover, our backlog is not necessarily indicative of actual sales for any succeeding period, as orders are subject to cancellation or delay by our original equipment manufacturers with limited or no penalty. None of our current customers have any minimum purchase obligations, and they may stop placing orders with us at any time, regardless of any forecast they may have previously provided. In the past, customers have unexpectedly reduced or cancelled orders for our products. In July 1998, Digital Equipment cancelled orders for our Bitstrip product, and in December 1998 Hewlett-Packard unexpectedly reduced orders for our Gibraltar 10-port product. More recently, in 2000 and 2001, orders for our products by original equipment manufacturers have declined significantly due to a decline in sell-through to end-user customers. The recent terrorist attacks in New York and Washington could also contribute to further weakening in general economic conditions. We expect that given the overall weak general economic condition and the weakness in the market for storage area network products in particular, our customers may continue to be slow to place orders for our products. RISKS RELATED TO OUR INDUSTRY THE STORAGE AREA NETWORK MARKET IN WHICH WE COMPETE IS RELATIVELY NEW AND STILL EVOLVING, AND IF THIS MARKET DOES NOT DEVELOP AND EXPAND AS WE ANTICIPATE, OUR BUSINESS WILL SUFFER. Fibre channel-based storage area networks were first deployed in 1997. As a result, the market for storage area network and related storage router products has only recently begun to develop and continues to rapidly evolve. Because this market is new, it is difficult to predict its potential size or future growth rate. Our products are used exclusively in storage area networks. Accordingly, widespread adoption of storage area networks as an integral part of data-intensive enterprise computing environments is critical to our future success. Most of the organizations that potentially may purchase our products from our original equipment manufacturer customers have invested substantial resources in their existing computing and data storage systems and, as a result, potential end-user customers may be reluctant or slow to adopt a new approach, like storage area networks. Storage area networks are often implemented in connection with the deployment of new storage systems and servers. Therefore, our future success is also substantially dependent on the market for new storage systems and servers. Furthermore, the ability of the different components used in a storage area network to function effectively, or interoperate, with each other when placed in a computing system has not yet been achieved on a widespread basis. Until greater interoperability is achieved, customers may be reluctant to deploy storage area networks. The speed at which customers adopt current and new products for storage area networks is highly unpredictable. The rate of adoption of storage area networks as an alternative to existing data storage and management systems will materially affect our quarterly and annual operating results and the success of our business. Our success in generating revenue in this emerging market will depend on, among other things, our ability to: - educate potential original equipment manufacturers, distribution channel partners and end-users about the benefits of storage area networks switch technology; 42 - maintain and enhance our relationships with leading original equipment manufacturers customers and channel partners; - predict and base our products on standards which ultimately become industry standards; and - predict and deliver new and innovative products demanded by the storage area marketplace. OUR BUSINESS WILL SUFFER IF WE FAIL TO DEVELOP AND SUCCESSFULLY INTRODUCE NEW AND ENHANCED PRODUCTS THAT MEET THE CHANGING NEEDS OF OUR CUSTOMERS. Our future success depends upon our ability to address the rapidly evolving storage area networks market, including changes in relevant industry standards and the changing needs of our customers by developing and introducing high-quality, technologically-progressive, cost-effective products, product enhancements and services on a timely basis. For example, the technology being deployed today in most storage area networks products is FC-AL or FC-SW. During fiscal 2001, the development of competing technologies such as Ethernet IP has been discussed by the technical community. If we are unable to design, develop and manufacture products that anticipate or incorporate new technologies that are used in storage area networks in a timely manner and efficiently utilize such new technologies in our product developments, the demand for our current products may decrease significantly, which would harm our operating results. In addition, our ability to develop, introduce, ship and support new products and product enhancements could materially affect our quarterly and annual operating results. OUR OPERATING RESULTS MAY SUFFER BECAUSE THE COMPETITION IN THE STORAGE AREA NETWORKS MARKET IS INTENSE. WE ALSO FACE SIGNIFICANT COMPETITION FROM DATA NETWORKING COMPANIES AND ENTERPRISE SOFTWARE DEVELOPERS. Competition in the storage area network market is intense. In addition, the adoption of new technology in the our market likely will intensify the competition for improved storage area network products. In the storage area networks switch market, our current competitors include Brocade, McData, QLogic and Vixel. In the storage area networks hub market, our competitors include Emulex and Vixel. In addition to these companies, we expect new storage area networks competitors to emerge. In the future, we may also compete against data networking companies which may develop storage area networks products. Furthermore, although we currently offer products that complement the software products offered by Legato and Veritas, they and other enterprise software developers may in the future compete with us. We also compete with providers of data storage solutions that employ traditional storage technologies, including small computer system interface-based technology such as Adaptec, LSI Logic and QLogic. Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and financial resources may enter those markets, thereby further intensifying competition. Many of our current and potential competitors, in comparison to us, have: - longer operating histories; - greater name recognition; - greater financial resources; - larger customer bases; - more established distribution channels; and - significantly greater financial, technical, sales, marketing, manufacturing and other resources. Moreover, our competitors may foresee the course of market developments more accurately and could in the future develop new technologies that compete with our products or even render our products obsolete. Increased competition could also result in pricing pressures, reduced sales, reduced margins, reduced market share or the failure of our products to achieve or sustain market acceptance. Competitive pressures, including competitive technology and pricing pressures, could materially adversely affect our quarterly and annual operating results. In addition, we have limited experience competing in the market for storage area 43 network switch products as we only began selling our Capellix switch products in September 1999 and our first Slingshot switch product became commercially available only in July 2001. IF WE CANNOT INCREASE OUR SALES VOLUMES, REDUCE OUR COSTS OR INTRODUCE HIGHER MARGIN PRODUCTS TO OFFSET REDUCTIONS IN THE AVERAGE UNIT PRICE OF OUR PRODUCTS, OUR OPERATING RESULTS WILL SUFFER. We anticipate that as products in the storage area market become more commoditized, the average unit price of our products will continue to decline in the future in response to changes in product mix, competitive pricing pressures, new product introductions by us or our competitors or other factors. If we are unable to offset the anticipated decrease in our average selling prices by increasing our sales volumes, our net revenue will decline. In addition, to maintain our gross margins, we must continue to reduce the manufacturing cost of our products. Further, as average unit prices of our current products decline, we must develop and introduce new products and product enhancements with higher margins. If we cannot maintain our gross margins, our business could be seriously harmed, particularly if the average selling price of our products decreases significantly. IF WE CANNOT DEVELOP PRODUCTS THAT ARE COMPATIBLE WITH THESE EVOLVING INDUSTRY STANDARDS AND GOVERNMENT REGULATIONS, OUR ABILITY TO SELL OUR PRODUCTS WILL BE MATERIALLY ADVERSELY AFFECTED. Our products must comply with industry standards. For example, in the United States, our products must comply with various regulations and standards defined by the Federal Communications Commission. Internationally, our products are also required to comply with standards established by authorities in various countries. Any new products and product enhancements that we introduce in the future must also meet industry standards at the time they are introduced. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or certificates could materially harm our business. Our products comprise only a part of the entire storage area networks market. All components of the storage area networks must comply with the same standards in order to operate efficiently together. We depend on companies that provide other components of the storage area networks to support the industry standards as they evolve. Many of these companies are significantly larger and more influential in effecting industry standards than we are. Some industry standards may not be widely adopted or they may not be implemented uniformly, and competing standards may emerge that may be preferred by original equipment manufacturer customers or end users. If other companies do not support the same industry standards that we do, or if competing standards emerge, market acceptance of our products could suffer. IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY, OUR ABILITY TO COMPETE IN THE STORAGE AREA NETWORK MARKET WOULD BE MATERIALLY ADVERSELY AFFECTED. Our products rely on proprietary technology and will likely continue to rely on technological advancements for market acceptance and the protection of our intellectual property rights is critical to the success of our business. To protect our intellectual property rights, we rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure. We currently hold six patents which expire between 2013 and 2016, and have five patent applications pending in the United States with respect to our storage area network technology, and are also seeking patent protection for our technology in selected international locations. The patents for our pending patent applications may never be issued. In addition, with respect to our current patents and any patent applications that are approved in the future, these patents may not provide sufficiently broad protection or they may not prove enforceable in actions against alleged infringement. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to, and distribution of, our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult and the steps we have taken may not prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If we are unable to protect our intellectual property from infringement, other companies may be able to use our intellectual property to offer competitive products at lower prices. 44 WE RELY HEAVILY ON OUR INTELLECTUAL PROPERTY, AND EFFORTS TO PROTECT IT MAY CAUSE US TO BECOME INVOLVED IN COSTLY AND LENGTHY LITIGATION WHICH WOULD SERIOUSLY HARM OUR BUSINESS. We rely heavily on our intellectual property, and efforts to protect it may cause us to become involved in costly and lengthy litigation which would seriously harm our business. Although we are not currently involved in any intellectual property litigation, we may be a party to intellectual property litigation in the future either to protect our intellectual property or as a result of an alleged infringement of others' intellectual property. These claims and any resulting litigation could subject us to significant liability for damages and could cause our proprietary rights to be invalidated. Litigation, regardless of the merits of the claim or outcome, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation could also force us to do one or more of the following: - stop using the challenged intellectual property or selling our products or services that incorporate it; - obtain a license to use the challenged intellectual property or to sell products or services that incorporate it, which license may not be available on commercially reasonable terms, if at all; and - redesign those products or services that are based on or incorporate the challenged intellectual property. If we are forced to take any of the foregoing actions, we may be unable to manufacture and sell our products, our net revenues would be substantially reduced and we may be unable to sustain our business. RISKS ASSOCIATED WITH MANUFACTURING OUR PRODUCTS WE ARE DEPENDENT ON OUR MANUFACTURING RELATIONSHIP WITH SANMINA TO MANUFACTURE OUR STORAGE AREA NETWORK PRODUCTS. IF WE ARE UNABLE THROUGH OUR RELATIONSHIP WITH SANMINA, OR OTHERWISE, TO DEVELOP AND MAINTAIN MANUFACTURING CAPABILITIES THAT ENABLE US TO MEET OUR CUSTOMERS' REQUIREMENTS, OUR BUSINESS AND PROSPECTS WILL BE MATERIALLY ADVERSELY AFFECTED. We have limited internal manufacturing capabilities and have entered into a manufacturing relationship with Sanmina to manufacture our storage area networking products. Our ability to manufacture and deliver our products is dependent on our relationship with Sanmina and our ability to, together with Sanmina, develop manufacturing processes that will allow us to produce sufficient quantities of products at competitive prices. We only have limited means to internally manufacture our products and do not have alternate outsourcing relationship with other contract manufacturers that will enable us to meet our manufacturing requirements. While we are attempting to identify and enter into a relationship with alternative manufacturers, identifying and entering into an agreement with a new manufacturer and establishing manufacturing processes is time-consuming and if we were to experience difficulties with our manufacturing relationship with Sanmina this could significantly interrupt the supply of our products. In addition, many of the potential manufacturers who could manufacture our products have existing relationships with our competitors or potential competitors and may be unwilling to enter into agreements with us. If our relationship with Sanmina, or any relationship we enter in the future with other manufacturers, is impaired, this could prevent us from being able to deliver our products, damage our customer relationships, could materially adversely affect our operating results and financial condition. WE MAY EXPERIENCE DELAYS OR DISRUPTIONS IN MANUFACTURING OUR PRODUCTS WHICH COULD IMPAIR OUR ABILITY TO DELIVER OUR PRODUCTS TO CUSTOMERS. Our business would be harmed if we fail to effectively manage the manufacture of our products. If Sanmina experiences delays, disruptions, capacity constraints or quality control problems in its manufacturing operations, then product shipments to our customers could be delayed, which would negatively impact our customer relations, operating results, competitive position and reputation. We generally place orders with Sanmina at least two months prior to scheduled delivery of products to our customers. Accordingly, if we inaccurately forecast demand for our products, we may be unable to obtain adequate manufacturing capacity from Sanmina or adequate quantities of components to meet our customers' delivery requirements or we may accumulate excess inventories. In contrast, our usage of Sanmina's facilities and our related capital 45 expenditures assume a level of customer orders that we may not realize or, if we do realize, may not be sustained. Many of our manufacturing expenses are fixed, and if we do not receive anticipated levels of customer orders, our expected profit margin will decline and we may not be able to reduce our operating expenses quickly enough to prevent a decline in our operating results. In the future we intend to work with Sanmina and additional manufacturers that could potentially manufacture our higher volume products at lower costs in foreign locations. We may experience difficulties and disruptions in the manufacture of our products while we transition to new manufacturing facilities. Manufacturing disruptions could prevent us from achieving timely delivery of products and could result in lost revenue. Additionally, we must coordinate our efforts with those of our suppliers, Sanmina, or other third party manufacturers, to rapidly achieve volume production. We have experienced delays in the past product deliveries from one of our former contract manufacturers. Any delays in the manufacturing of our products could adversely affect our operating results or impair our customer relationships. BECAUSE WE DEPEND ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR MANY KEY COMPONENTS, WE ARE SUSCEPTIBLE TO SUPPLY SHORTAGES THAT COULD IMPAIR OUR ABILITY TO MANUFACTURE OUR PRODUCTS AND COULD MATERIALLY ADVERSELY