10-Q 1 f69223e10-q.txt FORM 10-Q PERIOD ENDED DECEMBER 31,2000 1 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-Q ------------------------ [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2000 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 0-26130 ------------------------ SELECTICA, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0432030 (STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NO.)
3 WEST PLUMERIA DRIVE, SAN JOSE, CA 95134 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (408) 570-9700 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) Indicate by a 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Approximately 36,989,961 shares of Common Stock, $0.0001 par value, as of January 31, 2001. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 2 FORM 10-Q SELECTICA INC. INDEX
PAGE ---- PART I FINANCIAL INFORMATION Item 1: Financial Statements Condensed Consolidated Balance Sheets as of December 31, 2000 and March 31, 2000..................................... 1 Condensed Consolidated Statements of Operations for the three months ended December 31, 2000 and 1999 and nine months ended December 31, 2000 and 1999..................... 2 Condensed Consolidated Statements of Cash Flows for the nine months ended December 31, 2000 and 1999..................... 3 Notes to Condensed Consolidated Financial Statements........ 4 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 9 Item 3: Quantitative and Qualitative Disclosure about Market Risk... 27 PART II OTHER INFORMATION Item 6: Exhibits and Reports on Form 8-K............................ 29 Signatures........................................................... 30
i 3 SELECTICA, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) (UNAUDITED) ASSETS
DECEMBER 31, MARCH 31, 2000 2000* ------------ --------- Current assets: Cash and cash equivalents................................. $ 52,826 $215,818 Short-term investments.................................... 95,978 -- Accounts receivable, net of allowance for doubtful accounts of $1,147 and $415, respectively.............. 19,906 5,749 Prepaid expenses and other current assets................. 3,503 9,418 -------- -------- Total current assets.............................. 172,213 230,985 Property and equipment, net................................. 10,341 6,127 Goodwill, net of amortization of $1,146 and $116, respectively.............................................. 13,307 30 Other assets................................................ 2,390 2,054 Long-term investments....................................... 29,856 -- Investments, restricted..................................... 1,950 100 Development agreement, net of amortization of $2,592 and $1,011, respectively.............................................. 1,575 3,156 -------- -------- Total assets...................................... $231,632 $242,452 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable.......................................... $ 4,073 $ 4,258 Accrued payroll and related liabilities................... 4,482 1,879 Other accrued liabilities................................. 4,617 3,755 Deferred revenues......................................... 21,475 18,482 -------- -------- Total current liabilities......................... 34,647 28,374 Other long term liabilities............................... 885 -- Commitments and contingencies Stockholders' equity: Common stock.............................................. 4 3 Additional paid-in capital................................ 290,989 281,773 Deferred compensation..................................... (9,703) (11,860) Stockholder notes receivable.............................. (7,830) (12,716) Accumulated deficit....................................... (77,580) (43,122) Accumulated other comprehensive gain...................... 220 -- -------- -------- Total stockholders' equity........................ 196,100 214,078 -------- -------- Total liabilities and stockholders' equity........ $231,632 $242,452 ======== ========
--------------- * Amounts derived from audited financial statements See accompanying notes. 1 4 SELECTICA, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------ ------------------- 2000 1999 2000 1999* -------- ------- -------- -------- Revenues: License.............................................. $ 8,659 $ 2,348 $ 18,614 $ 5,181 Services............................................. 10,950 2,157 21,823 3,959 -------- ------- -------- -------- Total revenues............................... 19,609 4,505 40,437 9,140 Cost of revenues: License.............................................. 414 117 922 259 Services............................................. 7,836 1,954 18,855 5,240 -------- ------- -------- -------- Total cost of revenues....................... 8,250 2,071 19,777 5,499 -------- ------- -------- -------- Gross profit........................................... 11,359 2,434 20,660 3,641 Operating expenses: Research and development............................. 5,131 1,892 16,467 4,132 Sales and marketing.................................. 13,004 4,408 38,571 9,271 General and administrative........................... 4,432 1,197 9,939 2,924 -------- ------- -------- -------- Total operating expenses..................... 22,567 7,497 64,977 16,327 -------- ------- -------- -------- Loss from operations................................... (11,208) (5,063) (44,317) (12,686) Other income, net: Interest income, net................................. 3,364 221 10,059 319 -------- ------- -------- -------- Loss before provision for income taxes................. (7,844) (4,842) (34,258) (12,367) Provision for income taxes............................. 75 -- 200 50 -------- ------- -------- -------- Net loss............................................... (7,919) (4,842) (34,458) (12,417) -------- ------- -------- -------- Deemed dividend on Series E preferred stock.......... -- 925 -- 925 Net loss applicable to common stockholders............. $ (7,919) $(5,767) $(34,458) $(13,342) ======== ======= ======== ======== Basic and diluted, net loss per share applicable to common stockholders.................................. $ (0.23) $ (0.23) $ (1.01) $ (0.59) ======== ======= ======== ======== Weighted-average shares of common stock used in computing basic and diluted, net loss per share applicable to common stockholders.................... 35,101 25,104 34,249 22,455 ======== ======= ======== ========
--------------- * Amounts derived from audited financial statements at the date indicated See accompanying notes. 2 5 SELECTICA, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED DECEMBER 31, --------------------- 2000 1999 --------- -------- OPERATING ACTIVITIES Net loss.................................................... $ (34,458) $(12,417) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization............................. 1,971 731 Amortization of private placement discount................ 2,722 -- Amortization of warrants in connection with license and service agreement....................................... 5,936 -- Issuance of common stock in exchange for services......... -- 371 Compensation expense related to repurchase of shares over fair market value....................................... 873 -- Accrued interest on convertible notes converted to convertible preferred stock............................. -- 7 Amortization of goodwill.................................. 1,028 -- In-process research and development....................... 1,870 -- Amortization of development agreement..................... 1,581 472 Amortization of deferred compensation..................... 2,576 590 Accelerated vesting of stock options to employees......... 527 66 Warrants issued in conjunction with debt financing........ -- 35 Changes in assets and liabilities: Accounts receivable, net................................ (13,647) (1,640) Prepaid expenses and other current assets............... (21) (435) Other assets............................................ (2,147) (1,263) Accounts payable........................................ (261) (70) Accrued payroll and related liabilities................. 2,169 699 Other accrued and long-term liabilities................. 617 1,710 Deferred revenues....................................... 271 2,976 --------- -------- Net cash used in operating activities....................... (28,393) (8,168) INVESTING ACTIVITIES Capital expenditures...................................... (6,063) (3,350) Acquisition of Wakely Software, Inc....................... (4,755) -- Acquisition of certain assets and liabilities of LoanMarket Resources, LLC............................... (216) -- Net purchase of short term investments.................... (95,915) -- Net purchase of long term investments..................... (29,699) -- Acquisition of Selectica, India........................... -- (150) --------- -------- Net cash used in investing activities....................... (136,648) (3,500) FINANCING ACTIVITIES Proceeds from issuance of convertible notes............... -- 1,000 Cost of financing......................................... (1,209) -- Proceeds from stockholder notes receivable................ 386 -- Exercise of warrants in exchange for preferred stock...... -- 23 Net proceeds from issuance of convertible preferred stock................................................... -- 24,913 Repurchase of common stock................................ -- (456) Proceeds from issuance of common stock.................... 2,865 312 --------- -------- Net cash provided by financing activities................... 2,042 25,792 --------- -------- Net increase (decrease) in cash and cash equivalents........ (162,999) 14,124 Cash and cash equivalents at beginning of the period........ 215,825 -- --------- -------- Cash and cash equivalents at end of the period.............. $ 52,826 $ 14,124 ========= ======== SUPPLEMENTAL CASH FLOW INFORMATION Deferred compensation related to stock options............ $ 1,111 $ 6,345 Cash paid for interest.................................... $ -- $ 53 Convertible notes payable and accrued interest converted to convertible preferred stock.......................... $ -- $ 944 Warrants issued in conjunction with convertible notes payable................................................. $ -- $ 50 Warrants issued in conjunction with convertible preferred stock financing......................................... $ -- $ 616 Warrants issued in connection with development agreement............................................... $ -- $ 381 Issuance of stock in exchange for notes................... $ -- $ 7,016 Repurchase of stock in exchange for cancellation of notes................................................... $ 4,500 $ --
See accompanying notes. 3 6 SELECTICA, INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The condensed consolidated balance sheet as of December 31, 2000, the condensed consolidated statements of operations and cash flows for the nine months ended December 31, 2000, and the condensed consolidated statements of operations for the three months ended December 31, 2000 and 1999 have been prepared by the Company and are unaudited. In the opinion of management, all necessary adjustments, including normal recurring adjustments, have been made to present fairly the financial position, results of operations, and cash flows at December 31, 2000 and for all periods presented. Interim results are not necessarily indicative of the results for a full fiscal year. The condensed consolidated balance sheet as of March 31, 2000 and the condensed consolidated statements of operations and cash flows for the nine months ended December 31, 1999 have been derived from audited consolidated financial statements at that date. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in this prospectus and the Company's Annual Report on Form 10-K for the year ended March 31, 2000. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Customer Concentrations A limited number of customers have historically accounted for a substantial portion of the Company's revenues. Customers who accounted for at least 10% of total revenues were as follows:
