-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MJgqVj3DAYrKAwqLDs5Ohts+lmQejTkMdkO7EYA8xGQbjFUac/IO3rTXtiPVe/QJ kj0biOLDSrbEWZDj/iw0mw== 0001012870-98-001788.txt : 19980710 0001012870-98-001788.hdr.sgml : 19980710 ACCESSION NUMBER: 0001012870-98-001788 CONFORMED SUBMISSION TYPE: S-1/A PUBLIC DOCUMENT COUNT: 6 FILED AS OF DATE: 19980709 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: ECHELON CORP CENTRAL INDEX KEY: 0000031347 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 770203595 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-1/A SEC ACT: SEC FILE NUMBER: 333-55719 FILM NUMBER: 98663507 BUSINESS ADDRESS: STREET 1: 4015 MIRANDA AVE CITY: PALO ALTO STATE: CA ZIP: 94304 BUSINESS PHONE: 6508557400 MAIL ADDRESS: STREET 1: 4015 MIRANDA AVE CITY: PALO ALTO STATE: CA ZIP: 94304 S-1/A 1 AMENDMENT NO. 2 TO FORM S-1 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JULY 9, 1998 REGISTRATION NO. 333-55719 =============================================================================== SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------- AMENDMENT NO. 2 FORM S-1 REGISTRATION STATEMENT --------------- ECHELON CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) --------------- DELAWARE 3670 77-0203595 (STATE OR OTHER (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER JURISDICTION OF CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.) INCORPORATION OR --------------- ORGANIZATION) 4015 MIRANDA AVENUE PALO ALTO, CALIFORNIA 94304 (650) 855-7400 (ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES) --------------- M. KENNETH OSHMAN CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER ECHELON CORPORATION 4015 MIRANDA AVENUE PALO ALTO, CALIFORNIA 94304 (650) 855-7400 (NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF AGENT FOR SERVICE) --------------- COPIES TO: LARRY W. SONSINI, ESQ. THOMAS A. BEVILACQUA, ESQ. JOHN V. ROOS, ESQ. CURTIS L. MO, ESQ. KATHLEEN B. BLOCH, ESQ. PETER S. BUCKLAND, ESQ. WILSON SONSINI GOODRICH & ROSATI, P.C. BROBECK, PHLEGER & HARRISON LLP 650 PAGE MILL ROAD TWO EMBARCADERO PLACE PALO ALTO, CA 94304 2200 GENG ROAD (650) 493-9300 PALO ALTO, CA 94303 (650) 424-0160 ---------------- APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as practicable after the effective date of this Registration Statement. --------------- If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box: [_] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] __________ If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] __________ If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [_] --------------- CALCULATION OF REGISTRATION FEE
============================================================================================ PROPOSED PROPOSED TITLE OF EACH CLASS OF MAXIMUM MAXIMUM SECURITIES AMOUNT TO OFFERING PRICE AGGREGATE AMOUNT OF TO BE REGISTERED BE REGISTERED(1) PER SECURITY(2) OFFERING PRICE(2) REGISTRATION FEE(3) - -------------------------------------------------------------------------------------------- Common Stock, $.01 par value................. 5,750,000 shares $9.00 $51,750,000 $15,266 ============================================================================================
(1) Includes 750,000 shares which the Underwriters have the option to purchase to cover over-allotments, if any. (2) Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457. (3) Previously paid. --------------- THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a), MAY DETERMINE. ================================================================================ ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ +INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A + +REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE + +SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY + +OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT + +BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR + +THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE + +SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE + +UNLAWFUL PRIOR TO THE REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS + +OF ANY SUCH STATE. + ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ SUBJECT TO COMPLETION, DATED JULY 9, 1998 5,000,000 SHARES [LOGO OF ECHELON(R)] COMMON STOCK All of the shares of Common Stock offered hereby are being sold by Echelon Corporation ("Echelon" or the "Company"). Prior to this offering, there has been no public market for the Common Stock of the Company. It is currently estimated that the initial public offering price will be between $7.00 and $9.00 per share. See "Underwriting" for a discussion of the factors to be considered in determining the initial public offering price. The Company's Common Stock has been approved for quotation on the Nasdaq National Market under the symbol ELON. THIS OFFERING INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS" COMMENCING ON PAGE 5 FOR A DISCUSSION OF CERTAIN FACTORS THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE COMMON STOCK OFFERED HEREBY. ----------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
================================================================================ Price to Underwriting Proceeds to Public Discount(1) Company(2) - -------------------------------------------------------------------------------- Per Share..................................... $ $ $ - -------------------------------------------------------------------------------- Total(3)...................................... $ $ $ ================================================================================
(1) See "Underwriting" for information concerning indemnification of the Underwriters and other matters. (2) Before deducting offering expenses payable by the Company estimated at $700,000. (3) The Company has granted to the Underwriters a 30-day option to purchase up to 750,000 additional shares of Common Stock solely to cover over- allotments, if any. If the Underwriters exercise this option in full, the Price to Public will total $ , the Underwriting Discount will total $ and the Proceeds to Company will total $ . See "Underwriting." The shares of Common Stock are offered by the several Underwriters named herein, subject to receipt and acceptance by them and subject to their right to reject any orders in whole or in part. It is expected that delivery of the certificates representing such shares will be made against payment therefor at the office of NationsBanc Montgomery Securities LLC, on or about , 1998. ----------- NationsBanc Montgomery Securities LLC BancAmerica Robertson Stephens Volpe Brown Whelan & Company , 1998 [LOGO APPEARS HERE] CAPTION: A GLOBAL STANDARD FOR CONTROL NETWORKS [Photographs and brief description depicting industries that use the Company's products] [Schematic depicting the transition from closed systems to open, distributed networks] CAPTION: Delivering Control to Your Networks CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK OFFERED HEREBY. SUCH TRANSACTIONS MAY INCLUDE STABILIZING, THE PURCHASE OF COMMON STOCK TO COVER SYNDICATE SHORT POSITIONS AND THE IMPOSITION OF PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING." Echelon, LonBuilder, LonMaker, LonMark, LonPoint, LonTalk, LonUsers, LonWorks, Neuron and NodeBuilder are trademarks, registered trademarks, service marks or registered service marks of the Company. This Prospectus also includes product names, trade names and trademarks of other companies. HEADLINE: LONWORKS(C) CONTROL NETWORK SOLUTIONS OPEN OPPORTUNITIES IN MANY INDUSTRIES Caption: Echelon offers products and services that provide the infrastructure and support required