AFFECT OUR OPERATING RESULTS. We depend upon a single source for each type of our application-specific integrated circuits, and limited sources of supply for several key components, including, but not limited to, power supplies, chassis and optical transceivers. We have in the past experienced and may in the future experience shortages of, or difficulties in acquiring, these components. Our only agreement for the supply of components of sole or limited sources is with LSI Logic Corporation for application-specific integrated chips. We may not be able to enter into other agreements on commercially reasonable terms, if at all, with other providers of sole on limited source components. The failure to do so may adversely affect our ability to manufacture our products and harm our operating results. Qualifying a new component manufacturer and commencing volume production is expensive and time-consuming and could significantly interrupt the supply of our products. If we are required or choose to change component manufacturers, we may damage our customer relationships, which could materially adversely affect our ability to sell our products. In addition, we rely on Sanmina to procure components required for the manufacture of our products. If for any reason these component manufacturers were to stop satisfying our needs without providing us or Sanmina with sufficient warning to procure an alternate source, our ability to manufacture and sell our products could be harmed. In addition, any failure by our component manufacturers to supply us or Sanmina with their products on a timely basis could result in late deliveries of our products to our customers. Our inability to meet our delivery deadlines could adversely affect our customer relationships and, in some instances, result in termination of these relationships or potentially subject us to litigation. Our ability to obtain sufficient supplies of components, including sole or limited source components, could materially adversely affect our quarterly and annual operating results. DELAYS IN PRODUCT DEVELOPMENT COULD ADVERSELY AFFECT OUR BUSINESS. We have experienced delays in product development in the past and may experience similar delays in the future. Given the short product life cycles in the markets for our products, any delay or unanticipated difficulty associated with new product introductions or product enhancements could have a material adverse effect on our business, quarterly and annual results of operations and financial condition. Prior delays have resulted from numerous factors, such as: - Changing original equipment manufacturer product specifications; - Difficulties in hiring and retaining necessary personnel; - Difficulties in reallocating engineering resources and other resource limitations; - Changing market or competitive product requirements; - Unanticipated engineering complexity; and - Undetected errors or failures in software and hardware. 46 Our operating results will be materially adversely affected if we fail to timely develop product enhancements, if we fail to introduce new products, or if any new products or product enhancements that we develop and introduce are not broadly accepted. In addition, we must successfully manage the introduction of new or enhanced products to minimize disruption in our customers' ordering patterns, avoid excessive levels of older product inventories and ensure that adequate supplies of new products can be delivered to meet our customers' demands. As discussed above, our product development is also dependent upon obtaining product components, including components from sole or limited sources, in a timely manner. BECAUSE WE ORDER COMPONENTS AND MATERIALS BASED ON ROLLING FORECASTS, WE MAY OVERESTIMATE OR UNDERESTIMATE OUR COMPONENT AND MATERIAL REQUIREMENTS, WHICH COULD INCREASE OUR COSTS AND THEREBY PREVENT US FROM MEETING CUSTOMER DEMAND AND MATERIALLY ADVERSELY AFFECT OUR OPERATING RESULTS. We use rolling forecasts based on anticipated product orders to determine our component requirements. Lead times for materials and components that we order vary significantly and depend on factors such as specific supplier requirements, contract terms and current market demand for such components. As a result, component requirement forecasts made by us or Sanmina may not be accurate. If we overestimate our component requirements, we may have excess inventory, which would increase our costs. If we underestimate our component requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our products to our customers. We are liable for materials that Sanmina purchases on our behalf that we do not use. Any of these occurrences would negatively impact our business and quarterly and annual operating results. In the past we have overestimated the demand for certain products, which has resulted in inventory writedowns and reserves for excess and obsolete inventory. For example, during fiscal 2001 we wrote off approximately $2.5 million of inventory and increased our inventory reserves by $10.6 million. OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS, WHICH COULD LEAD TO AN INCREASE IN OUR COSTS OR A REDUCTION IN OUR NET REVENUES. Networking products frequently contain undetected software or hardware errors when first introduced or as new versions are released. Our products are complex and we have found errors in existing products. In the future we may find errors in our existing, new or enhanced products. In addition, our products are usually integrated with products from other vendors. As a result, should problems occur, it may be difficult to identify the source of the problem. The occurrence of hardware and software errors, whether caused by our or other vendors' storage area networks products, could adversely affect sales of our products, cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relationship problems. ADDITIONAL RISKS ASSOCIATED WITH OUR BUSINESS IF WE DO NOT HIRE, RETAIN AND INTEGRATE HIGHLY SKILLED MANAGERIAL, ENGINEERING, SALES, MARKETING, FINANCE AND OPERATIONS PERSONNEL, OUR BUSINESS MAY SUFFER. Our ability to successfully develop, market, sell and support our products depends to a significant degree upon the continued contributions of our key personnel in engineering, sales, marketing, finance and operations, many of whom would be difficult to replace. The loss of the services of any of our key personnel could adversely affect our ability to implement our business plan. We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales, marketing, finance and operations personnel, including executive officers. In addition, our products and services require a sophisticated selling effort targeted at several key people within a prospective customer's organization. This process requires the efforts of experienced sales personnel as well as specialized consulting professionals. Competition for these people is intense, especially in the San Francisco Bay area where our operations are headquartered. In particular, in the past we have experienced difficulty in hiring and retaining qualified application-specific integrated circuits, software, system, test and customer support engineers and executive staff and we may not be successful in attracting and retaining individuals to fill these positions. In March 2001, we implemented a reduction of force decreasing our headcount by 27 employees. In August 2001, we 47 implemented a second reduction of force decreasing our headcount by 16 employees. In October 2001, we implemented a third reduction in force decreasing our headcount by a further 31 employees. As a result of these reductions in force, our workforce has been reduced by approximately 20% from its pre-March 2001 levels. Of the 74 employees that were terminated between March and October 2001, approximately 19 of the affected employees were in our sales and marketing department, 12 were in our operations department, 28 were in our engineering department and 5 were in our finance department. With respect to our March 2001 reduction in force, 7 of the affected employees were terminated as a direct result of our decision to discontinue the Axxess product line. The remaining employees who were terminated were in administrative positions. None of the employees laid-off as a result of these reductions in force were considered to be key personnel by management. We do not believe these reductions in force have had a material adverse affect on our operations. However, these reductions in force may make it difficult for us to recruit necessary personnel in the future. If we are unable to attract or retain qualified personnel in the future, or if we experience delays in hiring required personnel, particularly qualified engineers and sales personnel, our ability to develop, introduce and sell our products could be harmed. WE PLAN TO INCREASE OUR INTERNATIONAL SALES ACTIVITIES WHICH WILL SUBJECT US TO ADDITIONAL BUSINESS RISKS. During fiscal 2001, approximately 28% of our total revenue were derived from international sales activities, and during fiscal 2000, international sales represented 30% of our total revenues. In the six months ended September 30, 2001, international sales represented 29% of our total revenue. Our international sales will be limited if we cannot establish relationships with international distributors, establish additional foreign operations, expand international sales channel management, hire additional personnel and develop relationships with international service providers. Even if we are able to successfully continue international operations, we may not be able to maintain or increase international market demand for our products which could materially affect our quarterly and annual operating results. Our international operations are subject to a number of risks, including: - multiple, protectionist, adverse and changing governmental laws and regulations; - reduced or limited protections of intellectual property rights; - potentially adverse tax consequences resulting from changes in tax laws; and - political and economic instability. To date, none of our international revenues and costs have been denominated in foreign currencies. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and thus less competitive in foreign markets. In the future, a portion of our international revenues may be denominated in foreign currencies, which would subject us to risks associated with fluctuations in those foreign currencies. OUR BUSINESS MAY BE HARMED BY PENDING CLASS ACTION LITIGATION. On June 6, 2001, a putative securities class action, captioned Cooper v. Gadzoox Networks, Inc., et al., was filed against us, three of our former executive officers and Credit Suisse First Boston Corporation and BancBoston Robertson Stephens, Inc., two underwriters in our 1999 initial public offering, in the United States District Court for the Southern District of New York. The complaint alleges violations of Section 11 of the Securities Act against all defendants, a violation of Section 15 of the Securities Act against our former executive officers, and violations of Section 12(a)(2) of the Securities Act and Section 10(b) of the Securities Exchange Act and Rule 10b-5, promulgated thereunder against the underwriters. The complaint seeks unspecified damages on behalf of a purported class of purchasers of common stock between July 19, 1999 and December 6, 2000. On June 25, 2001, a similar complaint, captioned Goldgrab v. Gadzoox et al., was filed against Gadzoox, the former executive officers and several of the underwriters participating in our initial public offering in the Southern District of New York. The complaint is substantially identical to the Cooper complaint, except in that it alleges violations of Section 10(b) of the Exchange Act against all defendants, including Gadzoox and the individual defendants. There have been additional lawsuits filed 48 containing allegations substantially identical to those in the Cooper and Goldgrab complaints and we anticipate that additional related lawsuits may be brought against us with substantially identical allegations to the Cooper lawsuit. The allegations of the complaints focus on purported actions of the underwriters in our 1999 initial public offering. The plaintiffs claim that the underwriters solicited and received excessive commissions from investors in exchange for favorable allocations of initial public offering shares. The plaintiffs also claim that the underwriters entered into agreements with their customers whereby, in exchange for favorable allocations of shares in the offering, the customers would commit to purchase additional shares in the aftermarket at pre-determined prices. The complaints filed to date, however, do not contain any particular allegations of any specific "tie-in" agreement or excessive commission received in connection with our offering specifically. The plaintiffs contend that we are liable under Section 11 of the Securities Act because our registration statement in the initial public offering did not disclose the purported actions by the underwriters. Two of the complaints also bring claims under Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, contending that we knew of, participated in or acted with reckless disregard to the alleged misconduct of the underwriters. We further anticipate that all such lawsuits will eventually be coordinated or consolidated with one another. We believe we have meritorious defenses to the allegations and we intend to defend the lawsuits vigorously. We do not believe that these matters will have material adverse affect on our results of operation or financial condition. However, litigation is subject to inherent uncertainties, and the disposition of the litigation could materially adversely affect our financial condition, results of operation and cash flows. The uncertainty associated with substantial unresolved litigation may also impair our relationships with existing customers and its ability to obtain new customers. Defending such litigation will likely result in a diversion of management's time and attention away from business operations. Such litigation may also have the effect of discouraging potential acquirors from bidding for Gadzoox or reducing the consideration such acquirors would otherwise be willing to pay in connection with an acquisition. PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT OR DELAY A CHANGE IN CONTROL OF OUR COMPANY AND MAY REDUCE THE MARKET PRICE OF OUR COMMON STOCK. Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include: - authorizing our board of directors to issue preferred stock without stockholder approval; - providing for a classified board of directors with staggered, three-year terms; - prohibiting cumulative voting in the election of directors; - requiring super-majority voting to effect significant amendments to our certificate of incorporation and bylaws; - limiting the ability of stockholders to call special meetings; - prohibiting stockholder actions by written consent; and - establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings. We are subject to the antitakeover provisions of Delaware law which regulate corporate acquisitions. Delaware law prevents certain Delaware corporations, including Gadzoox, from engaging, under certain circumstances, in a "business combination" with any "interested stockholder" for three years following the date that such stockholder became an interested stockholder. This provision of Delaware law may discourage, delay or prevent someone from acquiring or merging with us, which may cause the market price of our common stock to decline. 49 WE MAY INCUR FINANCIAL PENALTIES IN CONNECTION WITH REGISTERING FOR RESALE THE SHARES OF COMMON STOCK WE SOLD IN MAY 2001 AND AUGUST 2001 WHICH WOULD CAUSE US TO SUSTAIN ADDITIONAL LOSSES. In connection with our May 2001 sale of 5,600,000 shares of our common stock and our August 2001 sale of an additional 5,000,000 shares of our common stock, we agreed to register these shares for resale under the Securities Act. The registration rights agreements that we entered into with our May 2001 and August 2001 investors contain provisions requiring us to pay penalties unless a registration statement covering the resale of these shares is declared effective by the SEC no later than 90 days after our sale of the common stock to the investors. With respect to the sale of the May 2001 shares, we have incurred penalty fees totalling $375,000 for not having the registration statement covering the resale of the shares effective through October 23, 2001 and we will incur additional penalties of $150,000 for each 30 day period after October 23, 2001 that the registration statement covering the resale of the shares is not effective. If the registration statement is not effective by May 2002, the investors will have the right to demand that we repurchase the shares at 110% of the original $2.65 per share price, which could result in an obligation of up to $16.3 million. With respect to the sale of the August 2001 shares, we will incur a $75,000 penalty if the registration statement covering the resale of the shares has not been declared effective by November 2001 and we will incur additional penalties of $112,500 for each subsequent 30 day period that the registration statement covering the resale of the shares is not effective. If the registration statement is not effective by August 2002, the investors will have the right to demand that we repurchase the shares at 110% of the original $1.50 per share price, which could result in an obligation of up to $8.3 million. Any penalties we are required to pay under the terms of our agreements with the May 2001 and August 2001 investors will result in losses and will hurt our operating results and financial condition. OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VOLATILE. The market price of our common stock has fluctuated substantially, and there can be no assurance that such volatility will not continue. From January 1, 2000 through November 6, 2001, the market price has ranged from a high of $68.75 per share to a low of $0.84 per share. Several factors could impact our stock price including, but not limited to: - announcements concerning Gadzoox, our competitors or customers; - quarterly fluctuations in our operating results; - introduction of new products or changes in product pricing policies by us or our competitors; - conditions in the storage area network industry; - changes in earnings estimates by industry analysts; or - market conditions for high technology equities in general. In addition, stock markets have experienced extreme price and volume volatility in recent years and stock prices of technology companies have been especially volatile. This volatility has had a substantial effect on the market prices of securities of many smaller public companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations could adversely affect the market price of our common stock. 50 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we may invest in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate. As of March 31, 2001, all of our investments were in cash and cash equivalents. See Note 2 of the Notes to the Financial Statements. The following table details our short-term investments and cash and cash equivalents at March 31, 2001 and 2000 (in thousands):