THREE MONTHS NINE MONTHS ENDED ENDED DECEMBER 31, DECEMBER 31, ------------- ------------- 2000 1999 2000 1999 ---- ---- ---- ---- Cisco Systems......................................... 18% * 13% * Dell.................................................. 14% * 16% * Highmark Blue Cross Blue Shield....................... 12% * * * Samsung SDS........................................... 12% * 18% * Fireman's Fund Insurance.............................. * 28% * 14% Fujitsu Network Corporation........................... * 16% * * Aspect Communications................................. * * * 15% 3Com Corporation...................................... * * * 14%
--------------- * Revenues were less than 10%. 4 7 SELECTICA, INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. INVESTMENTS All investments as of December 31, 2000 are classified as available-for-sale securities. The Company did not hold any investments as of March 31, 2000. The following is a summary of the aggregate cost, gross unrealized gains, and estimated fair value of the Company's short-term and long-term investments:
DECEMBER 31, 2000 --------------- (IN THOUSANDS) SHORT-TERM INVESTMENTS: Commercial Paper..................................... $22,535 Corporate notes and bonds............................ 32,994 Government agencies.................................. 40,386 ------- Short-term investments at cost....................... 95,915 Unrealized gain...................................... 63 ------- Fair value........................................ $95,978 =======
DECEMBER 31, 2000 --------------- (IN THOUSANDS) LONG-TERM INVESTMENTS: Corporate notes and bonds............................ $14,708 Government agencies.................................. 14,991 ------- Short-term investments at cost.................... 29,699 Unrealized gains..................................... 157 ------- Fair value........................................ $29,856 =======
Unrealized holding gains and losses on available-for-sale securities at March 31, 2000 and gross realized gains and losses on sales of available-for-sale securities during the three and nine months ended December 31, 2000 and 1999 were not significant. 3. STOCKHOLDERS' EQUITY Warrants In September 1999, the Company entered into a development agreement with an investor whereby the investor and the Company will work to port the current suite of ACE products to additional platforms. In connection with the development agreement, the Company issued warrants to purchase 57,000 shares of Series E convertible preferred stock at $4.382 per share. The warrants were issued in December 1999 and were exercised on March 9, 2000. The Company determined the fair value of the warrants using the Black-Scholes valuation model assuming a fair value of the Company's Series E convertible preferred stock of $19.00, risk free interest rate of 5.5%, volatility factor of 80% and a life of 22 months. The fair value of $381,000 is being amortized over the remaining life of the development agreement. As December 31, 2000, total amortization of this warrant was approximately $225,000. In November 1999, the Company entered into a license agreement and one year maintenance contract in the amount of $3.0 million with a customer and in connection with the agreement committed to the issuance of a warrant to purchase 800,000 shares of common stock. In January 2000 the warrant was issued with an exercise price of $13.00 and was net exercised on July 25, 2000. The value of the warrants was estimated to be $16.4 million and was based upon a Black-Scholes valuation model with the following assumptions: risk free interest rate of 5.5%, dividend yield of 0%, volatility of 80%, expected life of 2 years, exercise price of $13.00 5 8 SELECTICA, INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) and fair value of $30.00. As the warrant value less the warrant purchase price of $800,000, exceeds the related license and maintenance revenue under the agreement and subsequent services agreements, the Company recorded a $9.7 million loss on the contract in the year ended March 31, 2000. The Company amortized against revenue $733,000 and $5.9 million related to the fair value of the warrants in the three and nine months ended December 31, 2000, respectively. Deferred Compensation The Company granted 250,850 and 643,665 options to employees with exercise price that were less than fair value and recorded net deferred compensation of approximately $703,000 and $1.2 million, for the three and nine months ended December 31, 2000, respectively. Such compensation will be amortized over the vesting period of the options, typically four years. For the nine months ended December 31, 2000 and 1999, the Company amortized approximately $2.6 million and $590,000, respectively. Accelerated Options During the nine months ended December 31, 2000, in association with employee termination agreements, the Company accelerated vesting on options to purchase 24,807 shares of common stock and recorded approximately $527,000 of related compensation expense. Stock Repurchase On December 29, 2000, the Company elected to repurchase 150,000 shares of common stock at cost from certain key employees (the "Stock Repurchase").These shares were originally issued in exchange for full recourse promissory notes with an aggregate value of $4.5 million. As compensation for services rendered by these employees and in order to provide an inducement for continued employment, we repurchased these shares at a repurchase price which was greater than the fair value of the stock at the time of the repurchase. As a result we recorded a total compensation expense of approximately $873,000 of which $291,000 was expensed in cost of goods sold, $291,000 was expensed in sales and marketing, and $291,000 was expensed in general and administrative expense. 4. INCOME TAXES The Company has recorded a tax provision of $200,000 and $50,000 for the nine months ended December 31, 2000 and 1999 primarily for state and foreign taxes. 5. EARNINGS PER SHARE The Company calculates earnings per share in accordance with Financial Accounting Standards Board No. 128, Earnings per Share. The diluted net loss per share is equivalent to the basic net loss per share because the Company has experienced losses since inception and thus no potential common shares from the exercise of stock options, conversion of convertible preferred stock, or exercise of warrants have been included in the net loss per share calculation. Options and warrants to purchase 4,896,675 and 2,455,102 shares of common stock were excluded from the nine months ended December 31, 2000 and 1999 computation as their effect is antidilutive. 6 9 SELECTICA, INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table presents the computation of basic and diluted net loss per share
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------ -------------------- 2000 1999 2000 1999 ------- ------- -------- -------- (IN THOUSANDS) Net loss applicable to common stockholders............................ $(7,919) $(5,767) $(34,458) $(13,342) ======= ======= ======== ======== Basic and diluted: Weighted-average shares of common stock outstanding.......................... 36,894 26,894 36,454 23,791 Less weighted-average shares subject to repurchase........................... (1,793) (1,790) (2,205) (1,336) ------- ------- -------- -------- Weighted-average shares used in computing basic and diluted, net loss per share applicable to common stockholders......................... 35,101 25,104 34,249 22,455 ======= ======= ======== ======== Basic and diluted, net loss per share applicable to common stockholders.... $ (.23) $ (.23) $ (1.01) $ (.59) ======= ======= ======== ========
6. COMPREHENSIVE LOSS The components of comprehensive loss are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------ -------------------- 2000 1999 2000 1999 ------- ------- -------- -------- (IN THOUSANDS) Net loss applicable to common stockholders............................ $(7,919) $(5,767) $(34,458) $(13,342) Change in unrealized gain on securities... 113 -- 220 -- ------- ------- -------- -------- Comprehensive loss........................ $(7,806) $(5,767) $(34,238) $(13,342) ======= ======= ======== ========
Accumulated other comprehensive loss as of December 31, 2000, represents net unrealized gain on securities. There were no elements of accumulated other comprehensive income at March 31, 2000. 7. ACQUISITIONS In August 2000, the Company acquired Wakely Software, Inc. ("Wakely"), a provider of rating software and actuarial services for the insurance industry. The purchase price for privately-held Wakely was approximately $13.7 million, consisting of approximately $4.4 million in cash and approximately for 175,000 shares of the Company's common stock that was paid at closing. Wakely had an accumulated deficit of $961,000 at the date of acquisition. We accounted for the acquisition of Wakely as a purchase for accounting purposes and allocated approximately $13.1 million to identified intangible assets and goodwill. These assets are being amortized over a period of three to seven years. We also expensed $1.9 million of in-process research and development at the time of acquisition. Based upon an independent valuation, it was determined that there was an allocation between developed and in-process research and development. This allocation was based on whether or not technological feasibility was achieved and whether there was an alternative future use for the technology. SFAS 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed," sets guidelines for establishing technological feasibility. Technological feasibility can be achieved through the existence of either a detailed program design or a completed working model. As of the respective dates for the acquisition discussed above, we concluded that the purchased in-process research and developments had no alternative future use and expensed it according to the provisions of SFAS 86. 7 10 SELECTICA, INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In November 2000, the Company acquired certain assets and liabilities of LoanMarket Resources, LLC ("LoanMarket"), a provider of real-time, mortgage, home equity, and unsecured lending software solutions. The purchase price for these assets and liabilities from the privately-held LoanMarket was approximately $1.5 million, consisting of approximately $403,000 in cash, 35,000 shares of the Company's common stock that was paid at closing and assumed liabilities of approximately $155,000. The Company allocated $1.5 million to intangible assets and will amortize this amount over a period of three years, the expected future life of the assets. 8 11 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Selectica is a leading provider of Internet selling system software and services that enable companies to efficiently sell complex products and services over intranets, extranets and the Internet. Our ACE suite of software products is a comprehensive Internet selling system solution that gives sellers the ability to manage the sales process in order to facilitate the conversion of prospective buyers into customers. Our Internet selling system solution allows companies to use the Internet platform to deploy a selling application to many points of contact, including personal computers, in-store kiosks and mobile devices, while offering customers, partners and employees an interface customized to their specific needs. Revenues We enter into arrangements for the sale of (1) licenses of our software products and related maintenance contract; (2) bundled license, maintenance, and services; and (3) services on a time and material basis. In instances where maintenance is bundled with a license of our software products, such maintenance term is typically one year. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met. For those contracts that consist solely of license and maintenance we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered and recognize maintenance revenues over the term of the maintenance contract as vendor specific objective evidence of fair value for maintenance does exist. Services can consist of maintenance, training and/or consulting services. Consulting services include a range of services including installation of our off-the-shelf software, customization of our software for the customer's specific application, data conversion and building of interfaces to allow our software to operate in customized environments. In all cases, we assess whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In this determination we focus on whether the software is off-the-shelf software, whether the services include significant alterations to the features and functionality of the software, whether the services involve the building of complex interfaces, the timing of payments and the existence of milestones. Often the installation of our software requires the building of interfaces to the customer's existing applications or customization of the software for specific applications. As a result, judgement is required in the determination of whether such services constitute "complex" interfaces. In making this determination we consider the following: (1) the relative fair value of the services compared to the software, (2) the amount of time and effort subsequent to delivery of the software until the interfaces or other modifications are completed, (3) the degree of technical difficulty in building of the interface and uniqueness of the application, (4) the degree of involvement of customer personnel, and (5) any contractual cancellation, acceptance, or termination provisions for failure to complete the interfaces. We also consider refunds, forfeitures and concessions when determining the significance of such services. In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement using contract accounting. For those arrangements accounted for using contract accounting that do not include contractual milestones or other acceptance criteria we utilize the percentage of completion method based upon input measures of hours. For those contracts that include contract milestones or acceptance criteria we recognize revenue as such milestones are achieved or as such acceptance occurs. 9 12 In some instances the acceptance criteria in the contract requires acceptance after all services are complete and all other elements have been delivered. In these instances we recognize revenue based upon the completed contract method after such acceptance has occurred. For those arrangements for which we have concluded that the service element is not essential to the other elements of the arrangement we determine whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether we have sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting we use vendor specific objective evidence for the fair value of the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element. Vendor-specific objective evidence of fair value of services is based upon hourly rates. As noted above, we enter into contracts for services alone and such contracts are based upon time and material basis. Such hourly rates are used to assess the vendor specific objective evidence in multiple element arrangements. In accordance with paragraph 10 of Statement of Position 97-2, Software Revenue Recognition, vendor specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate), which is based on the price established by management having the relevant authority. Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration. To date we have had four maintenance contracts come up for renewal for which the customer elected to renew such maintenance contracts. We believe that given the nature of our products as selling solutions for the Internet, our customers view maintenance of those products as important to their business and will continue to need upgrades and support of licensed products. As a result, we believe renewals will occur in the future as more contracts come up for renewal. To date we have not entered into arrangements solely for license of our products and, therefore, we have not demonstrated vendor specific objective evidence for the fair value of the license element. In all cases we classify revenues for these arrangements as license revenues and services revenues based on the estimates of fair value for each element. For the nine months ended December 31, 2000, we recognized 39%of license and services revenues using the percentage-of-completion method, 34% using the residual method, and 26% using the completed contract method. For the nine months ended December 31, 1999, we recognized 40% of license and services revenues using completed contract method, 29% using the percentage of completion method, and 23% using the residual method. For the three months ended December 31, 2000, we recognized 40% of license and services revenues using the percentage of completion method, 34% using the completed contract method, and 26% using the residual method. For the three months ended December 31, 1999, we recognized 46% of license and services revenues using the residual method, 29% of license and services revenues using the percentage of completion method and 24% under the completed contract method. Because we rely on a limited number of customers, the timing of customer acceptance or milestone achievement, or the amount of services we provide to a single customer can significantly affect our operating results. For example, our services revenues declined significantly in the quarter ended June 30, 1999 due to the completion of services under a contract with BMW of North America, one of our significant customers. Our license and services revenues increased significantly in the quarters ended September 30, 1999 and December 31, 1999 generally due to the addition of two new customers in each respective quarter. Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenue. Amounts recognized as revenue in advance of billing (typically under percentage-of-completion accounting) are recorded as unbilled receivables. 10 13 Factors Affecting Operating Results A relatively small number of customers account for a significant portion of our total revenues. For the nine months ended December 31, 2000, revenue from Samsung SDS, Dell, and Cisco accounted for 18%, 16%, and 13% of our revenues, respectively. For the nine months ended December 31, 1999, revenue from Aspect Communications, 3Com, and Fireman's Fund Insurance accounted for 15%, 14%, and 14% of our revenues, respectively. For the three months ended December 31, 2000, revenue from Cisco, Dell, Highmark Blue Cross Blue Shield, and Samsung SDS accounted for 18%, 14%, 12% and 12%, respectively. For the three months ended December 31, 1999, revenue from Fireman's Fund Insurance and Fujitsu Network Corporation accounted for 28% and 16% of our revenues, respectively. We expect that revenues from a limited number of customers will continue to account for a large percentage of total revenues in future quarters. To date, our revenues have been predominantly attributable to sales in the United States. We plan to expand our international operations significantly, because we believe international markets represent a significant growth opportunity. Consequently, we expect that international revenues will increase as a percentage of total revenues in the future. The expansion of our international operations will be subject to a variety of risks that could significantly harm our business and operating results. As our international sales and operations expand, we anticipate that our exposure to foreign currency fluctuations will increase because we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations. We have a limited operating history upon which we may be evaluated. We have incurred significant losses since inception and, as of December 31, 2000, we had an accumulated deficit of approximately $77.6 million. We believe our success depends on the continued growth of our customer base and the development of the emerging Internet selling system market. Accordingly, we intend to continue to invest heavily in sales and marketing and research and development. Furthermore, we expect to continue to incur substantial operating losses for the foreseeable future. In view of the rapidly changing nature of our business and our limited operating history, we believe that period-to-period comparisons of revenues and operating results are not necessarily meaningful and should not be relied upon as indications of future performance. Our limited operating history makes it difficult to forecast future operating results. Additionally, despite our recent revenue growth, we do not believe that historical growth rates are necessarily sustainable or indicative of future growth and we cannot be certain that revenues will increase. Even if we were to achieve profitability in any period, we may not be able to sustain or increase profitability on a quarterly or annual basis. Equity Transactions During October 1999, we issued, 1,505,702 shares of Series E Preferred Stock to various investors, including parties related to us, for gross proceeds of $6,597,986. Of this amount, $23,000 related to the exercise of warrants to purchase 5,250 shares of Series E Preferred Stock issued in connection with the convertible debt financing in May 1999. We issued 1,500,452 of these shares at $4.382 per share while the deemed fair value of such preferred stock at that date was approximately $7.70. As a result, in the third quarter of fiscal 2000 we recorded $5.0 million of charges related to the difference between the actual issuance price of the preferred stock and its deemed fair value. Of this amount, $266,000 was accounted for as compensation expense, $925,000 was accounted for as a dividend to stockholders in the third quarter of fiscal 2000 and the remaining amount will be amortized over an approximate two-year period in connection with a development agreement entered into in September 1999 with Intel, one of the investors. As of December 31, 2000 approximately $2.4 million had been amortized. Under the terms of the development agreement with Intel, we will work with Intel to port the current suite of ACE products to additional platforms. In connection with the development agreement, we issued warrants to purchase 57,000 shares of Series E convertible Preferred Stock. The warrants were issued in December 1999 and were valued using the Black-Scholes valuation model. The value of the warrants is approximately $381,000 and this amount will be expensed over the remaining life of the development agreement, which will be approximately two years. As of December 31, 2000, approximately $225,000 had been amortized. 11 14 On January 7, 2000, in connection with a license agreement entered into in November 1999 and one year maintenance agreement of $3.0 million, we issued a warrant to purchase 800,000 shares of common stock to one of our customers, for $800,000. The warrant is fully vested, has a life of two years, and an exercise price per share of $13. The value of the warrant is approximately $16.4 million and was determined based upon a Black-Scholes valuation model. The value of the warrant, less the warrant purchase price of $800,000, is greater than the revenues associated with the license and maintenance agreement, and accordingly, we recorded a loss of approximately $9.7 million in the fourth quarter of fiscal 2000. Between April 1, 2000 and December 31, 2000, an aggregate of 2,269,330 options to purchase common stock were granted at a weighted average price of $32.61. We have recorded deferred compensation related to these options of approximately $1.6 million representing the difference between the exercise price of the options granted and the deemed fair value of our common stock at the date of grant. RESULTS OF OPERATIONS The following table sets forth the percentage of total revenues for certain items in the Company's condensed consolidated statements of operations data for the three and nine months ended December 31, 2000 and 1999.