to build and implement multi-vendor, distributed control network solutions for building, industrial, transportation, home, and other automation markets. The Company's products are based on its LONWORKS networking technology, an open standard for interoperable networked control. [GRAPHIC DEPICTING CLOSED CENTRAL ARCHITECTURE] Caption: Traditional closed, centrally-controlled architecture [GRAPHIC DEPICTING COMMERCIAL BUILDINGS] BUILDING AUTOMATION Companies worldwide are using LONWORKS control networks in most facets of the building automation industry, including access control, automatic doors, elevators, energy management, fire/life/safety, HVAC, lighting, metering, security and window blinds. [GRAPHIC DEPICTING OPEN CONTROL NETWORK] Open interoperable, distributed control network [GRAPHIC DEPICTING RESIDENCES] HOME AUTOMATION AND UTILITIES Companies are now selling LONWORKS based products for HVAC, lighting, security, utility meters and whole house automation. [GRAPHIC DEPICTING INDUSTRIAL COMPLEXES] INDUSTRIAL AUTOMATION LONWORKS control networks are found in semiconductor fabrication plants, gasoline tank farms, oil pumping stations, textile dyeing machinery, pulp and paper processing equipment, automated conveyor systems and many other industrial environments. [GRAPHIC DEPICTING AIRPLANE, SHIP AND TRAIN] TRANSPORTATION LONWORKS control networks are used in important transportation applications, including railcars, light rail systems, buses, motor coaches, fire trucks, naval vessels and aircraft. [SIDEBAR] Echelon's LONWORKS control network solutions can provide customers with the following benefits over closed, centrally-controlled systems: . Installation cost savings - replaces individual hard-wired connections with shared network resources and eliminates complex control logic software programming and debugging . Life-cycle cost savings - allows end-users to select the most cost-effective products and services for their applications and simplifies adds, moves and changes . Improved quality and functionality - enables end-users to create tailored applications and have complete access to information from devices . Improved reliability - eliminates single point of failure since all devices are "self aware" and can take appropriate actions independently . Increased market demand - enables OEMs and and systems integrators to create low-cost, customized solutions to satisfy market demands not met by traditional control systems [LOGO] PROSPECTUS SUMMARY The following summary is qualified in its entirety by the more detailed information, including "Risk Factors" and the Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Prospectus. This Prospectus contains certain forward-looking statements that involve risks and uncertainties, such as statements of the Company's plans, objectives, expectations and intentions, and actual results may differ materially from those anticipated in such forward-looking statements. Unless otherwise noted, all information in this Prospectus assumes (i) the conversion of all outstanding shares of the Company's Preferred Stock into Common Stock on a one- for-one basis upon the closing of this offering and (ii) no exercise of the Underwriters' over-allotment option. As used in this Prospectus, unless the context otherwise requires, the "Company" and "Echelon" refer to the Company and its subsidiaries. THE COMPANY Echelon develops, markets and supports a family of hardware and software products and services that enables original equipment manufacturers ("OEMs") and systems integrators to design and implement open, interoperable, distributed control networks. A control network enables any group of electrical devices, called nodes, to be linked together to implement sensing, monitoring, control and communications capabilities for a variety of applications. Control networks, an alternative to the traditional approach of centralized control, offer decreased costs of installation and maintenance and the ability to implement multi-vendor systems, thereby increasing competition while providing expanded features, flexibility and functionality. Echelon's control networking technology allows intelligence and communications capabilities to be embedded into individual control devices that can be connected together through a variety of communications media, such as a twisted pair of wires (data cable) and the existing power lines in a facility. The intelligent, networked control devices are then able to communicate with each other, peer-to-peer, to perform the desired control functions. In effect, the network becomes the controller, eliminating the need for central controllers, significantly reducing wiring costs and enhancing system functionality and flexibility. Control systems manage key functions in virtually every type of facility that affects our daily lives. These functions can be as simple as turning a light on and off and as complex as operating a chemical production line. Traditionally, most control systems have incorporated closed, centrally-controlled architectures, where the intelligence is in the central controller and complex wiring and customization are required for communication. These traditional control systems share many of the same drawbacks of centralized computing architectures that rely upon mainframes and minicomputers to communicate to "dumb" terminals that lack independent processing capabilities. These disadvantages, which include high installation and life-cycle costs, limited functionality and scalability, and a single point of failure, have limited the market opportunity for control systems because end-users find it costly and difficult to adapt these systems to their changing needs. To overcome these limitations, OEMs, systems integrators and end-users are increasingly moving from closed centrally-controlled systems towards open, distributed control networks. The Company offers a comprehensive set of products and services, including transceivers, control modules, routers, network interfaces, development tools and software tools and toolkits, that provide the infrastructure and support required to build and implement multi-vendor, open, interoperable, control network solutions. The Company's products are based on its LonWorks networking technology, an open standard for interoperable networked control. The Company's objective is to establish its LonWorks technology and products as the leading solution for networked control applications. To achieve this goal, the Company intends to extend its technological expertise, target industry-leading OEM customers, develop a systems integrator distribution channel, integrate LonWorks control networks with enterprise data networks and leverage international market opportunities. The Company markets its products and services to OEMs and systems integrators in the building, industrial, transportation, home and other automation markets. The Company sells primarily through a direct sales force in North America and other countries where it has operations, and augments its direct sales efforts with distributors in Europe, Japan and Asia Pacific. Representative customers include Bombardier Inc. ("Bombardier"), Edwards High Vacuum International Ltd. ("Edwards"), Fuji Electric Company Limited ("Fuji Electric"), Hitachi Limited ("Hitachi"), Honeywell, Inc. ("Honeywell"), Johnson Controls, Inc. ("Johnson Controls"), Kawasaki Limited ("Kawasaki"), Landis & Staefa, Staefa Control System Corporation ("Landis & Staefa") and Raytheon Company ("Raytheon"). The Company was incorporated in California in 1988 and reincorporated in Delaware in 1989. The Company's principal executive offices are located at 4015 Miranda Avenue, Palo Alto, California 94304, and its telephone number is (650) 855-7400. 3 THE OFFERING Common Stock offered by the Company.......... 5,000,000 shares Common Stock to be outstanding after the of- fering...................................... 32,125,612 shares(1) Use of proceeds.............................. For general corporate purposes, including working capital and capital expenditures. See "Use of Proceeds." Nasdaq National Market symbol................ ELON