MARCH 31, ----------------- 2001 2000 ------- ------- U.S. Government Agencies.................................... $ -- $28,243 Corporate bonds and notes................................... 6,747 42,577 Money market funds and available cash....................... 4,192 2,629 ------- ------- Total................................................ $10,939 $73,449 ======= =======
51 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS
PAGE ---- Report of Independent Public Accountants.................... F-2 Balance Sheets as of March 31, 2001 and 2000................ F-3 Statements of Operations for the years ended March 31, 2001, 2000 and 1999............................................. F-4 Statements of Stockholders' Equity for the years ended March 31, 2001, 2000 and 1999................................... F-5 Statements of Cash Flows for the years ended March 31, 2001, 2000 and 1999............................................. F-6 Notes to Financial Statements............................... F-7 Schedule II -- Valuation and Qualifying Accounts............ F-27
F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Gadzoox Networks, Inc. We have audited the accompanying balance sheets of Gadzoox Networks, Inc., a Delaware corporation, as of March 31, 2001 and 2000, and the related statements of operations, stockholders' equity and cash flows for each of the three years in the period ended March 31, 2001. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Gadzoox Networks, Inc. as of March 31, 2001 and 2000, and the results of its operations and its cash flows for each of the three years in the period ended March 31, 2001, in conformity with accounting principles generally accepted in the United States. As explained in Note 2 to the financial statements, effective April 1, 2000, the Company changed its method of accounting for revenue recognition for sales to distributors. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed under Item 14(a)2 is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP San Jose, California June 29, 2001 F-2 GADZOOX NETWORKS, INC. BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
MARCH 31, -------------------- 2001 2000 --------- -------- ASSETS Current assets: Cash and cash equivalents................................. $ 10,939 $ 42,830 Short-term investments.................................... -- 30,619 Accounts receivable, net of allowance for doubtful accounts of $350 and $600 in 2001 and 2000, respectively........................................... 2,922 14,131 Inventories............................................... 10,626 6,665 Prepaid expenses and other current assets................. 961 2,464 --------- -------- Total current assets.............................. 25,448 96,709 Property and equipment, net................................. 8,244 6,495 Other assets................................................ 795 292 --------- -------- $ 34,487 $103,496 ========= ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Convertible notes......................................... $ -- $ 3,052 Current portion of note payable........................... -- 196 Current portion of capital lease obligations.............. 924 1,545 Accounts payable.......................................... 6,176 7,079 Compensation related accruals............................. 1,331 1,534 Other accrued liabilities................................. 5,232 2,008 --------- -------- Total current liabilities......................... 13,663 15,414 Capital lease obligations, net of current portion........... 403 1,292 --------- -------- Total liabilities................................. 14,066 16,706 --------- -------- Commitments and contingencies (Note 3) Stockholders' equity: Common stock, $0.005 par value; 150,000,000 shares authorized; 28,376,200 and 26,841,844 shares issued and outstanding in 2001 and 2000, respectively............. 142 134 Additional paid-in capital................................ 153,003 127,251 Deferred compensation..................................... (426) (1,140) Accumulated deficit....................................... (132,298) (39,455) --------- -------- Total stockholders' equity........................ 20,421 86,790 --------- -------- $ 34,487 $103,496 ========= ========
The accompanying notes are an integral part of these financial statements. F-3 GADZOOX NETWORKS, INC. STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED MARCH 31, ------------------------------ 2001 2000 1999 -------- -------- -------- Net revenues................................................ $ 33,290 $ 47,931 $ 24,821 Cost of revenues............................................ 32,131 26,128 18,638 -------- -------- -------- Gross margin...................................... 1,159 21,803 6,183 -------- -------- -------- Operating expenses: Research and development.................................. 29,368 18,223 13,928 Sales and marketing....................................... 23,982 11,638 5,765 General and administrative................................ 7,992 4,285 1,649 Amortization of acquired intangible assets................ 3,842 -- -- In-process research and development....................... 4,900 -- -- Impairment of long lived assets........................... 17,829 -- -- Restructuring and other expenses.......................... 2,513 -- -- Amortization of deferred compensation..................... 608 1,285 547 -------- -------- -------- Total operating expenses.......................... 91,034 35,431 21,889 -------- -------- -------- Loss from operations........................................ (89,875) (13,628) (15,706) Other income (expense), net: Interest income........................................... 2,593 4,002 489 Interest and other expense................................ (261) (735) (715) -------- -------- -------- Total other income (expense), net................. 2,332 3,267 (226) -------- -------- -------- Loss before cumulative effect of change in accounting principle................................................. $(87,543) $(10,361) $(15,932) Cumulative effect of change in accounting principle......... (5,300) -- -- -------- -------- -------- Net loss.................................................... $(92,843) $(10,361) $(15,932) ======== ======== ======== Basic net loss per share before cumulative effect of change in accounting principle................................... $ (3.13) $ (0.53) $ (3.33) Cumulative effect of change in accounting principle......... (0.19) -- -- -------- -------- -------- Basic net loss per share.................................... $ (3.32) $ (0.53) $ (3.33) ======== ======== ======== Weighted average shares used in computing basic net loss per share..................................................... 28,006 19,731 4,789 ======== ======== ======== Pro forma amounts with the change in accounting principle related to revenue applied retroactively (unaudited) Net revenues.............................................. N/A $ 39,823 $ 24,568 Net loss.................................................. N/A (13,169) (15,988) Basic net loss per share.................................. N/A (0.67) (3.34)
For the year ended March 31, 2001, the Company's amortization of deferred compensation included $61 related to cost of revenues, $316 related to research and development, $152 related to sales and marketing, and $79 related to general and administrative. For the year ended March 31, 2000, the Company's amortization of deferred compensation included $129 related to cost of revenues, $668 related to research and development, $321 related to sales and marketing, and $167 related to general and administrative. For the year ended March 31, 1999, the Company's amortization of deferred compensation included $55 related to cost of revenues, $284 related to research and development, $137 related to sales and marketing, and $71 related to general and administrative. The accompanying notes are an integral part of these financial statements. F-4 GADZOOX NETWORKS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
CONVERTIBLE PREFERRED STOCK COMMON STOCK ADDITIONAL TOTAL -------------------- ------------------- PAID-IN DEFERRED ACCUMULATED STOCKHOLDERS' SHARES AMOUNT SHARES AMOUNT CAPITAL COMPENSATION DEFICIT EQUITY ----------- ------ ---------- ------ ---------- ------------ ----------- ------------- BALANCE AT MARCH 31, 1998...................... 12,227,822 $ 60 5,078,328 $ 26 $ 21,245 $ -- $ (13,162) $ 8,169 Issuance of common stock for cash................ -- -- 511,401 2 128 -- -- 130 Deferred compensation..... -- -- 2,972 (2,972) -- Amortization of deferred compensation............ -- -- -- -- -- 547 -- 547 Issuance of preferred stock for cash, net..... 1,436,883 8 -- -- 10,881 -- -- 10,889 Issuance of preferred upon partial conversion of notes................... 242,694 1 -- -- 1,855 -- -- 1,856 Net loss.................. -- -- -- -- -- -- (15,932) (15,932) ----------- ---- ---------- ---- -------- ------- --------- -------- BALANCE AT MARCH 31, 1999...................... 13,907,399 69 5,589,729 28 37,081 (2,425) (29,094) 5,659 Issuance of common stock for cash, net of offering costs of $7,030.................. -- -- 5,835,439 30 78,579 -- -- 78,604 Amortization of deferred compensation............ -- -- -- -- -- 1,285 -- 1,285 Issuance of common stock for employee stock purchase plan........... -- -- 38,879 -- 693 -- -- 693 Conversion of warrant to common stock............ -- -- 44,370 -- -- -- -- -- Conversion of note payable to common stock......... -- -- 1,426,028 7 10,903 -- -- 10,910 Conversion of preferred stock to common stock... (13,907,399) (69) 13,907,399 69 -- -- -- -- Net loss.................. -- -- -- -- -- -- (10,361) (10,361) ----------- ---- ---------- ---- -------- ------- --------- -------- BALANCE AT MARCH 31, 2000...................... -- -- 26,841,844 134 127,251 (1,140) (39,455) 86,790 Issuance of common stock for cash................ -- -- 1,182,861 6 989 -- -- 995 Acceleration of employee options................. -- -- -- -- 456 -- -- 456 Amortization of deferred compensation............ -- -- -- -- -- 608 -- 608 Issuance of common stock for employee stock purchase plan........... -- -- 112,062 -- 675 -- -- 675 Issuance common stock for acquisition of SmartSAN................ -- -- 239,433 2 23,625 -- -- 23,627 Issuance of warrant to acquire common stock.... -- -- -- -- 113 -- -- 113 Reversal of deferred compensation related to cancellation of stock options................. -- -- -- -- (106) 106 -- -- Net loss.................. -- -- -- -- -- -- (92,843) (92,843) ----------- ---- ---------- ---- -------- ------- --------- -------- BALANCE AT MARCH 31, 2001...................... -- $ -- 28,376,200 $142 $153,003 $ (426) $(132,298) $ 20,421 =========== ==== ========== ==== ======== ======= ========= ========
The accompanying notes are an integral part of these financial statements. F-5 GADZOOX NETWORKS, INC. STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED MARCH 31, ------------------------------ 2001 2000 1999 -------- -------- -------- Cash flows from operating activities: Net loss.................................................. $(92,843) $(10,361) $(15,932) Adjustments to reconcile net loss to net cash used in operating activities: Adjustment for change in accounting principle.......... 5,300 -- -- Depreciation and amortization.......................... 3,668 2,599 1,739 Amortization of deferred compensation.................. 608 1,285 547 Change in allowance for doubtful accounts.............. 172 450 85 Accrued but unpaid interest............................ 27 462 460 Change in inventory reserve............................ 8,115 -- -- Loss on disposal of property and equipment............. -- -- 181 Amortization of acquired intangible assets............. 3,842 -- -- Impairment of long-lived assets........................ 17,829 -- -- Write-off of in-process research and development....... 4,900 -- -- Non-cash restructuring and impairment charges.......... 1,529 -- -- Non-cash stock compensation............................ 456 -- -- Changes in current assets and liabilities, net of acquisition: Accounts receivable.................................. 7,482 (8,600) (2,642) Inventories.......................................... (12,075) (1,359) (1,843) Prepaid expenses and other assets.................... 138 (2,201) (250) Accounts payable and accrued liabilities............. (196) 4,136 1,939 -------- -------- -------- Net cash used in operating activities............. (51,048) (13,589) (15,716) -------- -------- -------- Cash flows from investing activities: Purchases of property and equipment....................... (5,286) (2,771) (1,598) Proceeds from sale of short term investments.............. 39,767 -- -- Purchase of short term investments........................ (9,148) (30,619) -- Purchase of long term investments......................... (1,000) -- -- Net cash used in SmartSAN acquisition..................... (1,167) -- -- Cash used for long term deposits.......................... (46) -- -- -------- -------- -------- Net cash provided by (used in) investing activities..................................... 23,120 (33,390) (1,598) -------- -------- -------- Cash flows from financing activities: Proceeds from convertible notes........................... -- -- 15,000 Repayment of notes payable................................ (3,555) (371) (345) Repayment of capital lease obligations.................... (1,543) (1,318) (782) Loans to officers......................................... (535) -- -- Proceeds from issuance of common stock.................... 1,670 1,801 130 Proceeds from issuance of common stock in initial public offering, net.......................................... -- 77,495 -- Proceeds from issuance of preferred stock, net............ -- -- 10,889 -------- -------- -------- Net cash (used in) provided by financing activities..................................... (3,963) 77,607 24,892 -------- -------- -------- Net (decrease) increase in cash and cash equivalents........ (31,891) 30,628 7,578 Cash and cash equivalents at beginning of year.............. 42,830 12,202 4,624 -------- -------- -------- Cash and cash equivalents at end of year.................... $ 10,939 $ 42,830 $ 12,202 ======== ======== ======== Supplemental cash flow information: Cash paid for interest.................................... $ 261 $ 274 $ 240 ======== ======== ======== Property and equipment acquired under capital lease obligations............................................ $ -- $ 1,770 $ 1,750 ======== ======== ======== Conversion of preferred stock into common stock........... $ -- $ 34,129 $ -- ======== ======== ======== Conversion of convertible notes to common stock........... $ -- $ 10,910 $ 1,857 ======== ======== ======== Issuance of common stock for the acquisition of SmartSAN............................................... $ 23,625 $ -- $ -- ======== ======== ======== Issuance of warrant for common stock...................... $ 113 $ -- $ -- ======== ======== ========