THREE MONTHS NINE MONTHS ENDED ENDED DECEMBER 31, DECEMBER 31, ------------ ------------ 2000 1999 2000 1999 ---- ---- ---- ---- AS A PERCENTAGE OF TOTAL REVENUES: Revenues: License............................................. 44% 52% 46% 57% Services............................................ 56 48 54 43 --- ---- ---- ---- Total revenues.............................. 100 100 100 100 Cost of revenues: License............................................. 2 3 2 3 Services............................................ 40 43 47 56 Services -- related party........................... -- -- -- 1 --- ---- ---- ---- Total cost of revenues...................... 42 46 49 60 --- ---- ---- ---- Gross profit (loss)......................... 58 54 51 40 Operating expenses: Research and development............................ 26 42 41 45 Sales and marketing................................. 66 98 95 101 General and administrative.......................... 23 26 25 32 --- ---- ---- ---- Total operating expenses.................... 115 166 161 178 --- ---- ---- ---- Loss from operations.................................. (57) (112) (110) (138) Interest and other income (expense), net.............. 17 5 25 3 --- ---- ---- ---- Net loss before taxes................................. (40) (107) (85) (135) Provision for income taxes............................ -- -- -- 1 --- ---- ---- ---- Net loss.............................................. (40) (107) (85) (136) --- ---- ---- ---- Deemed dividend on Series E preferred shares.......... -- 21 -- 10 --- ---- ---- ---- Net loss applicable to common stockholders............ (40)% (128)% (85)% (146)% === ==== ==== ====
THREE AND NINE MONTHS ENDED DECEMBER 31, 2000 AND 1999 Revenues Total revenues were $19.6 and $40.4 million in the three and nine months ended December 31, 2000 up from $4.5 million and $9.1 million, respectively, compared to the same periods a year ago. We believe that the future percentage increase in revenues will be significantly less than what has been achieved in prior periods. 12 15 License. License revenues totaled $8.7 million and $18.6 million in the three and nine months ended December 31, 2000 up from $2.3 million and $5.2 million, respectively, compared to the same periods a year ago. The net increase in license revenues was due to the addition of new customers as a result of expanded marketing activities, growth in our sales force, and greater demand for and the acceptance of our ACE suite of products. The increase was also offset by $2.1 million due to the amortization of the fair value of the warrant issued to a significant customer in connection with a license and service agreement. As of December 31, 2000, we have fully amortized the amount associated with the fair value of this warrant. We intend to generate additional license revenues from our existing customers and anticipate that revenues will increase in absolute dollars in future periods, although it will fluctuate as a percentage of total revenues as our customers and size of transactions change. Services. Services revenues totaled $11.0 million and $21.8 million in the three and nine months ended December 31, 2000, up from $2.2 million and $4.0 million, respectively, compared to the same periods a year ago. Our services revenues are comprised of fees from consulting, maintenance and training services. Services revenues from Wakely were immaterial from the date of acquisition to December 31, 2000. The increase in services revenues was due primarily to the increase in maintenance and maintenance renewals, consulting, and training services associated with our increased installed base. During the nine months ended December 31, 2000, revenues were also reduced by amortization of $3.8 million, the fair value of the warrant issued to a significant customer in connection with a license and service agreement as noted above. As of December 31, 2000, we have fully amortized the amount associated with the fair value of this warrant. We expect services revenues to continue to increase in terms of absolute dollars in future periods as the number of consulting projects and maintenance contracts increases with the addition of new customers. Cost of Revenues Cost of License Revenues. Cost of license revenues consists of the costs of the product media, duplication, packaging and delivery of our software products to our customers, which may include documentation, shipping and other data transmission costs. Cost of license revenues represented 5% and 5% of license revenues in the three and nine months ended December 31, 2000, and in the same periods a year ago. As we enter into more independent software vendor agreements we expect cost of license to increase in absolute dollars and to fluctuate as a percentage of license revenues. Cost of Services Revenues, including Related Party. Cost of services revenue is comprised mainly of salaries and related expenses of our services organization. Cost of services revenues totaled $7.8 million and $18.9 million in the three and nine months ended December 31, 2000 up from $2.0 million and $5.2 million, respectively, compared to the same periods a year ago. Cost of services revenues from Wakely was approximately $758,000 from the date of acquisition to December 31, 2000. Cost of services revenue, including related party, represented 72% and 86% of services revenues in the three and nine months ended December 31, 2000 compared to 91% and 132%, respectively, for the same periods a year ago. The increase in costs of services is primarily due to an increase in the number of consulting and technical support personnel necessary to support both the expansion of our installed base of customers and new implementations. We amortized approximately $548,000 for deferred compensation and approximately $291,000 for the stock repurchase for the nine months ended December 31, 2000. We anticipate that cost of services revenues will increase in absolute dollars in future periods as our number of customers increases. We expect cost of services revenues to fluctuate as a percentage of service revenue. Gross Margin For the three and nine months ended December 31, 2000, we experienced overall gross margins of 58% and 51% compared to overall gross margins of 54% and 40%, respectively, in the same periods a year ago. We expect that our overall gross margins will continue to fluctuate due to the timing of services and license revenue recognition and will continue to be adversely affected by lower margins associated with services revenues. The amount of impact on our gross margin will depend on the mix of services we provide, whether the services are performed by our in-house staff or third party consultants, and the overall utilization rates of our professional services organization. 13 16 Gross Margin -- Licenses. Gross margin for license revenues was approximately 95% and 95% for the three and nine months ended December 31, 2000 and in the same periods a year ago. During the nine months ended December 31, 2000, revenues were reduced by $2.1 million representing amortization of the fair value of the warrant issued to a significant customer in connection with a license and service agreement. As of December 31, 2000, we have fully amortized the amount associated with the fair value of this warrant. Gross Margin -- Services. Gross margin for services was approximately 28% and 14% for the three and nine months ended December 31, 2000 and 9% and negative 32%, respectively, for the same periods a year ago. The gross margin for the nine months ended December 31, 2000 included amortization of $3.8 million, the fair value of the warrant issued to a significant customer in connection with a license and service agreement. As of December 31, 2000, we have fully amortized the amount associated with the fair value of this warrant. We expect that our overall gross margins will continue to fluctuate due to the timing of services revenue recognition and will continue to be adversely affected by the lower margins on our service contracts. The impact on our gross profit will depend on the mix of services we provide, whether the services are performed by our in-house staff or third party consultants, whether the services are being performed on a fixed fee basis and the overall utilization rates of our professional services organization. We anticipate that cost of services revenues will increase in absolute dollars in future periods as our number of customers increases and that cost of services revenues will fluctuate as a percentage of service revenue. Operating Expenses Research and Development. Our research and development costs primarily consist of salaries and related costs of our engineering, quality assurance, and technical publications efforts. Research and development costs were $5.1 million and $16.5 million for the three and nine months ended December 31, 2000 and $1.9 million and $4.1 million, respectively, compared to the same periods a year ago. Research and development expenses from Wakely was approximately $230,000 from the date of acquisition to December 31, 2000. The increase was primarily due to an increase in the number of research and development personnel to support the development of ACE 4.0, ACE 4.5, quality assurance, and technical publications operations. We amortized approximately $260,000 for deferred compensation and approximately $1.6 million for the development agreement entered into with Intel. Research and development expenses also included $1.9 million for the one- time charge for in process research and development in relation to the Wakely acquisition for the nine months ended December 31, 2000. We expect that research and development expenses will increase in absolute dollars in future periods. Sales and Marketing. Our sales and marketing expenses primarily consist of salaries and related costs for our sales and marketing organization and marketing programs, including trade shows, sales materials, and advertising. Sales and marketing expenses totaled $13.0 million and $38.6 million in the three and nine months ended December 31, 2000 up from $4.4 and $9.3 million, respectively, for the same periods a year ago. Sales and marketing expense from Wakely was approximately $473,000 from the date acquisition to December 31, 2000. The increases were primarily due to the hiring of additional sales and marketing personnel and expenses incurred in connection with trade show and additional marketing programs. We amortized approximately $1.4 million for deferred compensation, $483,000 for acceleration of stock option vesting, and approximately $291,000 for the stock repurchase for the nine months ended December 31, 2000. We expect that sales and marketing expenses will increase in absolute dollars over the next year as we increase spending on advertising and marketing programs and establish sales offices in additional domestic and international locations. General and Administrative. Our general and administrative expenses consist primarily of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources and facilities as well as information system expenses not allocated to other departments. General and administrative expenses totaled $4.4 million and $9.9 million in the three and nine months ended December 31, 2000, up from $1.2 million and $2.9 million, respectively, compared to the same periods a year ago. General and administrative expense from Wakely was approximately $428,000 from the date of acquisition to December 31, 2000. The increase was primarily due to a higher number of personnel and additional legal and accounting costs incurred in connection with business activities. We amortized approximately $345,000 for 14 17 deferred compensation, $44,000 for acceleration of stock option vesting, and approximately $291,000 for the stock repurchase during the nine months ended December 31, 2000. In addition, we incurred approximately $639,000 from the amortization of goodwill in connection with the Wakely acquisition and anticipate incurring $383,000 in quarterly amortization for the next seven years. We expect that general and administrative expenses will increase in absolute dollars over the next fiscal year as we hire additional general and administrative personnel to support our expanding business activities. Interest and Other Income, Net Interest and other income, net primarily consists of interest earned on cash balances and stockholders notes receivable, offset by interest expense related to convertible debt issued in the three months ended June 30, 1999 and converted in the same quarter. Interest and other income, net totaled $3.4 