SUMMARY CONSOLIDATED FINANCIAL INFORMATION (IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, MARCH 31, ---------------------------------------------- ---------------- 1993 1994 1995 1996 1997 1997 1998 -------- -------- ------- -------- ------- ------- ------- CONSOLIDATED STATEMENT OF OPERATIONS DATA: (UNAUDITED) Revenues: Product................ $ 10,104 $ 14,368 $20,183 $ 20,708 $24,665 $ 6,548 $ 7,188 Service................ 1,441 2,364 3,160 3,282 3,637 926 771 -------- -------- ------- -------- ------- ------- ------- Total revenues......... 11,545 16,732 23,343 23,990 28,302 7,474 7,959 Gross profit........... 6,791 8,993 12,768 12,087 14,731 3,908 4,167 Loss from operations... (11,273) (10,250) (9,854) (10,937) (8,522) (1,944) (1,757) Net loss............... $(11,133) $ (9,483) $(8,713) $(10,716) $(8,214) $(1,907) $(1,737) Basic net loss per share(2).............. $ (0.85) $ (0.67) $ (0.56) $ (0.62) $ (0.44) $ (0.10) $ (0.09) Shares used in comput- ing basic net loss per share(2).............. 13,038 14,060 15,695 17,354 18,603 18,511 19,029 Pro forma basic net loss per share(2)..... $ (0.32) $ (0.08) $ (0.06) Shares used in comput- ing pro forma basic net loss per share(2).............. 25,756 24,399 26,916
MARCH 31, 1998 ------------------- AS ACTUAL ADJUSTED(3) ------- ----------- (UNAUDITED) CONSOLIDATED BALANCE SHEET DATA: Cash and cash equivalents.................................. $ 5,165 $41,665 Working capital............................................ 7,376 43,876 Total assets............................................... 15,695 52,195 Total stockholders' equity................................. 7,482 43,982
- -------- (1) Based on shares outstanding as of March 31, 1998. Includes 1,802,438 shares of Common Stock issued under stock purchase agreements subject to repurchase by the Company at a weighted average price of $1.26 per share. Excludes (i) 4,082,695 shares of Common Stock issuable upon exercise of options outstanding as of March 31, 1998 at a weighted average exercise price of $1.33 per share, of which options to purchase 3,932,695 shares (including 3,167,780 shares were subject to repurchase by the Company at a weighted average exercise price of $1.31 per share) were exercisable, (ii) 3,942,700 shares of Common Stock reserved for future issuance under the Company's stock option plans and (iii) 430,000 shares of Common Stock issuable upon exercise of warrants outstanding as of March 31, 1998 at a weighted average exercise price of $5.49 per share. See "Management--Stock Option Plans and Warrants," "Description of Capital Stock" and Note 6 of Notes to Consolidated Financial Statements. (2) See Note 2 of Notes to Consolidated Financial Statements for an explanation of the shares used in computing basic net loss per share and pro forma basic net loss per share. (3) Adjusted to reflect (i) the conversion of all outstanding shares of Preferred Stock into Common Stock on a one-for-one basis upon the closing of this offering and (ii) the sale of the 5,000,000 shares of Common Stock offered hereby (at an assumed initial public offering price of $8.00 per share and after deducting the underwriting discount and estimated offering expenses payable by the Company). See "Capitalization." 4 RISK FACTORS This offering involves a high degree of risk. In addition to the other information set forth in this Prospectus, the following risk factors should be considered carefully in evaluating the Company and its business before purchasing any shares of the Company's Common Stock. This Prospectus contains certain forward-looking statements that involve risks and uncertainties, such as statements of the Company's plans, objectives, expectations and intentions. The cautionary statements made in this Prospectus should be read as being applicable to all related forward-looking statements wherever they appear in this Prospectus. The Company's actual results could differ materially from those discussed in this Prospectus. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed elsewhere in this Prospectus. HISTORY OF LOSSES; ACCUMULATED DEFICIT; ANTICIPATED CONTINUING LOSSES; UNCERTAINTY OF FUTURE OPERATING RESULTS The Company has incurred net losses each year since its inception, including losses of $8.7 million, $10.7 million and $8.2 million for the fiscal years ended December 31, 1995, 1996 and 1997, respectively. At March 31, 1998, the Company had an accumulated deficit of $86.4 million. The Company has invested and continues to invest significant financial resources in product development, marketing and sales, and to the extent such expenditures do not result in significant increases in revenues, the Company's business, operating results and financial condition will be materially and adversely affected. Due to the limited history and undetermined market acceptance of many of the Company's products and technologies, the rapidly evolving nature of the Company's business and markets, potential changes in voluntary product standards that significantly influence many of the markets for the Company's products, the high level of competition in the industries in which the Company operates and the other factors described elsewhere in "Risk Factors," there can be no assurance that the Company's investment in these areas will result in increases in revenues or that any revenue growth that is achieved can be sustained. Any revenue growth that the Company has achieved or may achieve may not be indicative of future operating results. In addition, the Company's history of losses, together with the factors described under "--Fluctuations in Operating Results," make future operating results difficult to predict. The Company and its prospects must be considered in light of the risks, costs and difficulties frequently encountered by emerging companies. As a result, there can be no assurance that the Company will be profitable in any future period. Future operating results will depend on many factors, including the growth of the markets for the Company's products, the acceptance of the Company's products, the level of competition, the ability of the Company to develop and market new products, and general economic conditions. In view of the uncertainties identified herein, the Company believes that period-to-period comparisons of financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. As of December 31, 1997, the Company had net operating loss carryforwards for Federal and state income tax reporting purposes of approximately $76.0 million and $5.0 million, respectively, which expire at various dates through 2012. In addition, as of December 31, 1997, the Company had tax credit carryforwards of approximately $3.5 million, which expire at various dates through 2012. The Internal Revenue Code of 1986, as amended, contains provisions that may limit the use in any future period of net operating loss and credit carryforwards upon the occurrence of certain events, including a significant change in ownership interests. The Company had deferred tax assets, including its net operating loss carryforwards and tax credits, totaling approximately $33.6 million as of