The accompanying notes are an integral part of these financial statements. F-6 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS MARCH 31, 2001 1. BACKGROUND Gadzoox Networks, Inc. ("Gadzoox" or the "Company"), formerly Gadzoox Microsystems, Inc., was incorporated in the state of California on April 2, 1992 and was reincorporated in Delaware on January 6, 1998. The Company is a provider of products for storage area networks, or SANs. The Company's SAN products are designed to leverage the capabilities of Fibre Channel technology to enable companies to better manage the growth in mission-critical data by overcoming the limitations of traditional captive storage architecture and creating a foundation for data centralization. The Company is subject to a number of risks associated with companies in a similar stage of development, including dependency on key employees for technology development, reliance on a limited number of new products, reliance on a limited number of key suppliers, reliance on a limited number of key OEM and distribution channel customers, volatility of the storage industry, potential competition from larger, more established companies, the ability to penetrate the market with new products, the ability to sell its products through OEM and distribution channels and the ability to obtain adequate financing to support its growth. The Company has incurred a net loss in the year ended March 31, 2001 of $92.8 million and has an accumulated deficit of $132.3 million as of March 31, 2001. The Company has continuously incurred net losses from operations, and used $51.0 million for cash in operations for the year ended March 31, 2001, and has working capital of $11.8 million as of March 31, 2001. In May 2001, the Company sold 5.6 million shares of the Company's common stock in a private placement transaction for net proceeds of approximately $14.5 million. In June 2001, the Company entered into an Equity Line agreement with a financial institution. Under this agreement, the Company can raise up to $20 million additional cash via the sale of common stock dependent upon the terms and the conditions set out in the agreement (see note 7). The Company believes that its cash reserves, working capital and the funds available under the Equity Line agreement will be adequate to fund its operations through the year ended March 31, 2002. However, as discussed in note 7, the Company's right to sell shares under the Equity Line agreement is subject to a number of conditions and the Company may not be able to sell its shares of common stock under the Equity Line agreement as and when the Company wishes or needs. If the Company is unable to sell its shares of common stock under the Equity Line agreement, the Company will be required to raise additional funds to continue to operate its business. Many companies in the high technology manufacturing industry have experienced difficulty raising additional financing in recent months. Additional financing may not be available to the Company on favorable terms or at all. Even if additional financing is available, the Company may be required to obtain the consent of its stockholders, which it may not be able to obtain. If additional financing is not available, the Company may need to dramatically change its business plan, sell or merge its business, or face bankruptcy. In addition, the issuance of equity or equity-related securities will dilute the ownership interest of its stockholders and the issuance of debt securities could increase the risk or perceived risk of the Company. The Company's cash needs depend on numerous factors, including market acceptance of, and demand for its products, their ability to develop and introduce new products and product enhancements, prices at which it can sell their products, the resources the Company devotes to developing, marketing, selling and supporting its products, the timing and expense associated with expanding its distribution channels, increases in manufacturing costs and the prices of the components the Company purchases and other factors. In the year ended March 31, 2002, a substantial majority of the Company's revenues are expected to be derived from the sale of new products currently under evaluation or development, including the Slingshot 4218. The Company cannot assure that it will be able to develop and introduce the Slingshot or other new products successfully, and in the time frame it expects, or that these products will be adopted by the Company's OEM and distribution channel partners, or that significant net revenues would be derived if so adopted. If the Company is unable to raise additional capital, including through a draw down under the Equity Line, or if sales from new products are F-7 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) lower than expected, the Company will be required to make a significant reduction in operating expenses and capital expenditures in the year ended March 31, 2002 to ensure that the Company will have adequate cash reserves to fund operations through the year ended March 31, 2002. In addition, the Company may do one or more of the following: - engage a financial advisor to explore strategic alternatives, which may include a merger, asset sale, or another comparable transaction; - raise additional capital to fund continuing operations by private placements of equity and/or debt securities; and - form a joint venture with a strategic partner or partners to provide additional capital resources to fund operations. In addition to the foregoing, the Company is attempting to reduce its financial commitments and reduce future cash outflows by negotiating alternative terms with its suppliers. In addition, cost-cutting measures could include additional reductions in force. Further the Company is working with its channel partners to increase revenues through new marketing programs and promotions, and is exploring potential additional sources of revenue. There can be no assurance that it will be successful in increasing revenues or reducing cash outflows. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in preparing the financial statements include inventory reserves, allowance for doubtful accounts, and income tax valuation allowances. CASH AND CASH EQUIVALENTS Gadzoox considers all highly liquid investments with an original maturity of 90 days or less to be cash equivalents. The carrying value of cash equivalents approximates their fair value. SHORT-TERM INVESTMENTS As of March 31, 2000, the Company's short-term investments consisted of liquid debt instruments with maturities, at the time of purchase, greater than three months and less than one year. All such investments have been classified as available-for-sale, and are managed by a single financial institution. At March 31, 2000, all short-term investments were carried at fair value. Long-term holding gains and losses, net of taxes reported, have not been material to date, and are recorded as a separate component of stockholders' equity. The cost of the debt security is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization, interest income, realized gains and losses, and declines in value that are considered to be less than temporary, are included in other income (expense), net, on the accompanying statement of F-8 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) operations. There have been no declines in value that are considered to be other than temporary for any of the three years in the period ended March 31, 2001. Short-term investments are as follows (in thousands):
MARCH 31, -------------- 2001 2000 ---- ------- U.S. Government Agencies.................................... $-- $27,300 Corporate bonds and notes................................... -- 3,319 -- ------- $-- $30,619 == =======
CONCENTRATION OF CREDIT RISK As of March 31, 2001, financial instruments that potentially subject the Company to concentration of credit risk consist principally of bank deposits and trade accounts receivable. The Company places its cash and cash equivalents in checking and money market accounts in high credit quality financial institutions. The Company's trade accounts receivable are derived primarily from sales to OEMs and distributors located primarily in the U.S. who are generally large, well established companies. The Company performs ongoing credit evaluations of its customers and maintains an allowance for potential credit losses. Customers that account for greater than 10% of trade accounts receivable are as follows:
MARCH 31, ----------- 2001 2000 ---- ---- Customer A.................................................. 35% 23% Customer B.................................................. 33% 21% Customer C.................................................. --% 12%
INVENTORIES Inventories are stated at the lower of cost (first-in, first-out method) or market. Provisions, when required, are made to reduce excess and obsolete inventories to their estimated net realizable values. It is possible that estimates of net realizable value can change in the near future. The components of inventory are as follows (in thousands):
MARCH 31, ---------------- 2001 2000 ------- ------ Raw materials............................................... $ 5,157 $3,582 Work-in-process............................................. 26 58 Finished goods.............................................. 5,443 3,025 ------- ------ Total..................................................... $10,626 $6,665 ======= ======
PROPERTY AND EQUIPMENT Property and equipment are stated at cost, and depreciation and amortization are provided using the straight-line method based upon the estimated useful lives of the related assets as follows: Computer and laboratory equipment........ 3 years Software................................. 3 years Furniture and equipment.................. 5 years Leasehold Improvement.................... over the shorter of the remaining lease term or the estimated useful life of the improvement
F-9 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The components of property and equipment are as follows (in thousands):
MARCH 31, ----------------- 2001 2000 ------- ------- Computer and laboratory equipment........................... $ 8,700 $ 6,419 Software.................................................... 3,407 2,308 Furniture and equipment..................................... 3,945 1,540 Leasehold improvements...................................... 1,111 554 Construction in progress.................................... -- 841 ------- ------- 17,163 11,662 Accumulated depreciation and amortization................... (8,919) (5,167) ------- ------- Property and equipment, net................................. $ 8,244 $ 6,495 ======= =======
Depreciation and amortization expense of approximately $3.7 million, $2.6 million, and $1.7 million was recognized during the fiscal years ended March 31, 2001, 2000, and 1999, respectively. Included in property and equipment are assets acquired under capital lease obligations with an original cost of approximately $5.1 million and $5.1 million, as of March 31, 2001 and 2000, respectively. Related accumulated amortization of these leased assets was approximately $4.0 million and $2.4 million as of March 31, 2001 and 2000, respectively. IMPAIRMENT OF LONG-LIVED ASSETS The Company assesses the realizability of long-lived and intangible assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." Under SFAS No. 121, the Company is required to assess the valuation of its long-lived assets, including intangible assets, based on the estimated cash flows to be generated by such assets. The realizability of intangible assets, including goodwill, is evaluated periodically as events or circumstances indicate a possible inability to recover the net carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact of recent business combinations. The analyses involve a significant level of management judgement in order to evaluate the ability of the Company to perform within projections (See Note 9). REVENUE RECOGNITION Revenues consist of sales to OEM's and distributors. Revenues from sales to OEM's are recognized upon shipment from the Company. The Company provides for estimated sales returns and allowances and warranty costs related to such sales at the time of shipment. Net revenues consist of product revenues reduced by estimated sales returns and allowances. The Company's terms of sale to its customers do not include any formal customer acceptance provisions or installation requirements. As of April 1, 2000, the Company changed its accounting method for recognizing revenue net of appropriate reserves for sales returns when merchandise is shipped to distributors, to recognizing revenue when the product is shipped by the distributors to end-users. According to the management of the Company, this change was made as it better recognizes the substance of demand for its products due to changes in the market place during the year ended March 31, 2001, and will accordingly better focus the Company on, and allow investors to better understand end-user demand trends for its products. The cumulative effect of this change in accounting principle was a charge of $5.3 million or $0.19 per basic share. F-10 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) WARRANTY The Company warrants its products against defects in materials and workmanship for one to three year periods. The estimated cost of warranty obligations is recognized at the time of revenue recognition. GOODWILL AND INTANGIBLES Costs in excess of tangible assets acquired and liabilities assumed are recorded as goodwill and intangibles. Goodwill and intangibles are amortized on a straight-line basis over the estimated useful life of five years. Intangibles relate to developed technology and workforce, arising from the Company's acquisition of SmartSAN. As of March 31, 2001 the amount of goodwill and intangibles was $0. COMPREHENSIVE INCOME (LOSS) In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 130, "Reporting Comprehensive Income," which established standards for reporting and presentation of comprehensive income and its components. This standard defines comprehensive income as the changes in equity of an enterprise except those resulting from stockholder transactions. The Company had no such transactions that were material to the financial statements for the periods ended March 31, 2001, 2000, and 1999. For each of these years, comprehensive loss approximated the net loss. OTHER ACCRUED LIABILITIES Other accrued liabilities consist of the following (in thousands):
MARCH 31, --------------- 2001 2000 ------ ------ Purchase commitments........................................ 1,655 -- Restructuring reserve....................................... 687 -- Accrued warranty costs...................................... 266 639 Sales return reserve........................................ 315 651 Accrued professional fees................................... 525 50 Accrued marketing expenses.................................. 569 -- Other accrued liabilities................................... 1,215 668 ------ ------ Total..................................................... $5,232 $2,008 ====== ======
STOCK-BASED COMPENSATION The Company complies with SFAS No. 123, "Accounting for Stock-Based Compensation." This standard permits the use of either a fair value based method or the method defined in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") to account for stock-based compensation arrangements. Companies that elect to employ the valuation method provided in APB 25 are required to disclose the pro forma net income (loss) that would have resulted from the use of the fair value based method. The Company has elected to continue to determine the value of stock-based compensation arrangements under the provisions of APB 25, and accordingly, it has included the pro forma disclosures required under SFAS No. 123 in Note 7. SOFTWARE DEVELOPMENT COSTS Development costs incurred in the research and development of new software products are expensed as incurred until technological feasibility in the form of a working model has been established, in accordance with F-11 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) SFAS No. 86, "Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed." To date, the Company's software development has been completed concurrent with the establishment of technological feasibility and, accordingly, all software development costs have been charged to research and development expense in the accompanying statements of operations. SALES AND MARKETING COSTS Sales and marketing costs are expensed as incurred. These expenses consist primarily of salaries, commissions and other related expenses for personnel engaged in marketing, sales and customer engineering support functions, as well as, costs associated with trade shows, promotional activities, travel expenses and other related expenses. RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform to the current year presentation. BASIC NET LOSS PER SHARE Historical net loss per share has been calculated under SFAS No. 128, "Earnings Per Share." Basic net loss per share on a historical basis is computed using the weighted average number of shares of common stock outstanding. No diluted loss per share information has been presented in the accompanying statements of operations since potential common shares from conversion of the convertible debenture, preferred stock, stock options, and warrants are antidilutive. The total number of shares excluded from diluted loss per share relating to these securities was 4,724,751, 20,256,699 and 16,481,009 for fiscal 2001, 2000 and 1999 respectively. The following table presents the calculation of basic net loss per common share (in thousands, except per share data):