million and $10.1 million for the three and nine months ended December 31, 2000 compared with interest income of $221,000 and $319,000, respectively, for the comparable periods in the prior year. The increase in net interest income for the three and nine months ended December 31, 2000 resulted primarily from interest income on our initial public offering and private placement net proceeds of $193.1 million, which was completed on March 10, 2000. Provision for Income Taxes We have recorded a tax provision of $200,000 and $50,000 for the nine months ended December 31, 2000 and 1999, respectively. The provision for income taxes consists primarily of state income taxes and foreign taxes. CONSOLIDATED BALANCE SHEET DATA Cash, cash equivalents, short and long term investments were approximately $178.7 million at December 31, 2000 compared to $215.8 million at March 31, 2000. The decrease primarily relates to cash used in operations during the nine months ended December 31, 2000 of $28.4 million, the Wakely acquisition of $4.8 million, capital expenditures of $6.1 million and investments in short and long-term commercial paper of $125.6 million at December 31, 2000. Accounts receivable was approximately $19.9 million at December 31, 2000 compared to $5.7 million at March 31, 2000. The increase of $14.2 million is a direct result of increased deferred revenues related to advanced billings, maintenance, and increased license and services revenues from new customers. Prepaid expenses were approximately $3.5 million at December 31, 2000 compared to $9.4 million at March 31, 2000. The decrease of $5.9 million is primarily due to the amortization of the fair value of a warrant issued to a customer in connection with a license agreement. Property and equipment, net was $10.3 million at December 31, 2000 and $6.1 million at March 31, 2000. The $4.2 million increase primarily relates to capital additions of $6.1 million related to leasehold improvements to our new facility in San Jose as well as computers and networking equipment related to our headcount growth offset by accumulated depreciation of $2.0 million. Goodwill, net was $13.3 million at December 31, 2000 and $30,000 at March 31, 2000. This increase in net goodwill primarily relates to $13.1 million in relation to the acquisition of Wakely and $1.1 million with respect to the acquisition of certain assets of LoanMarket offset by amortization of $1.0 million. Investments, restricted was $2.0 million at December 31, 2000 and $100,000 at March 31, 2000. The $1.8 million increase primarily relates to $1.5 million in escrow as a result of the Wakely acquisition. Accrued payroll and related liabilities was approximately $4.5 million at December 31, 2000 compared to $1.9 million at March 31, 2000. The $2.6 million increase primarily relates to employee contributions withheld related to our Employee Stock Purchase Plan which began on March 8, 2000 and for which the second purchase cycle ends on April 30, 2001. Deferred revenues were $21.5 million at December 31, 2000 compared to $18.5 million at March 31, 2000. The $3.0 million increase was primarily due to cash advances and amounts billed in advance for performing services or delivering product. 15 18 LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2000, cash, cash equivalents and short term investments totaled $148.8 million, compared to $215.8 million at March 31, 2000. We currently have no significant capital commitments other than obligations under operating leases. We have funded our operations with proceeds from the private sale of common and preferred stock, and public offering. Cash used by operating activities for the nine months ended December 31, 2000 was $28.3 million and was primarily a result of our net loss adjusted for noncash items, increases in accounts receivable, and other assets offset by the increases in accrued payroll. Cash used for investing activities for the nine months ended December 31, 2000 was $136.6 million and consisted primarily of the acquisition of Wakely, long-term and short-term investments as well as capital expenditures. Cash provided by financing activities for the nine months ended December 31, 2000 was $2.0 million and was a result of the issuance of common stock during the nine months ended December 31, 2000 offset by fees related to our private placement in March 2000. We expect to experience growth in our operating expenses in absolute dollars for the foreseeable future in order to execute our business plan. As a result, we anticipate that operating expenses and planned capital expenditures will constitute a material use of our cash resources. Our capital requirements depend on numerous factors, including developing, marketing, selling and supporting our products, the timing and extent of establishing international operations, and other factors. We expect to devote substantial resources to hire additional research and development personnel to support the development of new products and new versions of existing products. Sales and marketing expenses are expected to increase in absolute dollars as we hire additional sales and marketing personnel, increase spending on advertising and marketing programs, and establish sales offices in additional domestic and international locations. General and administrative expenses are expected to increase in absolute dollars to support the expansion of our business as we hire additional general and administrative personnel. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes methods for derivative financial instruments and hedging activities related to those instruments, as well as other hedging activities. Because we do not currently hold any derivative instruments and do not engage in hedging activities, we expect that the adoption of SFAS No. 133 will not have a material impact on our financial position, results of operations or cash flows. We will be required to implement SFAS No. 133 for the year ending March 31, 2002. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements." SAB 101 provides guidance on the recognition, presentation, and disclosure of revenue in financial statements. SAB 101 is effective for years beginning after December 15, 1999 and is required to be reported beginning in the quarter ended March 31, 2001. SAB 101 is not expected to have a significant effect on the Company's consolidated results of operations, financial position, or cash flows. 16 19 RISK FACTORS RISKS RELATED TO OUR BUSINESS THE UNPREDICTABILITY OF OUR QUARTERLY REVENUES AND RESULTS OF OPERATIONS MAKES IT DIFFICULT TO PREDICT OUR FINANCIAL PERFORMANCE AND MAY CAUSE VOLATILITY OR A DECLINE IN THE PRICE OF OUR COMMON STOCK IF WE ARE UNABLE TO SATISFY THE EXPECTATIONS OF INVESTORS OR THE MARKET. In the past, our quarterly operating results have varied significantly, and we expect these fluctuations to continue. Future operating results may vary depending on a number of factors, many of which are outside of our control. Our quarterly revenues may fluctuate as a result of our ability to recognize revenue in a given quarter. We enter into arrangements for the sale of (1) licenses of our software products and related maintenance contract; (2) bundled license, maintenance, and services; and (3) services on a time and material basis. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met. Additionally, because we rely on a limited number of customers for our revenue, the loss or delay of one prospective customer may significantly harm our operating results. For those contracts that consist solely of license and maintenance we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as we have vendor specific objective evidence of fair value of maintenance we recognize maintenance revenues over the term of the maintenance contract. For those contracts that bundle the license with maintenance training, and/or consulting services, we assess whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement using contract accounting. For those arrangements accounted for using contract accounting that do not include contractual milestones or other acceptance criteria we utilize the percentage of completion method based upon input measures of hours. For those contracts that include contract milestones or acceptance criteria we recognize revenue as such milestones are achieved or as such acceptance occurs. In some instances the acceptance criteria in the contract requires acceptance after all services are complete and all other elements have been delivered. In these instances we recognize revenue based upon the completed contract method after such acceptance has occurred. For those arrangements for which we have concluded that the service element is not essential to the other elements of the arrangement we determine whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether we have sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting we have vendor specific objective evidence of fair value for the service. In addition, because we rely on a limited number of customers, the timing of milestone achievement or customer acceptance by, the amount of services we provide to, or the recognition of significant license revenues upon shipment to a single customer can significantly affect our operating results. For example, our services revenues declined significantly in the quarter ended June 30, 1999 due to completion of a services contract with BMW of North America, one of our significant customers. Our license and service revenues increased significantly in the quarters ended September 30, 1999, December 31, 1999 and March 31, 2000 generally due to the addition of two new customers. See "Management's Discussion and Analysis." We intend to significantly increase our operating expenses for the foreseeable future. Because these expenses are relatively fixed in the near term, any shortfall from anticipated revenues could cause our quarterly operating results to fall below anticipated levels. 17 20 We may also experience seasonality in revenues. For example, our quarterly results may fluctuate based upon our customers' calendar year budgeting cycles and changes in information technology spending patterns. These seasonal variations may lead to fluctuations in our quarterly revenues and operating results. Based upon the foregoing, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance. In some future quarter, our operating results may be below the expectations of public market analysts and investors, which could cause volatility or a decline in the price of our common stock. WE HAVE A HISTORY OF LOSSES AND EXPECT TO CONTINUE TO INCUR NET LOSSES FOR THE FORESEEABLE FUTURE. We have experienced operating losses in each quarterly and annual period since inception. We incurred net losses applicable to common stockholders of $7.5 million for the fiscal year ended March 31, 1999, $31.8 million for the fiscal year ended March 31, 2000 and $34.5 million for the nine months ended December 31, 2000. As of December 31, 2000, we had an accumulated deficit of $77.6 million. We expect to significantly increase our research and development, sales and marketing, and general and administrative expenses, and consequently our losses may increase in the future. In order to accommodate our increase in employees, we have leased a larger facility, and we will incur increased capital equipment costs. We will need to generate significant increases in our revenues to achieve and maintain profitability. If our revenue fails to grow or grows more slowly than we anticipate or our operating expenses exceed our expectations, our losses will significantly increase which would significantly harm our business and operating results. A DECLINE GENERAL ECONOMIC CONDITIONS OR A DECREASE IN INFORMATION TECHNOLOGY SPENDING COULD HARM OUR RESULTS OF OPERATIONS. The change in economic conditions may lead to revised budgetary constraints regarding information technology spending for our customers. For example, a potential customer which had selected our Internet selling system from a number of competitors recently decided not to implement any configuration system. That company had decided to reduce its expenditures for information technology. A general slowdown in information technology spending due to economic conditions or other factors could significantly harm our business and operating results. IF THE MARKET FOR INTERNET SELLING SYSTEM SOFTWARE DOES NOT DEVELOP AS WE ANTICIPATE, OUR OPERATING RESULTS WILL BE SIGNIFICANTLY HARMED, WHICH COULD CAUSE A DECLINE IN THE PRICE OF OUR COMMON STOCK. The market for Internet selling system software, which has only recently