December 31, 1997. A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance, the history of losses and the variability of operating results. See "--Fluctuations in Operating Results," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 7 of Notes to Consolidated Financial Statements. FLUCTUATIONS IN OPERATING RESULTS The Company has experienced, and expects to continue to experience, significant variability in its quarterly and annual results, as a result of a number of factors, many of which are outside of the Company's control. The Company believes that such variability is primarily due to the fluctuations in the rates at which OEMs purchase 5 the Company's products and services, the OEMs' own business cycles, the timely introduction of new products, any downturns in any customer's or potential customer's business, the Company's ability to anticipate and effectively adapt to developing markets and rapidly changing or new technologies and distribution channels, increased competition, market acceptance of the Company's products, product life cycles, order delays or cancellations, changes in the mix of products and services sold by the Company, shipment and payment schedules, changes in pricing policy by the Company or its competitors, changes in product distribution, product ratings by industry analysts and endorsement of competing products by industry groups. Declines in general economic conditions could also precipitate significant reductions in capital spending, which could, in turn, affect orders for the Company's products. The Company's expense levels are based, in significant part, on expectations of future revenues. Consequently, if revenue levels are below expectations, expense levels could be disproportionately high as a percentage of total revenues, and operating results would be immediately and adversely affected. The Company has failed to meet its expectations of future revenues in the past. As a result of these and other factors, the Company believes that its revenues and operating results are difficult to predict and are subject to fluctuations from period to period, and that period-to-period comparisons of its results of operations are not meaningful and should not be relied upon as indications of future performance. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." DEPENDENCE ON OEMS AND DISTRIBUTION CHANNELS To date, substantially all of the Company's sales of its products have been to OEMs. The rate at which the Company's products are used in control networks is primarily subject to product and marketing decisions made by OEMs. The Company believes that since OEMs in certain industries receive a large portion of their revenues from sales of products and services to their installed base, such OEMs have tended to moderate the rate at which they incorporate LonWorks technology into their products. The Company has attempted to motivate OEMs, as well as systems integrators and owners of control systems, to effect a more rapid transition to LonWorks technology. Furthermore, OEMs that manufacture and promote products and technologies that compete or may compete with the Company may be particularly reluctant to employ the Company's products and technologies to any significant extent, if at all. There can be no assurance that the Company will be able to improve the current rate of acceptance or usage of its products by OEMs and others, or that such usage will not decrease over time. The failure to increase acceptance or usage of the Company's products, or any decrease in usage of its products, would have a material adverse effect on the business, operating results and financial condition of the Company. See "Business--Competition." Currently, a significant portion of the Company's revenues are derived from sales by EBV Elektronik GmbH ("EBV"), the sole independent distributor of the Company's products to OEMs in Europe since December 1997. EBV accounted for 12.0%, 10.9% and 20.6% of the Company's total revenues in fiscal 1995, 1997 and the three months ended March 31, 1998, respectively. The Company's agreement with EBV expires in November 1998. In addition, as part of its distribution strategy, the Company intends to develop distribution arrangements with systems integrators. In particular, the Company expects that a significant portion of its future revenues will be derived from sales by such systems integrators. Any failure by EBV or any other existing or future distributor to dedicate sufficient resources and efforts to the marketing and selling of the Company's products, or to generate significant revenues for the Company, could have a material adverse effect on the Company's business, operating results and financial condition. Also, the failure of the Company to develop new distribution channels, to maintain the EBV arrangement or any other distribution channels, or to renew the EBV arrangement on a timely basis, would result in reduced or delayed revenues, increased operating expenses and loss of customer goodwill, any of which could have a material adverse effect on the business, operating results and financial condition of the Company. See "Business--Sales and Marketing." DEPENDENCE ON KEY MANUFACTURERS The Neuron Chip is an important component used by the Company's customers in control network nodes. In addition, the Neuron Chip is an important device used in many of the Company's products. Neuron Chips are manufactured and distributed by both Motorola, Inc. ("Motorola") and Toshiba Corporation ("Toshiba"). The Company has entered into licensing agreements with each of Motorola and Toshiba. The agreements, among other things, grant Motorola and Toshiba the worldwide right to manufacture and distribute Neuron Chips using 6 technology licensed from the Company and require the Company to provide support and unspecified updates to the licensed technology over the terms of the agreements. The Motorola and Toshiba agreements expire in December 1999 and January 2000 respectively, unless renewed. However, both Motorola and Toshiba have the right to terminate the agreements at any time. While the Company developed the first version of the Neuron Chip, Motorola and Toshiba subsequently developed improved, lower-cost versions of the Neuron Chip that are presently utilized in products developed and sold by the Company and its customers. The Company currently has no other source of supply for Neuron Chips and has neither the resources nor the skills to replace either Motorola or Toshiba as a designer, manufacturer or distributor of Neuron Chips. Motorola and Toshiba have played, and are expected to continue to play, a key role in the development and marketing of LonWorks technology. The loss of either Motorola or Toshiba as a supplier of the Neuron Chip would have a material adverse effect on the business, operating results and financial condition of the Company, and in such event there can be no assurance that the Company would be able to locate an alternate source for the design, manufacture or distribution of Neuron Chips. See "Business--Products and Services," "--Strategic Alliances," "--Manufacturing" and "Certain Transactions." The Company's future success will also depend, in significant part, on its ability to successfully manufacture its products cost-effectively and in sufficient volumes. For certain key products, the Company utilizes outsourced manufacturers including GET Manufacturing, Inc. ("GET"), Hi-Tech Manufacturing, Inc. ("Hi-Tech"), muRata Electronics North America, Inc. ("muRata") and Quadrus Manufacturing Division of Bell Microproducts, Inc. ("Quadrus"). These outsourced manufacturers procure material and