YEAR ENDED MARCH 31, ------------------------------ 2001 2000 1999 -------- -------- -------- Net loss............................................. $(92,843) $(10,361) $(15,932) ======== ======== ======== Basic: Weighted average shares of common stock outstanding........................................ 28,006 19,930 5,374 Less: Weighted average shares subject to repurchase......................................... -- (199) (585) -------- -------- -------- Weighted average shares used in computing basic net loss per common share.............................. 28,006 19,731 4,789 ======== ======== ======== Basic net loss per common share...................... $ (3.32) $ (0.53) $ (3.33) ======== ======== ========
NEW ACCOUNTING STANDARDS In June 2001, the FASB issued SFAS No. 138, "Accounting for Certain Derivative Instruments and Hedging Activities," an amendment of SFAS No. 133, which is effective for all fiscal years beginning after June 15, 2000. SFAS No. 138 establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Because the Company does not currently hold any derivative instruments and does not currently engage in any material hedging activities, management believes that the application of SFAS No. 138 will not have a material impact on the Company's financial position or results of operations. F-12 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) In March 2000, the FASB issued Financial Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation -- an Interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44 addresses the application of APB No. 25 to clarify, among other issues: (a) the definition of employee for purposes of applying APB No. 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequences of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. The Company's adoption of FIN 44 did not have a material impact on the Company's financial position or results of operation. 3. COMMITMENTS AND CONTINGENCIES LEASE AGREEMENTS During the year ended March 31, 2000 and 1999, the Company acquired certain equipment under capital leases. Additionally, the Company leases four facilities under non-cancelable operating leases which expire between January 2002 and August 2008. Future minimum lease payments under all capital and operating lease agreements as of March 31, 2001 are as follows (in thousands):
CAPITAL OPERATING YEAR ENDED MARCH 31, LEASES LEASES -------------------- ------- --------- 2002...................................................... 1,023 2,131 2003...................................................... 376 3,054 2004...................................................... -- 3,106 2005...................................................... -- 3,168 2006...................................................... -- 3,233 2007 and thereafter....................................... -- 5,183 ------ ------- 1,399 $19,875 ------- Less amounts representing interest (Weighted average interest rate of 7.50%)................. (72) ------ Present value of minimum lease payments................... 1,327 Less: current portion..................................... (924) ------ Non-current portion....................................... $ 403 ======
Rent expense under non-cancelable operating lease agreements for the years ended March 31, 2001, 2000 and 1999 was approximately $1.9 million, $1.1 million, and $0.8 million, respectively. LEGAL PROCEEDINGS From time to time, the Company may become involved in various lawsuits and legal proceedings, which arise, in the ordinary course of business. In May 1999, a former employee filed a complaint against the Company and in September 2000 the plaintiff and the company settled this lawsuit out of court. This lawsuit did not have a material adverse effect on the Company's financial statements or results of operations. Litigation is subject to inherent uncertainties, and an adverse result in other matters could arise from time to time that may harm Gadzoox' business, financial condition and results of operations. On June 6, 2001, a putative securities class action, captioned Cooper v. Gadzoox Networks, Inc., et al., Civil Action No. 01-CV-5309-RO, was filed against the Company, three of the Company's former officers and Credit Suisse First Boston Corporation and BancBoston Robertson Stephens, Inc., two underwriters in the Company's initial public offering, in the United States District Court for the Southern District of New York. F-13 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The complaint alleges violations of Section 11 of the Securities Act of 1933 ("Securities Act") against all defendants, a violation of Section 15 of the Securities Act against the former officers, and violations of Section 12(a)(2) of the Securities Act and Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5., promulgated thereunder) against the underwriters. The complaint seeks unspecified damages on behalf of a purported class of purchasers of common stock between July 19, 1999 and December 6, 2000. As of June 18, 2001, various plaintiffs have filed similar actions asserting virtually identical allegations against at least 45 other companies. To date, there have been no significant developments in the litigation. As of June 26, 2001, the Company had received two substantially identical lawsuits, and anticipates that additional related lawsuits may be brought against the Company with substantially identical allegations to the Cooper lawsuit. The Company further anticipates that all such lawsuits will eventually be coordinated or consolidated with one another. The Company intends to defend the lawsuits vigorously. 4. CONVERTIBLE NOTES On September 18, 1998, Gadzoox entered into a $15.0 million note purchase agreement (the "Agreement") with Seagate Technology, Inc. ("Seagate"). The Agreement provides that Seagate purchase up to $15.0 million of convertible subordinated promissory notes (the "Convertible Notes"), bearing simple interest on the unpaid principal balance at a rate equal to 5.75% per annum with principal and interest maturing on September 18, 2001. As further outlined and defined in the Agreement, upon the earlier to occur of (i) equity financing in which the Company receives at least $6 million, (ii) the Company's initial public offering, (iii) a change of control of the Company, or (iv) the maturity date of the Convertible Note, at the sole option of the Company, any portion or all of the then outstanding balance of principal and interest on the Convertible Note will convert into shares of Series G preferred stock at a price of $7.65 per share. Accrued interest is converted prior to any principal owing under the Convertible Note. In the event of a default, as defined in the agreement, Seagate may declare all outstanding interest and principal immediately due and payable in cash. Gadzoox may, upon thirty (30) days written notice to Seagate, prepay the Convertible Note in whole or in part. For the period from October 1998 through June 30, 2000, a total of $12.8 million of principal and accrued interest was converted into 1,668,722 shares of common stock in three separate transactions. On July 31, 2000, the Company repaid, in full, the outstanding principal and accrued interest under the loan of approximately $3.1 million in cash. As a result of the repayment, the company reclassified the amount of the convertible note at March 31, 2000, of $3.1 million from long-term liabilities to current liabilities. 5. NOTES PAYABLE In August 1997, in connection with lease financing (see Note 3), the Company entered into a loan agreement (the "Note") with a lessor to provide financing for equipment previously purchased. The face amount of the Note was for approximately $1.1 million. The repayment period is 36 months with monthly payments of principal and interest in the amount of approximately $33,000 with a final installment of approximately $162,000 due on September 1, 2000. The Note bears interest at approximately 9.0% per annum and is secured by the equipment previously purchased. At March 31, 2001, the note had been fully repaid. 6. ACQUISITION OF SMARTSAN SYSTEMS, INC. On March 2, 2000, the Company entered into a definitive agreement to acquire SmartSAN Systems, Inc. ("SmartSAN"), a California company. The acquisition was completed in April 2000 and was accounted for under the purchase method of accounting. The Company acquired all of the outstanding shares of SmartSAN by issuing 239,433 shares of its common stock and assuming options to purchase 108,376 additional shares F-14 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (which share number reflects the effect of the exchange ratio applied to the outstanding SmartSAN stock options at the time of the acquisition). Total consideration was as follows (in thousands): Fair value of common stock issued and options assumed....... $23,625 Merger and other related costs paid in cash................. 1,169 ------- Total consideration......................................... $24,794 =======
The fair value of the Company's common stock was determined using the average closing market price over several days on either side of the acquisition announcement on March 2, 2000. The fair value of the SmartSAN options assumed was estimated using the Black-Scholes pricing model and assumptions consistent with those used to value options issued to employees in accordance with EITF 90-9 (See Note 7). The allocation of the total consideration to the fair value of acquired assets and liabilities is as follows (in thousands): Fair value of net assets acquired and liabilities assumed... $ (778) Acquired intangibles........................................ 20,672 In-process research and development......................... 4,900 ------- $24,794 =======
At the time of the acquisition, the Company allocated approximately $4.9 million of the purchase price to in-process research and development products. This amount represented approximately 20% of the purchase price. This allocation represented the estimated fair value based on risk-adjusted cash flows related to the incomplete research and development projects. At the date of acquisition, the development of these projects had not yet reached technological feasibility, and the research and development in progress had no alternative future uses. Accordingly, these costs were expensed as of the acquisition date. At the acquisition date, SmartSAN was conducting design, development, engineering and testing activities associated with the development of next-generation Geminix products: SDM3000, RDM4000, and DDM5000, valued at $800,000, $1.1 million, and $3.0 million, respectively. The SDM3000 was a next-generation Fibre Channel to Fibre Channel router; the RDM4000 was being developed as a Fibre Channel to LAN/WAN remote domain manager; and the DDM5000 was scheduled to be the flagship distributed domain manager incorporating advanced storage virtualization. SmartSAN engineers had made significant progress on the projects as of the acquisition date, including design of the overall architecture, and in some cases, much of the development work. However, substantial integration and testing activities remained to develop the technologies into commercially viable products. At the acquisition date, the technologies under development were approximately 80% (SDM3000), 65% (RDM4000) and 25% (DDM5000) complete, based on engineering man-month data and technological progress. SmartSAN had spent approximately $700,000 on the in-process projects, and expected to spend approximately $2.5 million to complete all phases of the R&D projects. Anticipated completion dates ranged from 2 months for the SDM3000 to 12 months for the DDM5000, at which times the Company expected to begin benefiting, and generating cash flows, from the developed technologies. In making its purchase price allocation, management considered present value calculations of income, an analysis of project accomplishments and remaining outstanding items, an assessment of overall contributions, as well as project risks. The value assigned to purchased in-process technology was determined by estimating the costs to develop the acquired technology into commercially viable projects, estimating the resulting net cash flows from the projects, and discounting the net cash flow to their present value. The revenue projection used to value the in-process research and development was based on estimates of relevant market sizes and growth factors, expected trends in technology, and the nature and expected timing of new product F-15 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) introductions by the Company and its competitors. The resulting net cash flows from such projects are based on management's estimates of cost of sales, operating expenses, and income taxes from such projects. The rates utilized to discount the net cash flows to their present value were based on estimated cost of capital calculations. Due to the nature of the forecast and the risks associated with the projected growth and profitability of the developmental projects, discount rates of 40% to 45% were used in the analysis. These discount rates were commensurate with the projects' stage of development and the uncertainties in the economic estimates described above. Other acquired intangible assets, including goodwill, developed technology and other intangible assets of approximately $20.7 million are being amortized over their estimated useful lives of five years on a straight-line basis. During the year ended March 31, 2001, the Company amortized approximately $3.8 million of goodwill and acquired intangible assets. The amount allocated to developed technology was $4.4 million. The developed technology consists of the SR2001/SDM2001 platforms. Both are based on the same hardware platform and have the same estimated remaining life. SR2001 is a family of Fibre to SCSI Subnet Domain Managers that provide high-performance data routing between Fibre Channel SANs and SCSI devices with advanced management features and the SmartCafe graphical user interface. SR2001 is primarily a proof of concept-evaluation vehicle. The SR2001 contains a 64-bit RISC processor, which enables it to provide sophisticated management of the storage resources in the subnet beneath it. Such management features are essential to meeting the business needs for data availability, data integrity, and data security, and to realizing the full benefit potential of SAN technology. The SDM2001 Subnet Domain Manager is based on the same hardware platform as the SR2001, but adds a sophisticated suite of subnet management software. The Company acquired SmartSAN with the intent that SmartSAN would provide the Company with a full range of products to address the storage area networking market including hubs and switches, which the Company was already selling, and IP routers which SmartSAN was in the process of developing. Subsequent to the acquisition, the Company realized that the IP router market was extremely competitive and significant additional funding would be required to develop products and provide support. As a result, in March 2001, the Company changed its product strategy and refocused its efforts exclusively on the higher margin fibre channel fabric switch market. Consequently, the product lines and technologies acquired in the SmartSAN acquisition were abandoned because they did not support open-fabric switch technology. At this time, the former SmartSAN products were estimated to be 100% (SDM3000), 65% (RDM4000) and 25% (DDM5000) complete. 