begun to develop, is evolving rapidly and likely will have an increased number of competitors. Because this market is new, it is difficult to assess its competitive environment, growth rate and potential size. The growth of the market is dependent upon the willingness of businesses and consumers to purchase complex goods and services over the Internet and the acceptance of the Internet as a platform for business applications. In addition, companies that have already invested substantial resources in other methods of Internet selling may be reluctant or slow to adopt a new approach or application that may replace, limit or compete with their existing systems. The acceptance and growth of the Internet as a business platform may not continue to develop at historical rates and a sufficiently broad base of companies may not adopt Internet platform-based business applications, either of which could significantly harm our business and operating results. The failure of the market for Internet selling system software to develop, or a delay in the development of this market, would significantly harm our business and operating results. OUR LIMITED OPERATING HISTORY AND THE FACT THAT WE OPERATE IN A NEW INDUSTRY MAKES EVALUATING OUR BUSINESS PROSPECTS AND RESULTS OF OPERATIONS DIFFICULT. We were founded in June 1996 and have a limited operating history. We began marketing our ACE suite of products in early 1997, released ACE 4.0 in November 1999, and released ACE 4.5 in October 2000. Our business model is still emerging, and the revenue and income potential of our business and market are unproven. As a result of our limited operating history, we have limited financial data that you can use to 18 21 evaluate our business. You must consider our prospects in light of the risks and difficulties we may encounter as an early stage company in the new and rapidly evolving market for Internet selling systems. FAILURE TO ESTABLISH AND MAINTAIN RELATIONSHIPS WITH SYSTEMS INTEGRATORS AND CONSULTING FIRMS, WHICH ASSIST US WITH THE SALE AND INSTALLATION OF OUR PRODUCTS, WOULD IMPEDE ACCEPTANCE OF OUR PRODUCTS AND THE GROWTH OF OUR REVENUES. We rely in part upon systems integrators and consulting firms to recommend our products to their customers and to install and deploy our products. To increase our revenues and implementation capabilities, we must develop and expand our relationships with these systems integrators and consulting firms. If systems integrators and consulting firms develop, market or recommend competitive Internet selling systems, our revenues may decline. In addition, if these systems integrators and consulting firms are unwilling to install and deploy our products, we may not have the resources to provide adequate implementation services to our customers and our business and operating results could be significantly harmed. WE FACE INTENSE COMPETITION, WHICH COULD REDUCE OUR SALES, PREVENT US FROM ACHIEVING OR MAINTAINING PROFITABILITY AND INHIBIT OUR FUTURE GROWTH. The market for software and services that enable electronic commerce is new, intensely competitive and rapidly changing. We expect competition to persist and intensify, which could result in price reductions, reduced gross margins and loss of market share. Our principal competitors include Oracle Corporation, Siebel Systems, I2, SAP, Trilogy Software, FirePond, Calico Commerce and BAAN, all of which offer integrated solutions for electronic commerce incorporating some of the functionality of an Internet selling system. These competitors may intensify their efforts in our market. In addition, other enterprise software companies may offer competitive products in the future. Competitors vary in size and in the scope and breadth of the products and services offered. Many of our competitors and potential competitors have a number of significant advantages over us, including: - a longer operating history; - preferred vendor status with our customers; - more extensive name recognition and marketing power; and - significantly greater financial, technical, marketing and other resources, giving them the ability to respond more quickly to new or changing opportunities, technologies and customer requirements. Our competitors may also bundle their products in a manner that may discourage users from purchasing our products. Current and potential competitors may establish cooperative relationships with each other or with third parties, or adopt aggressive pricing policies to gain market share. Competitive pressures may require us to reduce the prices of our products and services. We may not be able to maintain or expand our sales if competition increases and we are unable to respond effectively. OUR LENGTHY SALES CYCLE MAKES IT DIFFICULT FOR US TO FORECAST REVENUE AND AGGRAVATES THE VARIABILITY OF QUARTERLY FLUCTUATIONS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. The sales cycle of our products has historically averaged between four and six months, and may sometimes be significantly longer. We are generally required to provide a significant level of education regarding the use and benefits of our products, and potential customers tend to engage in extensive internal reviews before making purchase decisions. In addition, the purchase of our products typically involves a significant commitment by our customers of capital and other resources, and is therefore subject to delays that are beyond our control, such as customers' internal budgetary procedures and the testing and acceptance of new technologies that affect key operations. In addition, because we intend to target large companies, our sales cycle can be lengthier due to the decision process in large organizations. As a result of our products' long sales cycles, we face difficulty predicting the quarter in which sales to expected customers may occur. If anticipated sales from a specific customer for a particular quarter are not realized in that quarter, our operating results for 19 22 that quarter could fall below the expectations of financial analysts and investors, which could cause our stock price to decline. IF WE DO NOT KEEP PACE WITH TECHNOLOGICAL CHANGE, INCLUDING MAINTAINING INTEROPERABILITY OF OUR PRODUCT WITH THE SOFTWARE AND HARDWARE PLATFORMS PREDOMINANTLY USED BY OUR CUSTOMERS, OUR PRODUCT MAY BE RENDERED OBSOLETE AND OUR BUSINESS MAY FAIL. Our industry is characterized by rapid technological change, changes in customer requirements, frequent new product and service introductions and enhancements and emerging industry standards. In order to achieve broad customer acceptance, our products must be compatible with major software and hardware platforms used by our customers. Our products currently operate on the Microsoft Windows NT, Sun Solaris, IBM AIX, Linux and Windows 2000 operating systems. In addition, our products are required to interoperate with electronic commerce applications and databases. We must continually modify and enhance our products to keep pace with changes in these operating systems, applications and databases. Internet selling system technology is complex and new products and product enhancements can require long development and testing periods. If our products were to be incompatible with a popular new operating system, electronic commerce application or database, our business would be significantly harmed. In addition, the development of entirely new technologies to replace existing software could lead to new competitive products that have better performance or lower prices than our products and could render our products obsolete and unmarketable. WE HAVE RELIED AND EXPECT TO CONTINUE TO RELY ON A LIMITED NUMBER OF CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR REVENUES, AND THE LOSS OF ANY OF THESE CUSTOMERS COULD SIGNIFICANTLY HARM OUR BUSINESS AND OPERATING RESULTS. Our business and financial condition is dependent on a limited number of customers. Our five largest customers accounted for approximately 57% of our revenues for the nine months ended December 31, 2000 and our ten largest customers accounted for 72% of our revenues for the nine months ended December 31, 2000. Our five largest customers accounted for approximately 53% of our revenues for the fiscal year ended March 31, 2000, and our ten largest customers accounted for 76% of our revenues for the fiscal year ended March 31, 2000. We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenues for the foreseeable future. Contracts with our customers can generally be terminated on short notice by the customer. As a result, if we fail to successfully sell our products and services to one or more customers in any particular period, or a large customer purchases less of our products or services, defers or cancels orders, or terminates its relationship with us, our business and operating results would be harmed. OUR FAILURE TO MEET CUSTOMER EXPECTATIONS ON DEPLOYMENT OF OUR PRODUCTS COULD RESULT IN NEGATIVE PUBLICITY AND REDUCED SALES, BOTH OF WHICH WOULD SIGNIFICANTLY HARM OUR BUSINESS AND OPERATING RESULTS. In the past, our customers have experienced difficulties or delays in completing implementation of our products. We may experience similar difficulties or delays in the future. Our Internet selling system solution relies on defining a knowledge base that must contain all of the information about the products and services being configured. We have found that extracting the information necessary to construct a knowledge base can be more time consuming than we or our customers anticipate. If our customers do not devote the resources necessary to create the knowledge base, the deployment of our products can be delayed. Deploying our ACE products can also involve time-consuming integration with our customers' legacy systems, such as existing databases and enterprise resource planning software. Failing to meet customer expectations on deployment of our products could result in a loss of customers and negative publicity regarding us and our products, which could adversely affect our ability to attract new customers. In addition, time-consuming deployments may also increase the amount of professional services we must allocate to each customer, thereby increasing our costs and adversely affecting our business and operating results. 20 23 IF WE ARE UNABLE TO MAINTAIN AND EXPAND OUR DIRECT SALES FORCE, SALES OF OUR PRODUCTS AND SERVICES MAY NOT MEET OUR EXPECTATIONS AND OUR BUSINESS AND OPERATING RESULTS WILL BE SIGNIFICANTLY HARMED. We depend on our direct sales force for all of our current sales and our future growth depends on the ability of our direct sales force to develop customer relationships and increase sales to a level that will allow us to reach and maintain profitability. There is a shortage of the sales personnel we need, such as sales engineers, and competition for qualified personnel is intense. In addition, it will take time for new sales personnel to achieve full productivity. If we are unable to hire or retain qualified sales personnel, or if newly hired personnel fail to develop the necessary skills or to reach productivity when anticipated, we may not be able to expand our sales organization and increase sales of our products and services. IF WE ARE UNABLE TO GROW AND MANAGE OUR PROFESSIONAL SERVICES ORGANIZATION, WE WILL BE UNABLE TO PROVIDE OUR CUSTOMERS WITH TECHNICAL SUPPORT FOR OUR PRODUCTS, WHICH COULD SIGNIFICANTLY HARM OUR BUSINESS AND OPERATING RESULTS. As we increase licensing of our software products, we must grow our professional services organization to assist our customers with implementation and maintenance of our products. Because these professional services have been expensive to provide, we must improve the management of our professional services organizations to improve our results of operations. Improving the efficiency of our consulting services is dependent upon attracting and retaining experienced project managers. Competition for these project managers is intense, particularly in the Silicon Valley and in India where the majority of our professional services organization is based, and we may not be able to hire qualified individuals to fill these positions. Although services revenues, which are primarily comprised of revenues from consulting fees, maintenance contracts and training, are important to our business, representing 54% and 43% of total revenues for the nine months ended December 31, 2000 and for the year ended March 31, 2000, respectively, services revenues have lower gross margins than license revenues. Gross margins for services revenues were 14% and negative 113% for the nine months ended December 