assemble, test and inspect the final products to the Company's specifications. Such a strategy involves certain risks, including the potential absence of adequate capacity and reduced control over delivery schedules, product availability, manufacturing yields, quality and costs. In addition, several key components are currently purchased only from sole or limited sources. Any interruption in the supply of these products or components, or the inability of the Company to procure these products or components from alternate sources at acceptable prices and within a reasonable time, could have a material adverse effect upon the Company's business, operating results and financial condition. See "Business--Manufacturing." COMPETITION Competition in the Company's markets is intense and involves rapidly changing technologies, evolving industry standards, frequent new product introductions and rapid changes in customer requirements. To maintain and improve its competitive position, the Company must continue to develop and introduce, on a timely and cost-effective basis, new products, features and services that keep pace with the evolving needs of its customers. The principal competitive factors affecting the markets for the Company's control network products are customer service and support, product reputation, quality, performance, price and product features such as adaptability, scalability, ability to integrate with other products, functionality and ease of use. The Company believes it has in the past generally competed favorably with offerings of its competitors on the basis of these factors. However, there can be no assurance that the Company will continue to be able to compete effectively based on these or any other competitive factors in the future. In each of its markets, the Company competes with a wide array of manufacturers, vendors, strategic alliances, systems developers and other businesses. The Company's competitors include some of the largest companies in the electronics industry, such as Siemens AG ("Siemens") in the building and industrial automation industries and Allen-Bradley, a subsidiary of Rockwell International ("Allen-Bradley"), and Groupe Schneider ("Schneider") in the industrial automation industry. Many of the Company's competitors, alone or together with their trade associations and partners, have longer operating histories, significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition and broader product offerings. As a result, such competitors may be able to devote greater resources to the development, marketing and sale of their products, and may be able to respond more quickly to changes in customer requirements or product technology. In addition, those competitors that manufacture and promote closed, proprietary control systems may enjoy a captive customer base dependent on such competitors for service, maintenance, upgrades and enhancements. Accordingly, there can be no assurance that the Company will be able to compete successfully with existing or new competitors, or that competition will not have a material adverse effect on the business, operating results or financial condition of the Company. 7 Many of the Company's current and prospective competitors are dedicated to promoting closed or proprietary systems, technologies, software and network protocols or product standards that differ from, or are incompatible with, those of the Company. In some cases, companies have established associations or cooperative relationships to enhance the competitiveness and popularity of their products, or to promote such different or incompatible technologies, protocols and standards. For example, in the building automation market, the Company faces widespread reluctance by vendors of traditional closed or proprietary control systems (who enjoy a captive market for servicing and replacing equipment) to utilize the Company's interoperable technologies, as well as strong competition by large trade associations that promote alternative technologies and standards in their native countries, such as the BatiBus Club International in France and the European Installation Bus Association in Germany (each of which has over 100 members and licensees). Other examples include the CEBus Industry Council, which is the proponent of an alternative protocol to the Company's LonTalk protocol for use in the home automation industry, and a group comprised of Asea Brown Boveri, ADtranz AB, Siemens, GEC Alstrom and other manufacturers that support an alternative rail transportation protocol to the Company's LonTalk protocol. There can be no assurance that the Company's technologies, protocols or standards will be successful in any of its markets, or that the Company will be able to compete with new or enhanced products or standards introduced by existing or future competitors. Any increase in competition or failure by the Company to effectively compete with new or enhanced products or standards could result in fewer customer orders, price reductions, reduced order size, reduced operating margins and loss of market share, any of which could have a material adverse effect on the business, operating results or financial condition of the Company. See "Business--Competition." LonWorks technology is open, meaning that many of the Company's key technology patents are broadly licensed without royalties or license fees. As a result, the Company's customers are capable of developing products that compete with some of the Company's products. Because some of the Company's customers are OEMs that develop and market their own control systems, these customers in particular could develop competing products based on the Company's open technology. This could decrease the market for the Company's products, increase competition, and have a material adverse effect on the Company's business, operating results and financial condition. See "Business-- Products and Services." DEPENDENCE ON KEY PERSONNEL The Company's performance is substantially dependent on the performance of its executive officers and key employees. The loss of the services of any of the Company's executive officers or key employees could have a material adverse effect on the business, operating results and financial condition of the Company. The Company is particularly dependent upon its Chief Executive Officer, as well as its technical personnel, due to the specialized technical nature of the Company's business. The Company's future success will depend on its ability to attract, integrate, motivate and retain qualified technical, sales, operations and managerial personnel. There is intense competition for qualified personnel in the areas of the Company's activities, and there can be no assurance that the Company will be able to continue to attract and retain qualified executive officers and key personnel necessary for the development and success of its business. Currently, only Frederik Bruggink, the Company's Vice President, Europe, Middle East and Africa, is bound by an employment agreement. If the Company is unable to hire personnel on a timely basis in the future, the Company's business, operating results and financial condition will be materially and adversely affected. In addition, the departure or replacement of key personnel could be disruptive, lead to additional departures and therefore have a material adverse effect on the Company's business, operating results and financial condition. The Company maintains and is the beneficiary of life insurance policies in the amount of $2.5 million covering each of M. Kenneth Oshman, its Chief Executive Officer, Beatrice Yormark, its Vice President of