7. COMMON STOCK In May 2001, the Company sold 5,600,000 shares of its common stock in a private placement transaction and received net proceeds of approximately $14.5 million. Under the terms of the purchase agreement, the Company is subject to certain financial penalties in the event that the Company fails to file an S-3 with the Securities and Exchange Commission and have the filing be declared effective by the deadlines established in the contract. In the event that the filing is not declared effective within 360 days of the date of the agreement, the Company is obligated to repurchase the shares from the investors at 110% of the original purchase price. This private placement of common stock has been recorded outside of shareholders' equity, as redeemable common stock, since the triggering event that would require the Company to repurchase the common stock is not solely within the control of the Company. This amount will remain as redeemable common stock until such time that the SEC has declared the related S-3 effective. Based on the Company's previous experience in dealings with the SEC, management believes that it is probable that the S-3 will be declared effective by the SEC within the deadlines established in the contract and that the Company will not be required to repurchase the common stock, and therefore the Company has F-16 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) not recorded any accretion to the common stock. The Company will recognize any change in the redemption value of the common stock immediately upon determining that such redemption is probable. In connection with this transaction, the Company issued a warrant to purchase 168,000 shares of common stock to its financial advisor for their assistance in the investor search. The warrant is immediately exercisable at $4.14 per share, is fully vested and non-forfeitable and expires three years from the date of grant. In the first quarter ending June 30, 2001, management will record the fair value of the warrant as an offering cost of $481,000, which was determined using the Black-Scholes option pricing model and the following assumptions: expected life of three years, volatility of 147%, dividend yield of 0%, and a risk-free interest rate of 4.32%. EQUITY LINE AGREEMENT On June 28, 2001, the Company entered into an equity line financing agreement (the "Equity Line") with Societe Generale pursuant to which the Company has the right to elect to sell and Societe Generale has the obligation to purchase up to $20 million of the Company's common stock. Pursuant to the terms of the Equity Line, the Company, from time to time, during the two year period beginning on June 28, 2001, can elect to sell (which election is referred to as a "draw down") a specific dollar amount of its common stock based upon the price and trading volume of its common stock during the thirty trading days prior to a draw down. The price per share and the actual number of shares sold by the Company pursuant to each draw down will be determined by the price and volume of trading in the Company's common stock during the five trading days following the day that the Company notifies Societe Generale of the draw down, provided that in no event will the price per share be less than the higher of $1.00 and the price set by the Company in its notice of election to make a draw upon the equity line. Under the terms of the Equity Line agreement, the Company is obligated to sell at least $5.0 million of common stock to Societe General or pay a penalty equal to 6% of any portion of such $5.0 million minimum obligation which is not sold by the Company. The Company cannot sell more than 6,812,400 shares of common stock pursuant to the Equity Lien without fist obtaining stockholder approval. The Company also is obligated in connection with the Equity Line to file a registration statement registering the sale by Societe Generale of any shares sold by the Company. If this registration statement is not declared effective within 180 days of June 28, 2001, then Societe Generale shall have the right to terminate the Equity Line, in which event the Company shall be obligated to pay the penalty described above. The Company's ability to sell shares of its common stock under the Equity Line is subject to a number of conditions set forth in the Equity Line agreement, including, but not limited to, (i) the requirement that the price per share of the Company's common stock remain higher than a specified minimum price during the five trading days following the Company's election to draw upon the Equity Line, (ii) the absence of any material adverse change in the business or financial condition of the Company, (iii) the continued effectiveness of the registration statement covering the sale of shares by Societe Generale and the absence of any material omission or misstatement from the then current prospectus relating to the registration statement and (iv) the delivery of certain letters and reports from the Company's counsel and accountants. The Equity Line prohibits Societe Generale from selling shares of the Company's Common Stock during the term of the Equity Line other than a number of shares equals to the amount of any draw down by the Company divided by 94% of the minimum selling price specified in the Company's draw down election. F-17 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) STOCK OPTION PLANS At March 31, 2001, shares of common stock were reserved for future issuances as follows: 1999 Employee Stock Purchase Plan........................... 249,059 1993 Stock Option Plan: Outstanding options and rights............................ 4,807,060 Reserved for future grants................................ 732,615 2000 Non-Statutory Stock Option Plan: Outstanding options and rights............................ 2,440,862 Reserved for future grants................................ 859,096 1999 Director Stock Option Plan: Outstanding options and rights............................ 33,020 Reserved for future grants................................ 37,500 SmartSAN 1998 Equity Incentive Plan: Outstanding options and rights............................ 33,350 Reserved for future grants................................ -- --------- 9,192,562 =========
1999 EMPLOYEE STOCK PURCHASE PLAN In May 1999, the Board of Directors approved the adoption of the Company's 1999 Employee Stock Purchase Plan (the "Stock Purchase Plan"). The Stock Purchase Plan allows eligible employees to purchase shares of common stock through payroll deductions at 85% of the fair market value of the common stock. A total of 150,000 shares of common stock were reserved for issuance under the Stock Purchase Plan. The number of shares reserved for issuance under the Stock Purchase Plan is subject to an annual increase to be added on the first day of the Company's fiscal year, beginning in fiscal 2001, equal to the lesser of (a) 250,000 shares, (b) 0.5 % of the outstanding shares on such date, or (c) a lesser amount determined by the Board of Directors. Accordingly, in April 2001 and April 2000, an additional 250,000 shares, respectively, were added to the Stock Purchase Plan. During fiscal 2001 and 2000, 112,044 and 38,897 shares, respectively, were issued under the Stock Purchase Plan. 1993 STOCK OPTION PLAN In May 1999, the Board of Directors approved and adopted an Amended and Restated 1993 Stock Option Plan (the "1993 Plan"). The maximum number of shares available for sale under the 1993 Plan was increased to 8,180,000. Beginning in the year ended March 31, 2001, the number of shares reserved for issuance under the Plan is subject to an annual increase to be added on the first day of the Company's fiscal year, equal to the lesser of (a) 1,500,000 shares, (b) 0.5% of the outstanding shares on such date, or (c) a lesser amount determined by the Board of Directors. Accordingly on April 1, 2001 and April 1, 2000, 1,418,791 and 1,342,092 additional shares, respectively, were added to the 1993 plan. Additionally in April 2000, the Board of Directors authorized an increase in the number of shares reserved for issuance under the amended Plan by 1,400,000 shares and in October 2000, the stockholders of the Company approved this increase. 2000 NON-STATUTORY STOCK OPTION PLAN In June 2000, the Board of Directors approved and adopted the 2000 Non-Statutory Stock Option Plan (the "NSO Plan"). The number of shares reserved for issuance under this Plan was 1,600,000. In August F-18 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 2000 and October 2000, the Board approved an additional 700,000 and 1,000,000 shares, respectively, for issuance under the NSO Plan. 1999 DIRECTOR STOCK OPTION PLAN In May 1999, the Board of Directors approved the adoption of the 1999 Director Stock Option Plan (the "Director Plan"). The Director Plan was approved by the stockholders in June, 1999. The Director Plan provides for the automatic grant of an option to purchase 5,000 shares of common stock to each non-employee director on the later of the date of adoption of the Director Plan or the date on which such person first becomes a director (the "Initial Grant"). After the Initial Grant, the non-employee director will receive an automatic annual grant of 2,500 shares of common stock. All shares granted under the Director Plan are 100% vested at the grant date and expire upon the earlier of three years after the date of grant, or the resignation of the director from the Board of Directors. During the year ended March 31, 2000, a total of 50,000 shares of common stock were reserved for issuance under the Director Plan. The number of shares reserved for issuance under the Director Plan is subject to annual increases on the first day of the Company's fiscal year, beginning in 2001, sufficient to bring the number of shares available for future issuance to 50,000 shares. Accordingly, in April 2001 and April 2000, an additional 12,500 and 25,000 shares, respectively, were allocated to the Director Plan. SMARTSAN 1998 STOCK OPTION PLAN In April 2000, in connection with the acquisition of SmartSAN Systems, Inc., ("SmartSAN"), the Company assumed the SmartSAN 1998 Equity Incentive Plan (the "SmartSAN Plan"). Only former employees of SmartSAN that became employees of the Company upon the closing of the merger with the Company are eligible to participate in the SmartSAN Plan. The Company reserved a total of 108,376 shares of Common Stock for issuance under the Plan. No additional shares may be reserved thereunder. STOCK OPTIONS Gadzoox, under the various stock option plans (the "Plans") discussed above, grants stock options for the shares of common stock to employees, directors and consultants. In accordance with the Plans, all incentive and non-statutory stock option grants must be at prices of at least 100% to 85%, respectively, of the fair value of the stock on the date of the grant, as determined by the Board of Directors. The options are exercisable as determined by the Board of Directors. Generally, stock options vest ratably over a four-year period except for options granted to new employees which vest 25% on the first anniversary of the grant date and vest ratably over the remaining three years. The options expire upon the earlier of ten years from the date of grant or thirty days following termination of employment. Stock purchase rights granted under the Plan must be exercised within ninety days from the date of grant. Shares purchased pursuant to the grant of a stock purchase right shall be subject to repurchase, and the repurchase option shall lapse at a minimum rate of 20% per year. F-19 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) A summary of transactions under the Plans is as follows:
OUTSTANDING OPTIONS AND RIGHTS ------------------------------- SHARES WEIGHTED- AVAILABLE NUMBER AVERAGE FOR GRANT OF SHARES EXERCISE PRICE ---------- ------------ ---------------- Balance at March 31, 1998............................... 457,627 4,224,945 $ 0.423 Authorized............................................ 1,100,000 -- -- Granted............................................... (1,119,400) 1,119,400 $ 2.759 Cancelled............................................. 303,251 (303,251) $ 1.270 Exercised............................................. -- (511,402) $ 0.235 ---------- ---------- ------- Balance at March 31, 1999............................... 741,478 4,529,692 $ 0.969 Authorized............................................ 550,000 -- -- Granted............................................... (1,403,050) 1,403,050 $33.145 Cancelled............................................. 163,420 (163,420) $10.798 Exercised............................................. -- (1,810,439) 0.64 ---------- ---------- ------- Balance at March 31, 2000............................... 51,848 3,958,883 $11.902 Authorized............................................ 6,175,468 -- -- Granted............................................... (6,804,326) 6,804,326 $ 9.542 Cancelled............................................. 2,266,055 (2,266,055) $15.436 Exercised............................................. -- (1,182,861) $ 0.877 Expired............................................... (59,834) -- -- ---------- ---------- ------- Balance at March 31, 2001............................... 1,629,211 7,314,293 $10.467 ========== ========== =======
The following table summarizes the stock options outstanding and exercisable at March 31, 2001:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ---------------------- --------------------- WEIGHTED- AVERAGE WEIGHTED- WEIGHTED- REMAINING AVERAGE AVERAGE RANGE OF CONTRACTUAL EXERCISE EXERCISE EXERCISE PRICE NUMBER LIFE PRICE NUMBER PRICE ----------------- --------- ----------- --------- --------- --------- (IN YEARS) $ 0.075 - $ 1.875 803,310 7.43 $ 0.883 438,634 $ 0.357 $ 2.000 - $ 4.000 790,666 8.07 $ 2.907 355,807 $ 2.701 $ 4.063 76,000 9.90 $ 4.063 -- $ -- $ 4.094 911,088 9.57 $ 4.094 101,256 $ 4.094 $ 4.125 1,184,000 9.59 $ 4.125 95,896 $ 4.125 $ 4.250 - $ 7.938 863,104 9.48 $ 7.314 83,569 $ 7.816 $ 8.000 - $ 9.500 311,162 8.00 $ 8.840 101,957 $ 9.000 $ 11.813 1,232,370 9.29 $11.813 171,780 $11.813 $12.563 - $42.000 958,811 8.96 $32.182 209,836 $33.768 $ 43.063 - $60.75 183,782 8.72 $54.260 76,475 $52.828 --------- --------- $ 0.075 - $60.75 7,314,293 8.96 $10.864 1,635,210 $10.296 ========= =========
F-20 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) VALUATION OF STOCK OPTIONS The Company applies the intrinsic value method prescribed by APB No. 25, "Accounting for Stock Issued to Employees", in accounting for its stock-based compensation plans (See Note 2). Had compensation costs for the Company's stock-based compensation plans been determined consistent with the fair value approach set forth in SFAS 123, the Company's net loss and net loss per share would have been adjusted to the pro forma amount indicated below:
YEAR ENDED MARCH 31, ------------------------------------- 2001 2000 1999 ----------- ---------- ---------- (IN THOUSANDS EXCEPT LOSS PER SHARE) Net loss: As reported....................................... $ (92,843) $(10,361) $(15,932) Pro forma......................................... $(108,471) $(14,219) $(16,129) Basic net loss per share: As reported....................................... $ (3.32) $ (0.53) $ (3.33) Pro forma......................................... $ (3.87) $ (0.72) $ (3.37)
The fair value of each stock option grant on the date of grant and the fair value of the shares granted under the Purchase Plan were estimated using the Black-Scholes option pricing model with the following average assumptions:
YEAR ENDED MARCH 31, --------------------------------------------- 2001 2000 1999 ------------- ------------- ------------- Volatility.............................. 147% 214.5% 0.01% Risk-free interest rate................. 4.57% - 6.60% 5.27% - 6.66% 4.56% - 6.73% Dividend yield.......................... -- -- -- Expected lives.......................... 4.0 4.18 4.0 Weighted average fair value............. $9.56 $10.63 $0.49
The pro forma effect on net loss for the years ended March 31, 2001, 2000, and 1999 are not representative of the pro forma effect on net loss in future years for the following reasons: (i) the number of future shares to be issued under these plans is unknown, and (ii) the assumptions do not take into consideration pro forma compensation expense related to grants made prior to January 1, 1995. DEFERRED COMPENSATION In connection with the grant of certain stock options to employees during the year ended March 31, 1999, the Company recorded deferred compensation within stockholders' equity of approximately $3.0 million, representing the difference between the deemed value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. The Company recorded amortization of deferred compensation of $0.6 million, and $1.3 million, and $0.5 million during the years ended March 31, 2001, 2000, and 1999, respectively. At March 31, 2001, the remaining deferred compensation of approximately $0.4 million will be amortized as follows: $0.3 million and $0.1 million for the years ended March 31, 2002 and 2003, respectively. The amortization expense relates to options awarded to employees in all operating expense categories. The amortization of deferred compensation has not been separately allocated to these categories. The amount of deferred compensation expense to be recorded in future periods could decrease if forfeiture for any accrued but unvested compensation arises from the early termination of an option holder's service. F-21 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 8. SALES TO SIGNIFICANT CUSTOMERS AND SEGMENT INFORMATION During the year ended March 31, 2000, the Company adopted SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information" which requires a new basis of determining reportable business segments, i.e., the management approach. This approach requires that business segment information used by management to assess performance and manage company resources be the source for information disclosure. On this basis, the Company is organized and operates as one business segment, the development, manufacture, marketing and sales of hubs and switches and managed storage systems for storage area networks. The Company's Chief Executive Officer is the Chief Operating Decision Maker (CODM), as defined by SFAS 131. The CODM allocates resources and assesses the performance of Gadzoox based on revenues and overall profitability. Revenues are attributed to geographic areas based on the location of the customer to which product is shipped. Domestic revenues include sales to certain OEM customers who may then distribute to their international customers. To date, service revenues have not been significant. Individual customers that accounted for more that 10% of net revenues are as follows:
YEAR ENDED MARCH 31, ------------------ 2001 2000 1999 ---- ---- ---- Customer A.................................................. 42% 29% 42% Customer B.................................................. 33% 17% 15% Customer C.................................................. -- 33% 10% Customer D.................................................. -- 12% --
Revenues by geographic area are as follows.