31, 2000 and for the year ended March 31, 2000, respectively, compared to gross margins for license revenues of 95% and 51% for the respective periods. As a result, a continued increase in the percentage of total net revenues represented by services revenues or an unexpected decrease in license revenues could have a detrimental impact on our overall gross margins and our operating results. We anticipate that customers will increasingly utilize third-party consultants to install and deploy our products. Additionally, for all new contracts we charge for our professional services on a time and materials rather than a fixed-fee basis. To the extent that customers are unwilling to utilize third-party consultants or require us to provide professional services on a fixed fee basis, our cost of services revenues could increase and could cause us to recognize a loss on a specific contract, either of which would adversely affect our operating results. In addition, if we are unable to provide these resources, we may lose sales or incur customer dissatisfaction and our business and operating results could be significantly harmed. A SUBSTANTIAL PORTION OF OUR OPERATIONS ARE CONDUCTED BY INDIA-BASED PERSONNEL, AND ANY CHANGE IN THE POLITICAL AND ECONOMIC CONDITIONS OF INDIA OR IN IMMIGRATION POLICIES, WHICH WOULD ADVERSELY AFFECT OUR ABILITY TO CONDUCT OUR OPERATIONS IN INDIA, COULD SIGNIFICANTLY HARM OUR BUSINESS. We conduct quality assurance and professional services operations in India. As of December 31, 2000, there were 356 persons employed in India. We are dependent on our India-based operations for these aspects of our business and we intend to grow our operations in India. As a result, we are directly influenced by the political and economic conditions affecting India. Operating expenses incurred by our operations in India are denominated in Indian currency and accordingly, we are exposed to adverse movements in currency exchange rates. This, as well as any other political or economic problems or changes in India, could have a negative impact on our India-based operations, resulting in significant harm to our business and operating results. Furthermore, the intellectual property laws of India may not adequately protect our proprietary rights. We 21 24 believe that it is particularly difficult to find quality management personnel in India, and we may not be able to timely replace our current India-based management team if any of them were to leave our company. Our training program for some of our India-based employees includes an internship at our San Jose, California headquarters. Additionally, we provide services to some of our customers internationally with India-based employees. We presently rely on a number of visa programs to enable these India-based employees to travel and work internationally. Any change in the immigration policies of India or the countries to which these employees travel and work could cause disruption or force the termination of these programs, which would harm our business. OUR OPERATING RESULTS ARE SIGNIFICANTLY DEPENDENT UPON THE SALE OF OUR ACE SUITE OF PRODUCTS, INCLUDING ACE 4.5 AND ACE SME RELEASED IN OCTOBER 2000. We expect that we will continue to depend on revenue from new and enhanced versions of ACE for the foreseeable future, and if companies do not adopt or expand their use of ACE, our business and operating results would be significantly harmed. ACE 4.5, the most recent release of our core product, and ACE SME, a version designed specifically for the requirements and resources of small to medium-sized enterprises, were introduced in October 2000. Since these new products have been only recently introduced, customers may discover errors or other problems with the product, which may adversely affect its acceptance. IF NEW VERSIONS AND RELEASES OF OUR PRODUCTS CONTAIN ERRORS OR DEFECTS, WE COULD SUFFER LOSSES AND NEGATIVE PUBLICITY, WHICH WOULD ADVERSELY AFFECT OUR BUSINESS AND OPERATING RESULTS. Complex software products such as ours often contain errors or defects, including errors relating to security, particularly when first introduced or when new versions or enhancements are released. In the past, we have discovered defects in our products and provided product updates to our customers to address such defects. ACE and other future products may contain defects or errors, which could result in lost revenues, a delay in market acceptance or negative publicity, which would significantly harm our business and operating results. OUR RAPID GROWTH PLACES A SIGNIFICANT STRAIN ON OUR MANAGEMENT SYSTEMS AND RESOURCES, AND IF WE FAIL TO MANAGE THIS GROWTH, OUR BUSINESS WILL BE HARMED. We have recently experienced a period of rapid growth and expansion, which places significant demands on our managerial, administrative, operational, financial and other resources. From December 31, 1998 to December 31, 2000, we expanded from 68 to 751 employees, including 29 employees from the acquisition of Wakely. We have also significantly expanded our operations in the U.S. and internationally and we plan to continue to expand the geographic scope of our operations. We will be required to manage an increasing number of relationships with customers, suppliers and employees, and an increasing number of complex contracts. If we are unable to initiate procedures and controls to support our future operations in an efficient and timely manner, or if we are unable to otherwise manage growth effectively, our business would be harmed. THE LOSS OF ANY OF OUR KEY PERSONNEL WOULD HARM OUR COMPETITIVENESS BECAUSE OF THE TIME AND EFFORT THAT WE WOULD HAVE TO EXPEND TO REPLACE SUCH PERSONNEL. We believe that our success will depend on the continued employment of our senior management team and key technical personnel, none of whom, except Rajen Jaswa, our President and Chief Executive Officer, and Dr. Sanjay Mittal, our Chief Technical Officer and Vice President of Engineering, has an employment agreement with us. If one or more members of our senior management team or key technical personnel were unable or unwilling to continue in their present positions, these individuals would be difficult to replace. Consequently, our ability to manage day-to-day operations, including our operations in Pune, India, develop and deliver new technologies, attract and retain customers, attract and retain other employees and generate revenues would be significantly harmed. 22 25 BECAUSE COMPETITION FOR QUALIFIED PERSONNEL IS INTENSE IN OUR INDUSTRY AND IN OUR GEOGRAPHIC REGION, WE MAY NOT BE ABLE TO RECRUIT OR RETAIN PERSONNEL, WHICH COULD IMPACT THE DEVELOPMENT OR SALES OF OUR PRODUCTS. Our success depends on our ability to attract and retain qualified management, engineering, sales and marketing and professional services personnel. Competition for these types of personnel is intense, especially in the Silicon Valley. We do not have employment agreements with most of our key personnel. If we are unable to retain our existing key personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products. An important component of our employee compensation is stock options. Because of the decline in our stock price, some of our employees hold options with an exercise price substantially below the current market price. This could adversely affect our ability to attract and retain employees. IF WE BECOME SUBJECT TO PRODUCT LIABILITY LITIGATION, IT COULD BE COSTLY AND TIME CONSUMING TO DEFEND AND COULD DISTRACT US FROM FOCUSING ON OUR BUSINESS AND OPERATIONS. Since our products are company-wide, mission-critical computer applications with a potentially strong impact on our customers' sales, errors, defects or other performance problems could result in financial or other damages to our customers. Although our license agreements generally contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate such limitation of liability provisions. Product liability litigation, even if it were unsuccessful, would be time consuming and costly to defend. OUR FUTURE SUCCESS DEPENDS ON OUR PROPRIETARY INTELLECTUAL PROPERTY, AND IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY FROM POTENTIAL COMPETITORS OUR BUSINESS MAY BE SIGNIFICANTLY HARMED. We rely on a combination of trademark, trade secret and copyright law and contractual restrictions to protect the proprietary aspects of our technology. These legal protections afford only limited protection for our technology. We currently hold one patent. We also currently have two pending U.S. patent applications. In addition, we have three trademarks and have applied to register two of the trademarks in the United States. Our trademark and patent applications might not result in the issuance of any trademarks or patents. If any patent or trademark is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We seek to protect source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to signed license agreements, which impose certain restrictions on the licensee's ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of many countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Our failure to adequately protect our intellectual property could significantly harm our business and operating results. ANY ACQUISITIONS THAT WE MAY MAKE COULD DISRUPT OUR BUSINESS AND HARM OUR OPERATING RESULTS. We may acquire or make investments in complementary companies, products or technologies. In the event of any such investments, acquisitions or joint ventures, we could: - issue stock that would dilute our current stockholders' percentage ownership; - incur debt; - assume liabilities; - incur amortization expenses related to goodwill and other intangible assets; or - incur large and immediate write-offs. 23 26 These investments, acquisitions or joint ventures also involve numerous risks, including: - problems combining the purchased operations, technologies or products with ours; - unanticipated costs; - diversion of managements' attention from our core business; - adverse effects on existing business relationships with suppliers and customers; - potential loss of key employees, particularly those of the acquired organizations; and - reliance to our disadvantage on the judgment and decisions of third parties and lack of control over the operations of a joint venture partner. Any acquisition or joint venture may cause our financial results to suffer as a result of these risks. IF WE ARE SUBJECT TO INTELLECTUAL PROPERTY LITIGATION, WE MAY INCUR SUBSTANTIAL COSTS, WHICH WOULD HARM OUR OPERATING RESULTS. Our success and ability to compete are dependent on our ability to operate without infringing upon the proprietary rights of others. Any intellectual property litigation could result in substantial costs and diversion of resources and could significantly harm our business and operating results. In the past, we received correspondence from two patent holders recommending that we license their respective patents. After review of these patents, we informed these patent holders that in our opinion, it would not be necessary to license these patents. However, we may be required to license either or both patents or incur legal fees to defend our position that such licenses are not necessary. We cannot assure you that if required to do so, we would be able to obtain a license to use either patent on commercially reasonable terms, or at all. Any threat of intellectual property litigation could force us to do one or more of the following: - cease selling, incorporating or using products or services that incorporate the challenged intellectual property; - obtain from the holder of the infringed intellectual property right a license to sell or use the relevant intellectual property, which license may not be available on reasonable terms; - redesign those products or services that incorporate such intellectual property; or - pay money damages to the holder of the infringed intellectual property right. In the event of a successful claim of infringement against us and our failure or inability to license the infringed intellectual property on reasonable terms or license a substitute intellectual property or redesign our product to avoid infringement, our business and operating results would be significantly harmed. If we are forced to abandon use of our trademark, we may be forced to change our name and incur substantial expenses to build a new brand, which would significantly harm our business and operating results. RESTRICTIONS ON EXPORT OF ENCRYPTED TECHNOLOGY COULD CAUSE US TO INCUR DELAYS IN INTERNATIONAL PRODUCT SALES, WHICH WOULD ADVERSELY IMPACT THE EXPANSION AND GROWTH OF OUR BUSINESS. Our software utilizes encryption technology, the export of which is regulated by the United States government. If our export authority is revoked or modified, if our software is unlawfully exported or if the United States adopts new legislation restricting export of software and encryption technology, we may experience delay or reduction in shipment of our products internationally. Current or future export regulations could limit our ability to distribute our products outside of the United States. While we take precautions against unlawful exportation of our software, we cannot effectively control the unauthorized distribution of software across the Internet. 