Sales and Marketing, and Oliver R. Stanfield, its Chief Financial Officer. There can be no assurance that such proceeds would be sufficient to compensate the Company in the event of the death of Mr. Oshman, Ms. Yormark or Mr. Stanfield. See "Management." NEW PRODUCTS AND RAPID TECHNOLOGICAL CHANGE Customer requirements for control network products can change as a result of innovations or changes within the building, industrial, transportation, home and other industries. For example, the adoption of new or different 8 standards within industry segments may give rise to new customer requirements, which may or may not be compatible with the Company's current or future product offerings. The Company's future success depends in large part on its ability to continue to enhance existing products, lower product cost and develop new products that maintain technological competitiveness. There can be no assurance that the Company will be successful in modifying its products and services to address these requirements and standards. For example, certain of the Company's competitors may develop competing technologies based on Internet protocols that may have advantages over the Company's products in remote connection. If the Company is unable, for technological or other reasons, to develop new products or enhancements of existing products in a timely manner to respond to changing market conditions, competitive factors and customer requirements, the Company's business, operating results and financial condition would be materially adversely affected. See "Business--Competition." From time to time, the introduction of new products by the Company has been delayed beyond the Company's projected shipping date for such products. In each instance, such delays have resulted in increased costs and delayed revenues. Because future revenues are dependent on the timely introduction of new product offerings, any such future delays could have a material adverse effect on the Company's business, operating results and financial condition. MARKET ACCEPTANCE OF INTEROPERABILITY The future operating success of the Company will depend, in significant part, on the successful development of interoperable products by the Company and OEMs, and the acceptance of interoperable products by systems integrators and end-users. When products or subsystems from multiple vendors can be integrated into a control system without the need to develop custom hardware or software, they are "interoperable." The Company has expended considerable resources to develop, market and sell interoperable products, and has made such products a cornerstone of its sales and marketing strategy. The Company has widely promoted interoperable products as offering benefits such as lower life-cycle costs and improved flexibility to owners and users of control networks. However, there can be no assurance that OEMs who manufacture and market closed systems will accept, promote or employ interoperable products, since doing so may expose such OEMs' businesses to increased competition. In addition, there can be no assurance that OEMs will, in fact, successfully develop interoperable products, or that OEMs' interoperable products will be accepted by their customers. The failure of OEMs to develop interoperable products, or the failure of interoperable products to achieve market acceptance, would have a material adverse effect on the business, operating results and financial condition of the Company. See "--Competition" and "Business--Industry Background." INTERNATIONAL OPERATIONS; CURRENCY FLUCTUATIONS The Company's sales and marketing operations are located in 10 countries. Revenues from international sales, which include both export sales and sales by international subsidiaries, accounted for approximately 52.0%, 53.6%, 57.5% and 57.0% of the Company's total revenues during 1995, 1996, 1997 and the three months ended March 31, 1998, respectively. The Company's operations and the market price of its products may be directly affected by economic and political conditions in the countries where the Company does business. In addition, there can be no assurance that the Company will be able to maintain or increase the international demand for its products. Additional risks inherent in the Company's international business activities generally include currency fluctuations, unexpected changes in regulatory requirements, tariffs and other trade barriers, costs of localizing products for foreign countries, lack of acceptance of non-local products in foreign countries, longer accounts receivable payment cycles, difficulties in managing international operations, potentially adverse tax consequences, including restrictions on repatriation of earnings, and the burdens of complying with a wide variety of foreign laws. Differing vacation and holiday patterns in other countries, particularly in Europe, may also affect the amount of business transacted by the Company in other countries in any given quarter, the timing of the Company's revenues and its ability to forecast its projected operating results for such quarter. In 1997, approximately 10.7% of the Company's revenues were conducted in currencies other than the U.S. dollar, principally the Japanese Yen. Fluctuations in the value of currencies in which the Company conducts its business 9 relative to the U.S. dollar could cause currency translation adjustments. The Company has recently experienced and in the future may experience an increase in currency translation adjustments relative to currencies of Asia Pacific countries, as well as order delays, cancellations and pricing pressure in those countries as a result of general economic conditions in that region. The forthcoming introduction of the "Euro" as the standard currency in participating European countries may also impact the ability of the Company to denominate sales transactions in U.S. dollars. To the extent that fewer of the Company's sales in Europe are denominated in U.S. dollars, the Company may experience an increase in currency translation adjustments, particularly as a result of general economic conditions in Europe as a whole. The Company does not currently engage in currency hedging transactions or otherwise cover its foreign currency exposure. There can be no assurance that such factors will not have a material adverse effect on international revenues and, consequently, the Company's business, operating results and financial condition. See "Business--Sales and Marketing." LENGTHY SALES CYCLE The sales cycle between initial customer contact and execution of a contract or license agreement with a customer can vary widely. OEMs typically conduct extensive and lengthy product evaluations before making initial purchases of the Company's products. Subsequent purchases of the Company's products may be delayed by prolonged product development and introduction periods for OEMs. Attendant delays in the Company's sales cycle can result from, among other things, changes in customers' budgets or in the priority assigned to control network development and to educating customers as to the potential applications of and cost savings associated with the Company's products. The Company generally has little or no control over these factors, which may cause a potential customer to favor a competitor's products, or to delay or forgo purchases altogether. As a result of the foregoing, the Company's ability to forecast the timing and amount of specific sales is limited, and the delay or failure to complete transactions could have a material adverse effect on the Company's business, operating results and financial condition and cause the