YEAR ENDED MARCH 31, ------------------ 2001 2000 1999 ---- ---- ---- North America (principally the United States)............... 72% 70% 64% Germany..................................................... 16% 12% 12% Europe (excluding Germany).................................. 9% 7% 5% Asia........................................................ 3% 11% 19% --- --- --- Total.................................................. 100% 100% 100% === === ===
Identifiable assets located outside the United States were not material at March 31, 2001, 2000, and 1999. 9. RESTRUCTURING AND IMPAIRMENT CHARGES In the fourth quarter ended March 31, 2001, the Company recorded restructuring expenses totaling approximately $2.5 million, and an additional $17.8 million relating to the impairment of long lived assets. These charges reflect the Company's plan, announced in the fourth quarter, to focus more resources on the development of open-fabric switch technology products, and to streamline operations and reduce overall costs. This plan primarily resulted in the termination and abandonment of the Axxess and Geminix product lines, reduction of head count, and the implementation of a plan to consolidate all San Jose, California operations into one building. The Company's research and development facility in southern California will remain in operation. F-22 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) In March 2001, the Company made the decision to terminate and abandon the Axxess product line. As a result, the Company incurred approximately $0.3 million of severance costs relating to the termination of 27 employees, and incurred a further write down of approximately $1.5 million of other assets associated with the Axxess product line, including property and equipment with no alternate use and licenses related to software used in the Axxess product line. This impairment charge included a $1.0 million prepaid royalty fee relating to a software license agreement that the Company and DataCore Software Corporation ("DataCore") entered into in 1999. Under the terms of this license agreement, DataCore and the Company had agreed to work collaboratively to develop products to address both the hardware and software needs of storage area networks. The Company intended to integrate DataCore's software with the Axxess hardware and software products that were under development at the time. Pursuant to the software license agreement, the Company paid DataCore an upfront loyalty fee of $1 million during 1999 and 2000. In connection with the termination of the Axxess product line, the Company decided to write-off the entire $1.0 million prepaid royalty fee. In addition, the Company expensed an additional $0.7 million relating to future cash outlays that are expected to be incurred from exiting lease agreements for office space that will no longer be used as a result of the restructuring and consolidation into its one main facility. The Company anticipates payment of this amount in six equal monthly payments commencing April 2001. The Geminix product line was acquired with the acquisition of SmartSAN (see Note 6). With the termination and abandonment of the Geminix product line, the Company was not going to generate any future cash flows and had no future alternative use for the intangible assets and other assets acquired that related to the Geminix product line. Based on a value of $0 assigned by the Company to the SmartSAN assets, using the discounted cash flow method, the Company expensed the unamortized acquired intangible assets of SmartSAN, totaling $16.8 million, in March 2001. In May 2000, the Company purchased 49,164 shares of Series C Preferred Stock of DataCore for an aggregate purchase price of $999,504. In its Series C Preferred Stock round of financing, DataCore sold an aggregate of 1,750,000 shares of Series C Preferred Stock to approximately 30 investors at a purchase price of $20.33 per share for aggregate purchase price consideration of $35,577,500. The Series C Preferred Stock were voting securities and were convertible into common stock of DataCore. The Company owns less than one percent of DataCore's voting stock on an as converted to common stock basis. At the time of the investment, management initially recorded its financial investment in DataCore based on the purchase price of the shares. The Company's investment in DataCore was not contingent upon any other contractual arrangement with DataCore nor has the Company invested in any affiliate of DataCore. In March 2001, management determined the fair value of the existing equity investment in DataCore to be approximately $0. As a result of the impact of the current economic environment on DataCore's valuation and management's view that the change in valuation was less than temporary, the Company wrote down its investment to management's estimate of its fair value. As a result, the Company recognized an impairment charge of $1 million in March 2001. The following table summarizes the Company's restructuring activity for the year ended March 31, 2001 (in thousands):
SEVERANCE EXCESS AND BENEFITS FACILITIES OTHER ASSETS TOTAL ------------ ---------- ------------ ------- Restructuring expense.............................. $ 297 $687 $ 1,529 $ 2,513 Cash charge........................................ (297) -- -- (297) Non-cash charge.................................... -- -- (1,529) (1,529) ----- ---- ------- ------- Reserve balance, March 31, 2001.................... $ -- $687 $ -- $ 687 ===== ==== ======= =======
F-23 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 10. LEASE AGREEMENT As part of the restructuring of the Company, management has determined that previously leased office space currently under construction will not be utilized by the Company. In March 2001, management reached an incentive agreement with the lessor, whereby in exchange for the lessor's efforts to find a suitable replacement tenant for the office space, the Company issued a warrant to purchase 50,000 shares of the Company's common stock at $3.00 per share. The warrant is immediately exercisable, fully vested and nonforfeitable and expires three years from the date of grant. Management has recorded a prepaid expense of $113,000 related to the warrant, which will be amortized over the lease period or expensed in full upon release from the lease agreement. The prepaid expense amount was determined using the Black-Scholes option pricing model and the following assumptions: expected life of three years, volatility of 147%, dividend yield of 0%, and a risk-free interest rate of 4.45%. The Company will issue an additional warrant to purchase 50,000 shares of common stock to the lessor that will become exercisable upon the landlord meeting certain timetable targets to find a new tenant. The Company will value the warrant at the time it becomes exercisable. 11. RELATED PARTY TRANSACTIONS In January 1998, a Gadzoox executive entered into a loan agreement (the "Loan") and borrowed approximately $300,000 from seven individuals who are employed by a key supplier (the "Lenders"). The Loan is collateralized by stock held by the Gadzoox executive. Additionally, the Gadzoox executive has issued to the Lenders options to purchase additional shares of the executive's Gadzoox stock (the "Private Options"). The Private Options were exercised by the Lenders in July 2000. At March 31, 2001, the Company held two notes receivable from two executive officers totaling $535,000. At March 31, 2000, the Company held no notes receivable. Loans were extended to these individuals to assists them in their housing costs in California. The notes bear interest at rates of 6.0% and 6.3%, and the principal amounts due, plus interest, are forgiven over two and four year periods, subject to certain conditions included in the terms of the notes. 12. INCOME TAXES Due to the Company's loss position, there was no provision for income taxes for the years ended March 31, 2001, 2000 and 1999. The components of the net deferred tax asset at March 31, 2001 and 2000 were as follows (in thousands):
2001 2000 -------- -------- Net operating loss carryforwards............................ $ 39,433 $ 13,207 Cumulative book to tax differences.......................... 7,475 3,135 Tax credit carryforwards.................................... 5,911 2,994 -------- -------- 52,819 19,336 Valuation allowance......................................... (52,819) (19,336) -------- -------- $ -- $ -- ======== ========
A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance due to the variability of operating results. As of March 31, 2001 Gadzoox had net cumulative operating loss carryforwards for Federal and state income tax reporting purposes of approximately $108.3 million and $26.9 million, respectively. The Company also had Federal and state research and development tax credit carryforwards of approximately $3.1 million and $2.8 million, respectively. The net cumulative operating loss and credit carryforwards will expire at various F-24 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) dates beginning in the years 2001 through 2015, if not utilized. Utilization of net operating losses and credits may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses before utilization. 13. QUARTERLY FINANCIAL DATA (UNAUDITED) The following tables set forth the unaudited consolidated statement of operations data for each of the eight quarterly periods ended March 31, 2001. The data for the four quarterly periods for the year ended March 31, 2000 are under the historical shipment method of recognizing revenue to distributors, and the data for the four quarterly periods for the year ended March 31, 2001 are under the revised revenue recognition policy for product shipments to distributors. The unaudited consolidated information has been prepared on a basis consistent with the audited consolidated financial statements, reflecting all normal recurring adjustments that are considered necessary for a fair presentation of the financial position. The quarterly information is as follows (in thousands):
QUARTER ENDED (UNAUDITED) --------------------------------------------------------------------------------- JUN 30, SEP 30, DEC 31, MAR 31, JUN 30, SEP 30, DEC 31, MAR 31, 1999 1999 1999 2000 2000 2000 2000 2001 ------- ------- ------- ------- -------- -------- -------- -------- CONSOLIDATED STATEMENT OF OPERATIONS Net sales.......................... $ 9,211 $11,081 $12,561 $15,079 $ 10,858 $ 8,051 $ 7,937 $ 6,444 Cost of revenues................... 5,414 6,325 6,903 7,486 5,461 13,702 4,490 8,478 ------- ------- ------- ------- -------- -------- -------- -------- Gross profit (loss)................ 3,797 4,756 5,658 7,593 5,397 (5,651) 3,447 (2,034) ------- ------- ------- ------- -------- -------- -------- -------- Operating expenses: Research and development......... 3,917 4,540 4,461 5,303 5,519 8,641 5,836 9,372 Sales and marketing.............. 1,888 1,914 2,742 5,094 5,727 5,989 6,497 5,769 General and administrative....... 764 866 959 1,698 1,484 2,344 1,885 2,279 In-process research and development.................... -- -- -- -- 4,900 -- -- -- Amortization of acquired intangible assets.............. -- -- -- -- 1,048 1,048 1,048 698 Impairment of long lived assets......................... -- -- -- -- -- -- -- 17,829 Restructuring and other expenses....................... -- -- -- -- -- -- -- 2,513 Amortization of deferred compensation................... 322 321 321 321 168 169 163 108 ------- ------- ------- ------- -------- -------- -------- -------- Total operating expenses........... 6,891 7,641 8,483 12,416 18,846 18,191 15,429 38,568 ------- ------- ------- ------- -------- -------- -------- -------- Loss from operations............... (3,094) (2,885) (2,825) (4,823) (13,449) (23,842) (11,982) (40,602) Interest and other income (expense), net................... (142) 936 1,027 1,446 885 710 521 216 ------- ------- ------- ------- -------- -------- -------- -------- Loss before cumulative effect of change in accounting principle... (3,236) (1,949) (1,798) (3,377) (12,564) (23,132) (11,461) (40,386) Cumulative effect of change in accounting principle............. -- -- -- -- (5,300) -- -- -- ------- ------- ------- ------- -------- -------- -------- -------- Net loss......................... $(3,236) $(1,949) $(1,798) $(3,377) $(17,864) $(23,132) $(11,461) $(40,386) ======= ======= ======= ======= ======== ======== ======== ======== Net loss per basic share before cumulative effect of change in accounting principle........... $ (0.58) $ (0.09) $ (0.07) $ (0.13) $ (0.46) $ (0.83) $ (0.41) $ (1.42) Cumulative effect of change in accounting principle............. -- -- -- -- $ (0.20) -- -- -- ------- ------- ------- ------- -------- -------- -------- -------- Net loss per basic share........... $ (0.58) $ (0.09) $ (0.07) $ (0.13) $ (0.66) $ (0.83) $ (0.41) $ (1.42) ======= ======= ======= ======= ======== ======== ======== ======== Shares used in computing loss per share............................ 5,626 21,199 25,614 26,441 27,125 27,782 27,889 28,411
F-25 GADZOOX NETWORKS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The following information below has been included to demonstrate the effect on the first three quarters of the year ended March 31, 2001 as if the change in accounting principle had been applied as of the beginning of the year ended March 31, 2001, and to reconcile the differences with amounts previously reported for those quarterly periods (in thousands):
QUARTER ENDED ----------------------------------------- JUN 30, SEP 30, DEC 31, MAR 31, 2000 2000 2000 2001 -------- -------- -------- -------- Net revenues As previously reported........................... $ 9,002 $ 7,219 $ 7,220 $ 6,444 Effect of change in accounting principle......... 1,856 832 717 -- -------- -------- -------- -------- As restated in first three quarters and reported in fourth quarter............................. $ 10,858 $ 8,051 $ 7,937 $ 6,444 -------- -------- -------- -------- Gross profit (loss) As previously reported........................... $ 3,779 $ (6,397) $ 2,900 $ (2,034) Effect of change in accounting principle......... 1,618 746 547 -- -------- -------- -------- -------- As restated in first three quarters and reported in fourth quarter............................. $ 5,397 $ (5,651) $ 3,447 $ (2,034) ======== ======== ======== ======== Net loss As previously reported........................... (14,182) (23,878) (12,008) (40,386) Effect of change in accounting principle......... 1,618 746 547 -- -------- -------- -------- -------- Cumulative effect of change in accounting principle..................................... (5,300) -- -- -- As restated in first three quarters and reported in fourth quarter............................. $(17,864) $(23,132) $(11,461) $(40,386) ======== ======== ======== ======== Net income (loss) per basic share: Net income (loss) per share before cumulative effect of change in accounting principle as previously reported.............................. $ (0.52) $ (0.86) $ (0.43) $ (1.42) Effect of change in accounting principle......... 0.06 0.03 0.02 -- -------- -------- -------- -------- As restated in first three quarters and reported in fourth quarter............................. (0.46) (0.83) (0.41) (1.42) Cumulative effect of change in accounting principle........................................ (0.20) -- -- -- -------- -------- -------- -------- Net income (loss) after cumulative effect of change in accounting principle.......................... $ (0.66) $ (0.83) $ (0.41) $ (1.42) ======== ======== ======== ======== Shares used in computing income (loss) per share: Basic............................................ 27,125 27,782 27,889 28,411
F-26 GADZOOX NETWORKS, INC. SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
BALANCE AT BEGINNING CHARGED TO COSTS BALANCE AT DESCRIPTION OF PERIOD AND EXPENSES DEDUCTIONS END OF PERIOD ----------- ---------- ---------------- ---------- ------------- Year ended March 31, 1999 Allowance for returns and doubtful accounts............................. $ 65,000 $ 88,535 $ 3,535 $ 150,000 Year ended March 31, 2000 Allowance for returns and doubtful accounts............................. $150,000 $ 463,667 $ 13,667 $ 600,000 Year ended March 31, 2001 Allowance for returns and doubtful accounts............................. $600,000 $ 172,000 $ 422,000 $ 350,000 Restructuring reserve................... $ -- $ 2,513,000 $1,826,000 $ 687,000 Inventory: Year ended March 31, 1999 Inventory reserves...................... $150,000 $ 73,000 $ 73,000 $ 150,000 Year ended March, 31, 2000 Inventory reserves...................... $150,000 $ 150,000 $ 150,000 $ 150,000 Year ended March 31, 2001 Inventory reserves...................... $150,000 $10,600,000 $2,485,000 $8,265,000
F-27 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information regarding our directors is incorporated by reference from "Election of Directors -- Directors and Nominees" in our Proxy Statement for our 2001 Annual Meeting of Stockholders. The required information concerning executive officers of the Company is contained in the section entitled "Executive Officers of the Registrant" in Part I of this Form 10-K. Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") requires the Company's Executive Officers and Directors and persons who own more than ten percent (10%) of a registered class of the Company's equity securities to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission") and the National Association of Securities Dealers, Inc. Executive Officers, Directors and greater than ten percent (10%) stockholders are required by Commission regulation to furnish the Company with copies of all Section 16(a) forms they file. A late report on Form 4 was filed by Wayne Rickard on May 8, 2001 with respect to his sales of shares of common stock on November 14, 2000 and November 15, 2000. A late report on Form 4 was filed by William Hubbard on May 8, 2001 with respect to his stock options exercises on April 11, 2000 and September 26, 2000. A report on Form 5 was not filed by Christine Munson with respect to her grants of options on July 14, 2000 and July 24, 2000. Based solely on its review of the copies of such forms received by it, or written representations from certain reporting persons, the Company believes that, other than the exceptions described in this paragraph, during fiscal 2001, all executive officers and directors of the Company complied with all applicable filing requirements. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference from our definitive Proxy Statement referred to in Item 10 above under the heading "Executive Compensation and Other Matters". ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference from our definitive Proxy Statement referred to in Item 10 above under the heading "Security Ownership of Certain Beneficial Owners and Management". ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference from our definitive Proxy Statement referred to in Item 10 above under the heading "Certain Relationships and Related Transactions". 52 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Form 10-K: (1) Financial Statements: Report of Independent Public Accountants Balance Sheets as of March 31, 2001 and 2000 Statements of Operations for the years ended March 31, 2001, 2000 and 1999 Statements of Stockholders' Equity for the years ended March 31, 2001, 2000 and 1999 Statements of Cash Flows for the years ended March 31, 2001, 2000 and 1999 Notes to Financial Statements (2) Financial Statement Schedules: The following financial statement schedule of Gadzoox Networks, Inc. for the years ended March 31, 2001, March 31, 2000 and March 31, 1999 is filed as part of this Annual Report and should be read in conjunction with the Financial Statements of Gadzoox Networks, Inc. Schedule II -- Valuation and Qualifying Accounts All other schedules have been omitted since the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the financial statements or notes thereto. (3) Exhibits:
NUMBER DESCRIPTION OF DOCUMENT ------ ----------------------- 3.1(a) Amended and Restated Certificate of Incorporation 3.2(a) Amended and Restated Bylaws 4.1(a) Specimen Common Stock Certificate 4.2(f) Registration Rights Agreement between Gadzoox and Societe General dated as of June 28, 2001. 4.3(f) Registration Rights Agreement between Gadzoox and purchasers of Gadzoox common stock dated May 25, 2001 4.4(g) Registration Rights Agreement between Gadzoox and purchasers of Gadzoox common stock dated August 30, 2001. 10.1(a) Form of Indemnification Agreement between Gadzoox and each of its directors and officers 10.2(a) Amended and Restated 1993 Stock Plan and form of agreements thereunder 10.3(a) 1999 Employee Stock Purchase Plan and form of agreements thereunder 10.4(a) 1999 Director Option Plan and form of agreement thereunder 10.5(a) Agreement for electronic manufacturing services between Gadzoox and Sanmina Corporation dated December 29, 1998 10.6(a) Convertible Subordinated Promissory Note, dated October 12, 1998, made by Gadzoox and payable to Seagate Technology, Inc. 10.7(a) Change of Control Agreement between Gadzoox and K. William Sickler, as amended 10.8(a) Change of Control Agreement between Gadzoox and Kent Bridges. 10.9(a) Restricted Stock Purchase Agreement between Gadzoox and K. William Sickler 10.10(a) Compaq Computer Corporation Purchase Agreement -- JIT Program, entered into as of June 13, 1997, by Compaq Computer Corporation and Gadzoox 10.11(a) First Amended and Restated Registration and Information Rights Agreement, dated as of October 12, 1998 10.12(a) Warrant to purchase shares of Series F Preferred Stock of the Gadzoox issued to Comdisco, Inc. 10.13(a) Warrant to purchase shares of Series G Preferred Stock of Gadzoox issued to Comdisco, Inc.