24 27 IF WE ARE UNABLE TO EXPAND OUR OPERATIONS INTERNATIONALLY OR ARE UNABLE TO MANAGE THE GREATER COLLECTIONS, MANAGEMENT, HIRING, LEGAL, REGULATORY AND CURRENCY RISKS FROM THESE INTERNATIONAL OPERATIONS, OUR BUSINESS AND OPERATING RESULTS WILL BE HARMED. We intend to expand our operations internationally. This expansion may be more difficult or take longer than we anticipate, and we may not be able to successfully market, sell or deliver our products internationally. If successful in our international expansion, we will be subject to a number of risks associated with international operations, including: - longer accounts receivable collection cycles; - expenses associated with localizing products for foreign markets; - difficulties in managing operations across disparate geographic areas; - difficulties in hiring qualified local personnel; - difficulties associated with enforcing agreements and collecting receivables through foreign legal systems; - unexpected changes in regulatory requirements that impose multiple conflicting tax laws and regulations; and - fluctuations in foreign exchange rates and the possible lack of financial stability in foreign countries that prevent overseas sales growth. OUR RESULTS OF OPERATIONS WILL BE HARMED BY CHARGES ASSOCIATED WITH OUR PAYMENT OF STOCK-BASED COMPENSATION AND CHARGES ASSOCIATED WITH OTHER SECURITIES ISSUANCE BY US. We have in the past and expect in the future to incur a significant amount of amortization of charges related to securities issuances in future periods, which will negatively affect our operating results. Since inception we have recorded $14.3 million in net deferred compensation charges. During the year ended March 31, 2000 and the nine months ended December 31, 2000 we amortized $1.3 million and $2.6 million of such charges, respectively. We expect to amortize approximately $3.4 million of stock-based compensation for the fiscal year ending March 31, 2001 and we may incur additional charges in the future in connection with grants of stock-based compensation at less than fair value. In January 2000, in connection with a license and maintenance agreement, we issued a warrant to purchase 800,000 shares of common stock for $800,000. The fair value of the warrant was $16.4 million. In the quarter ended March 31, 2000, we recorded a charge of $9.7 million related to the loss on the license and software maintenance contract, of which $4.1 million was charged to cost of license revenues and $5.6 million was charged to costs of services revenues, in relation to the issuance of these warrants. During the nine months ended December 31, 2000, revenues were reduced by amortization of $5.9 million in connection with this license and services agreement. As of December 31, 2000, we have fully amortized the amount associated with the fair value of this warrant. We accounted for the acquisition of Wakely as a purchase for accounting purposes and allocated approximately $13.1 million to identified intangible assets and goodwill. These assets are being amortized over a period of three to seven years. We also expensed $1.9 million of in-process research and development at the time of acquisition. See Note 10 of the Notes to consolidated financial statements for the year ended March 31, 2000 and Note 7 of Notes to condensed financial statements for the nine months ended December 31, 2000. DEMAND FOR OUR PRODUCTS AND SERVICES WILL DECLINE SIGNIFICANTLY IF OUR SOFTWARE CANNOT SUPPORT AND MANAGE A SUBSTANTIAL NUMBER OF USERS. Our strategy requires that our products be highly scalable. To date, only a limited number of our customers have deployed our ACE products on a large scale. If our customers cannot successfully implement large-scale deployments, or if they determine that we cannot accommodate large-scale deployments, our business and operating results would be significantly harmed. 25 28 IF WE FAIL TO IMPROVE OUR ACCOUNTING AND FINANCIAL CONTROL SYSTEMS OR ACCURATELY MANAGE THE PROGRESS OF OUR CUSTOMER CONTRACTS, OUR OPERATING RESULTS WILL BE SIGNIFICANTLY HARMED. In the past, we have had difficulty managing our accounting and financial reporting systems and the volume and complexity of our customer contracts. We need to improve our financial and accounting controls, improve our reporting and approval procedures, expand and train key personnel within our finance and management organizations, implement more robust information systems, and accurately record and track our customer contracts. If we fail to improve our financial systems, procedures and controls or if we fail to effectively manage our customer contracts, our business and operating results would be significantly harmed. RISKS RELATED TO THE INDUSTRY IF USE OF THE INTERNET DOES NOT CONTINUE TO DEVELOP AND RELIABLY SUPPORT THE DEMANDS PLACED ON IT BY ELECTRONIC COMMERCE, THE MARKET FOR OUR PRODUCTS AND SERVICES MAY BE ADVERSELY AFFECTED, AND WE MAY NOT ACHIEVE ANTICIPATED SALES GROWTH. Growth in sales of our products and services depends upon the continued and increased use of the Internet as a medium for commerce and communication. Growth in the use of the Internet is a recent phenomenon and may not continue. In addition, the Internet infrastructure may not be able to support the demands placed on it by increased usage and bandwidth requirements. There have also been recent well-publicized security breaches involving "denial of service" attacks on major web sites. Concerns over these and other security breaches may slow the adoption of electronic commerce by businesses, while privacy concerns over inadequate security of information distributed over the Internet may also slow the adoption of electronic commerce by individual consumers. Other risks associated with commercial use of the Internet could slow its growth, including: - inadequate reliability of the network infrastructure; - slow development of enabling technologies and complementary products; and - limited accessibility and ability to deliver quality service. In addition, the recent growth in the use of the Internet has caused frequent periods of poor or slow performance, requiring components of the Internet infrastructure to be upgraded. Delays in the development or adoption of new equipment and standards or protocols required to handle increased levels of Internet activity, or increased government regulation, could cause the Internet to lose its viability as a commercial medium. If the Internet infrastructure does not develop sufficiently to address these concerns, it may not develop as a commercial marketplace, which is necessary for us to increase sales. INCREASING GOVERNMENT REGULATION OF THE INTERNET COULD LIMIT THE MARKET FOR OUR PRODUCTS AND SERVICES, OR IMPOSE GREATER TAX BURDENS ON US OR LIABILITY FOR TRANSMISSION OF PROTECTED DATA. As electronic commerce and the Internet continue to evolve, federal, state and foreign governments may adopt laws and regulations covering issues such as user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. If enacted, these laws and regulations could limit the market for electronic commerce, and therefore the market for our products and services. Although many of these regulations may not apply directly to our business, we expect that laws regulating the solicitation, collection or processing of personal or consumer information could indirectly affect our business. Laws or regulations concerning telecommunications might also negatively impact us. Several telecommunications companies have petitioned the Federal Communications Commission to regulate Internet service providers and online service providers in a manner similar to long distance telephone carriers and to impose access fees on these companies. This type of legislation could increase the cost of conducting business over the Internet, which could limit the growth of electronic commerce generally and have a negative impact on our business and operating results. 26 29 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK We develop products in the United States and India and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets. Interest income is sensitive to changes in the general level of U.S. interest rates, particularly since our investments are in short-term instruments calculated at variable rates. We established policies and business practices regarding our investment portfolio to preserve principal while obtaining reasonable rates of return without significantly increasing risk. This is accomplished by investing in widely diversified short-term investments, consisting primarily of investment grade securities, substantially all of which mature within the next twelve months or have characteristics of short-term investments. A hypothetical 50 basis point increase in interest rates would result in an approximate $320,000 (less than 0.18%) in the fair value of our available-for-sale securities. This potential change is based upon a sensitivity analysis performed on our financial positions at December 31, 2000. 27 30 PART II OTHER INFORMATION ITEM 1. None ITEM 2. (a) Modification of Constituent Instruments Not applicable (b) Change in Rights Not applicable (c) Issuances of Securities On November 9, 2000, we issued 35,000 shares of our common stock in connection with the acquisition of certain assets and liabilities of LoanMarket Resources, LLC. The issuance of the shares of common stock was exempt from the registration requirements of the Securities Act of 1933, as amended, pursuant to Section 4(2) thereof. The Company relied on the following criteria to make such exemption available: the number of offerees, the size and manner of the offering, the sophistication of the offeree and the availability of material information. (d) Use of Proceeds On March 15, 2000 Selectica completed the initial public offering of its common stock. The shares of the common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (No. 333-92545). The Securities and Exchange Commission declared the Registration Statement effective on March 9, 2000. The offering commenced on March 10, 2000 and terminated on March 15, 2000 after we had sold all of the 4,600,000 shares of common stock registered under the Registration Statement (including 450,000 shares sold by Selectica and 150,000 sold by one of our stockholders in connection with the exercise of the underwriters' over-allotment option). The managing underwriters in the offering were Credit Suisse First Boston, Thomas Weisel Partners LLC, U.S. Bancorp Piper Jaffray and E*Offering. The initial public offering price was $30.00 per share for an aggregate initial public offering of $138.0 million. We paid a total of $11.3 million in underwriting discounts, commissions, and other expenses related to the offering. None of the costs and expenses related to the offering were paid directly or indirectly to any director, officer, general partner of Selectica or their associates, persons owning 10 percent or more of any class of equity securities of Selectica or an affiliate of Selectica. After deducting the underwriting discounts and commissions and the offering expenses the estimated net proceeds to Selectica from the offering were approximately $122.2 million. The net offering proceeds have been used for general corporate purposes, to provide working capital to develop products and to expand the Company's operations. Funds that have not been used have been invested in certificate of deposits and other investment grade securities. We also may use a portion of the net proceeds to acquire or invest in businesses, technologies, products or services. ITEM 3. None ITEM 4. None 28 31 ITEM 5. None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. Exhibits None
B. Reports on Form 8-K None 29 32 SIGNATURES Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized. Date: February 8, 2000 SELECTICA, INC. By: /s/ STEPHEN R. BENNION ------------------------------------ Stephen R. Bennion Chief Financial Officer and Secretary 30