Company's operating results to vary significantly from period to period. LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS The Company's success depends significantly upon its intellectual property rights. The Company relies on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect its intellectual property rights, all of which afford only limited protection. The Company has 65 issued U.S. patents, 21 pending U.S. patent applications, and various foreign counterparts. There can be no assurance that patents will issue from these pending applications or from any future applications or that, if issued, any claims allowed will be sufficiently broad to protect the Company's technology. Failure of any patents to protect the Company's technology, may make it easier for the Company's competitors to offer equivalent or superior technology. The Company has registered or applied for registration for certain trademarks, and will continue to evaluate the registration of additional trademarks as appropriate. Any failure by the Company to properly register or maintain its trademarks or to otherwise take all necessary steps to protect its trademarks may diminish the value associated with the Company's trademarks. In addition, any failure by the Company to take all necessary steps to protect its trade secrets or other intellectual property rights may have a material adverse effect on the Company's ability to compete in its markets. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or services or to obtain and use information that the Company regards as proprietary. There can be no assurance that any patents, trademarks, copyrights or intellectual property rights that have been or may be issued or granted will not be challenged, invalidated or circumvented, or that any rights granted thereunder would provide protection for the Company's proprietary rights. In addition, there can be no assurance that the Company has taken or will take all necessary steps to protect its intellectual property rights. Third parties may also independently develop similar technology without breach of the Company's trade secrets or other proprietary rights. The Company has licensed in the past and may license in the future its key technologies to third parties. In addition, the laws of some foreign countries, including several in which the Company operates or sells its products, do not protect proprietary rights to as great an extent as do the laws of the United States. Certain of the Company's products are licensed under shrink wrap license agreements that are not signed by licensees and therefore may not be binding under the laws of certain jurisdictions. 10 From time to time, litigation may be necessary to defend and enforce the Company's proprietary rights. Such litigation could result in substantial costs and diversion of management resources and could have a material adverse effect on the Company's business, operating results and financial condition, regardless of the final outcome. Despite the Company's efforts to safeguard and maintain its proprietary rights both in the United States and abroad, there can be no assurance that the Company will be successful in doing so or that the steps taken by the Company in this regard will be adequate to deter infringement, misuse, misappropriation or independent third-party development of the Company's technology or intellectual property rights or to prevent an unauthorized third party from copying or otherwise obtaining and using the Company's products or technology. Any of such events could have a material adverse effect on the Company's business, operating results and financial condition. See "Business--Proprietary Rights." RISKS OF PRODUCT DEFECTS OR MISUSE Products developed, licensed and sold by the Company may contain errors or failures or may be improperly installed or implemented. There can be no assurance that errors or failures will not be found in the Company's products or that, if discovered, the Company will be able to successfully correct such errors or failures in a timely manner or at all. In addition, there can be no assurance that the Company's products will be properly installed or implemented by third parties. The occurrence of errors or failures in the Company's products and applications, or improper installation or implementation of the Company's products, could result in loss of or delay in market acceptance, increased service and warranty costs or payment of compensatory or other damages. In addition, such errors or failures may result in delays of revenue recognition by the Company and diversion of the Company's engineering resources to correct such defects. The Company maintains errors and omissions insurance to cover liability associated with its operations but there can be no assurance that any such insurance will be available or will be sufficient in amount to cover any particular claim. Although the Company's agreements with its customers typically contain provisions intended to limit the Company's exposure to potential claims as well as any liabilities arising from such claims, and may in very limited instances require that the Company be named as an additional insured under the insurance policies carried by some of its customers, such contracts and insurance may not effectively protect the Company against the liabilities and expenses associated with product errors or failures. Accordingly, errors or failures in the Company's products or applications or improper installation or implementation of the Company's products by third parties could have a material adverse effect on the Company's business, operating results and financial condition. In addition, because of the low cost and interoperable nature of the Company's products, LonWorks technology could be used in a manner for which it was not intended, which could lead to loss of goodwill or material financial losses for the Company, or otherwise have a material adverse effect on the Company's business, operating results and financial condition. REGULATORY ACTIONS Many of the Company's products and the industries in which they are used are subject to U.S. and foreign regulation. Government regulatory action could greatly reduce the market for the Company's products. For example, the power line medium (the communications medium used by some of the Company's products) is subject to special regulations in North America, Europe and Japan. These regulations limit the ability of companies in general to use power lines as a communication medium. In addition, some of the Company's competitors have attempted to use regulatory actions to reduce the market opportunity for the Company's products or to increase the market opportunity for the competitors' products. For example, the Consumer Electronics Manufacturers Association ("CEMA"), a trade association that developed the CEBus protocol, an alternative to the Company's LonTalk protocol for use in home automation applications, has proposed that the Federal Communications Commission ("FCC") adopt a standard for television-cable compatibility that encompasses CEBus. CEMA has also proposed the use of such standard with respect to an FCC rulemaking relating to the commercial availability of navigation devices, such as set-top boxes. The Company has resisted these efforts and will continue to oppose competitors' efforts to use regulation to impede competition in the markets for the Company's products. There can be no assurance that existing or future regulations or regulatory actions would not adversely affect the market for the Company's products or require significant expenditures of management, technical or financial resources, any of which could have a material adverse effect on the Company's business, operating results and a financial condition. See "Business--Government Regulation." 