53
NUMBER DESCRIPTION OF DOCUMENT ------ ----------------------- 10.14(a) First Amended and Restated Series F, G and H Preferred Stockholders' Agreement, dated as of October 12, 1998 10.15(b) Agreement and Plan of Reorganization between Gadzoox, Gadzoox Acquisition Corporation and SmartSAN Systems, Inc. dated as of March 2, 2000 10.16(c) Lease Amendment #2 between Gadzoox and Mission West Properties, L.P. II dated as of April 21, 2000 10.17(c) Lease Agreement and Lease Amendment #1 between Gadzoox and Mission West Properties, L.P. II dated August 13, 1998 and December 31, 1998, respectively 10.18(d) Employment, Change of Control and Severance Agreement between Gadzoox and Michael Parides dated as of September 1, 2000 10.19(d) Employment, Change of Control and Severance Agreement between Gadzoox and Ronald G. von Trapp dated as of September 29, 2000 10.20(e) Change of Control Agreement between Gadzoox and Wayne Rickard effective as of October 20, 2000 10.21(e) Change of Control Agreement between Gadzoox and Clark Foy effective as of October 20, 2000 10.22(e) Change of Control Agreement between Gadzoox and Steve Dalton effective as of October 20, 2000 10.23(f) Office Lease between Gadzoox and Irvine Oaks Realty Holding Co., Inc. dated as of October 1999 10.24(f) Loan Agreement between Gadzoox, Clark Foy and Catherine Foy dated as of June 26, 2000 10.25(f) First Amendment to Office Lease between Gadzoox and Oaks Realty Holding Co., Inc. dated as of June 30, 2000 10.26(f) Second Amendment to Office Lease between Gadzoox and Oaks Realty Holding Co., Inc. dated as of September 18, 2000 10.27(f) Change of Control Agreement between Gadzoox and Kristin Strout dated as of February 20, 2001 10.28(f) Lease Amendment Agreement #3 between Gadzoox and Mission West Properties, L.P. II dated as of March 23, 2001 10.29(f) Change of Control Agreement between Gadzoox and Ed Turner dated as of March 26, 2001 10.30(f) Amended and Restated Equity Line Financing Agreement between Gadzoox and Societe Generale dated as of October 26, 2001 10.31(f) Letter Agreement between Gadzoox and Shoreline Pacific Institutional Finance dated May 2, 2001 10.32(f) Terms of Engagement between LSI Logic Corporation and Gadzoox dated December 20, 2000 18.1(f) Letter regarding change in accounting principles 23.1 Consent of Arthur Andersen LLP, Independent Public Accountants 24.1(f) Power of Attorney
--------------- (a) Incorporated by reference from Gadzoox's Registration Statement on Form S-1 (Reg. No. 333-78029), as amended. (b) Incorporated by reference from Gadzoox's Current Report on Form 8-K filed on March 16, 2000. (c) Incorporated by reference from Gadzoox's Annual Report on Form 10-K filed on June 29, 2000. (d) Incorporated by reference from Gadzoox's Quarterly Report on Form 10-Q/A for the quarter ended September 30, 2000 filed on March 30, 2001. (e) Incorporated by reference from Gadzoox's Quarterly Report on Form 10Q/A for the quarter ended December 31, 2000 filed on March 30, 2001. (f) Previously filed. (g) Incorporated by reference from Gadzoox's Current Report on Form 8-K filed on September 6, 2001. (b) Reports on Form 8-K None. 54 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GADZOOX NETWORKS, INC. By: /s/ MICHAEL PARIDES ------------------------------------ Michael Parides President and Chief Executive Officer (Principal Executive Officer) Dated: November 7, 2001 Pursuant to the requirements of the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
NAME TITLE DATE ---- ----- ---- /s/ MICHAEL PARIDES President, Chief Executive November 7, 2001 --------------------------------------------- Officer and Director Michael Parides (Principal Executive Officer) /s/ DAVID P. EICHLER* Vice President, Finance and November 7, 2001 --------------------------------------------- Chief Financial Officer David P. Eichler (Principal Financial and Accounting Officer) /s/ MILTON CHANG* Director November 7, 2001 --------------------------------------------- Milton Chang /s/ ROBERT KUHLING* Director November 7, 2001 --------------------------------------------- Robert Kuhling /s/ STEVEN WEST* Director November 7, 2001 --------------------------------------------- Steven West /s/ SYLVIA SUMMERS* Director November 7, 2001 --------------------------------------------- Sylvia Summers *By: /s/ MICHAEL PARIDES November 7, 2001 ------------------------------------------ Michael Parides Attorney-in-fact
55 EXHIBIT INDEX
NUMBER ------ 3.1(a) Amended and Restated Certificate of Incorporation 3.2(a) Amended and Restated Bylaws 4.1(a) Specimen Common Stock Certificate 4.2(f) Registration Rights Agreement between Gadzoox and Societe General dated as of June 28, 2001. 4.3(f) Registration Rights Agreement between Gadzoox and purchasers of Gadzoox common stock dated May 25, 2001 4.4(g) Registration Rights Agreement between Gadzoox and purchasers of Gadzoox common stock dated August 30, 2001. 10.1(a) Form of Indemnification Agreement between Gadzoox and each of its directors and officers 10.2(a) Amended and Restated 1993 Stock Plan and form of agreements thereunder 10.3(a) 1999 Employee Stock Purchase Plan and form of agreements thereunder 10.4(a) 1999 Director Option Plan and form of agreement thereunder 10.5(a) Agreement for electronic manufacturing services between Gadzoox and Sanmina Corporation dated December 29, 1998 10.6(a) Convertible Subordinated Promissory Note, dated October 12, 1998, made by Gadzoox and payable to Seagate Technology, Inc. 10.7(a) Change of Control Agreement between Gadzoox and K. William Sickler, as amended 10.8(a) Change of Control Agreement between Gadzoox and Kent Bridges. 10.9(a) Restricted Stock Purchase Agreement between Gadzoox and K. William Sickler 10.10(a) Compaq Computer Corporation Purchase Agreement -- JIT Program, entered into as of June 13, 1997, by Compaq Computer Corporation and Gadzoox 10.11(a) First Amended and Restated Registration and Information Rights Agreement, dated as of October 12, 1998 10.12(a) Warrant to purchase shares of Series F Preferred Stock of the Gadzoox issued to Comdisco, Inc. 10.13(a) Warrant to purchase shares of Series G Preferred Stock of Gadzoox issued to Comdisco, Inc. 10.14(a) First Amended and Restated Series F, G and H Preferred Stockholders' Agreement, dated as of October 12, 1998 10.15(b) Agreement and Plan of Reorganization between Gadzoox, Gadzoox Acquisition Corporation and SmartSAN Systems, Inc. dated as of March 2, 2000 10.16(c) Lease Amendment #2 between Gadzoox and Mission West Properties, L.P. II dated as of April 21, 2000 10.17(c) Lease Agreement and Lease Amendment #1 between Gadzoox and Mission West Properties, L.P. II dated August 13, 1998 and December 31, 1998, respectively 10.18(d) Employment, Change of Control and Severance Agreement between Gadzoox and Michael Parides dated as of September 1, 2000 10.19(d) Employment, Change of Control and Severance Agreement between Gadzoox and Ronald G. von Trapp dated as of September 29, 2000 10.20(e) Change of Control Agreement between Gadzoox and Wayne Rickard effective as of October 20, 2000 10.21(e) Change of Control Agreement between Gadzoox and Clark Foy effective as of October 20, 2000 10.22(e) Change of Control Agreement between Gadzoox and Steve Dalton effective as of October 20, 2000 10.23(f) Office Lease between Gadzoox and Irvine Oaks Realty Holding Co., Inc. dated as of October 1999 10.24(f) Loan Agreement between Gadzoox, Clark Foy and Catherine Foy dated as of June 26, 2000
.25(f)10 First Amendment to Office Lease between Gadzoox and Oaks Realty Holding Co., Inc. dated as of June 30, 2000 10.26(f) Second Amendment to Office Lease between Gadzoox and Oaks Realty Holding Co., Inc. dated as of September 18, 2000 10.27(f) Change of Control Agreement between Gadzoox and Kristin Strout dated as of February 20, 2001 10.28(f) Lease Amendment Agreement #3 between Gadzoox and Mission West Properties, L.P. II dated as of March 23, 2001 10.29(f) Change of Control Agreement between Gadzoox and Ed Turner dated as of March 26, 2001 10.30(f) Amended and Restated Equity Line Financing Agreement between Gadzoox and Societe Generale dated as of October 26, 2001 10.31(f) Letter Agreement between Gadzoox and Shoreline Pacific Institutional Finance dated May 2, 2001 10.32(f) Terms of Engagement between LSI Logic Corporation and Gadzoox dated December 20, 2000 18.1(f) Letter regarding change in accounting principles 23.1 Consent of Arthur Andersen LLP, Independent Public Accountants 24.1(f) Power of Attorney
--------------- (a) Incorporated by reference from Gadzoox's Registration Statement on Form S-1 (Reg. No. 333-78029), as amended. (b) Incorporated by reference from Gadzoox's Current Report on Form 8-K filed on March 16, 2000. (c) Incorporated by reference from Gadzoox's Annual Report on Form 10-K filed on June 29, 2000. (d) Incorporated by reference from Gadzoox's Quarterly Report on Form 10-Q/A for the quarter ended September 30, 2000 filed on March 30, 2001. (e) Incorporated by reference from Gadzoox's Quarterly Report on Form 10Q/A for the quarter ended December 31, 2000 filed on March 30, 2001. (f) Previously filed. (g) Incorporated by reference from Gadzoox's Current Report on Form 8-K filed on September 6, 2001.
EX-23.1 3 f76028a3ex23-1.txt EXHIBIT 23.1 Exhibit 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K/A, into the Company's previously filed Registration Statement No. 333-47362 on Form S-8, No. 333-41726 on Form S-3/A, No. 333-64798 on Form S-3/A, No. 333-68084 on Form S-8, No. 333-69418 on Form S-3/A and No. 333-69408 on Form S-3/A. /s/ Arthur Andersen LLP ----------------------- Arthur Andersen LLP San Jose, California November 5, 2001