11 VOLUNTARY STANDARDS Standards bodies, which are formal and informal associations that attempt to set voluntary, non-governmental product standards, are influential in many of the Company's target markets. Some of the Company's competitors have attempted to use voluntary standards to reduce the market opportunity for the Company's products, or to increase the market opportunity for the competitors' products, by lobbying for the adoption of voluntary standards that would exclude or limit the use of the Company's products. The Company participates in many voluntary standards processes both to avoid adoption of exclusionary standards and to promote voluntary standards for the Company's products. However, the Company does not have the resources to participate in all voluntary standards processes that may affect its markets. The adoption of voluntary standards that are incompatible with the Company's products or technology could have a material adverse effect on the Company's business, operating results and financial condition. See "Business--Competition." YEAR 2000 COMPLIANCE Computer programs that are written using two digits rather than four to define the applicable year, may have date-sensitive software and, for instance, may recognize a date using 00 as the year 1900 rather than the year 2000 ("Date Code Dependency"). This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in normal business activities. The Company's enterprise resource planning ("ERP") system does have Date Code Dependencies. The Company is in the process of replacing its current ERP system, and believes that this replacement will be completed by June 1999, before any Date Code Dependencies within the Company's current ERP system have a material adverse impact upon the Company's operations. The Company has not yet estimated the cost of such replacement. The Company is currently evaluating the dependency of its products on date codes and intends to announce a program for addressing the impact of the year 2000 on any such products in the near future. Failure of the Company's ERP system or its products to operate properly with regard to the Year 2000 and thereafter could require the Company to incur unanticipated expenses to remedy any problems, which could have a material adverse effect on the Company's business, operating results and financial condition. Date Code Dependency issues may also arise with respect to any modifications made to the Company's products by a party other than the Company or from the combination or use of the Company's products with any other software programs or hardware devices not provided by the Company, and therefore may result in unforeseen Year 2000 compliance problems for some of the Company's customers, which could result in reduced customer orders or liability to the Company, and which could have a material adverse effect on the Company's business, operating results and financial condition. The Company faces risks to the extent that suppliers of products, services and systems purchased by the Company have business systems or products that have a Date Code Dependency. In the event any such third parties cannot provide the Company with products, services or systems that meet year 2000 requirements in a timely manner, the Company's business operating results and financial condition could be materially adversely affected. In addition, some of the Company's customers or vendors could experience Date Code Dependency problems that could result in disruptions of their internal operations, could delay their purchases of the Company's products, and, in turn, could result in a material adverse effect on the Company's business, operating results and financial condition. CONTROL BY EXISTING STOCKHOLDERS Immediately after the closing of this offering, the directors and executive officers of the Company, together with certain entities affiliated with them, assuming no exercise of outstanding stock options, will beneficially own 46.9% of the Company's outstanding Common Stock and Motorola, a principal stockholder of the Company, will own 12.2% of the Company's outstanding Common Stock. Further, pursuant to the terms of the stock purchase agreement under which Motorola initially acquired its shares, Motorola and two other stockholders which together own approximately 6.1% of the Company's outstanding Common Stock have agreed to vote (i) all of their shares in favor of the slate of director nominees recommended by the Board of Directors, and (ii) a number of shares equal to at least that percentage of shares voted by all other stockholders for or against any given matter, as recommended by the Board of Directors, (except certain matters relating to certain changes 12 to the Company's charter, liquidations, a sale of the Company or a merger of the Company into another entity), as recommended by a majority of the Board of Directors. As a result, these stockholders would be able to control substantially all matters requiring approval by the stockholders of their Company, including the election of all directors and approval of significant corporate transactions. See "Management--Executive Officers and Directors," "Certain Transactions" and "Principal Stockholders." SHARES ELIGIBLE FOR FUTURE SALE Upon completion of this offering, based on the outstanding shares of Common Stock at March 31, 1998, the Company will have outstanding 32,125,612 shares of Common Stock outstanding (32,875,612 if the Underwriters' over-allotment option is exercised in full). On the date of this Prospectus, in addition to the 5,000,000 shares offered hereby, 483,674 shares of Common Stock held by current stockholders will be immediately eligible for sale in the public market without restriction. The Company, its officers, directors and certain security holders of the Company have agreed not to offer, sell, contract to sell, grant any option or other right for the sale of, or otherwise dispose of any shares of Common Stock or any securities, indebtedness or other rights exercisable for or convertible or exchangeable into Common Stock owned or acquired in the future in any manner prior to the expiration of 180 days after the date of this Prospectus without the prior written consent of NationsBanc Montgomery Securities LLC on behalf of the Underwriters. Subject to volume limitations on sales by affiliates pursuant to Rule 144 under the Securities Act of 1933, as amended (the "Securities Act"), and taking into account the effect of lock-up provisions applicable to the officers, directors and certain stockholders of the Company, 26,641,938 additional shares of Common Stock will be eligible for sale beginning 180 days after the date of this Prospectus. This includes 247,375 shares held by existing stockholders pursuant to an effective Regulation A offering statement covering the Company's 1997 Stock Plan. No prediction can be made of the effect, if any, that sales of shares under Rule 144 or the availability of shares for sale will have on the market price of the Common Stock prevailing from time to time after this offering. The Company is unable to estimate the number of shares that may be sold in the public market under Rule 144, because such amount will depend on the trading volume in, and market price for, the Common Stock and other factors. Nevertheless, sales of substantial amounts of shares in the public market, or the perception that such sales could occur, could adversely affect the market price of the Common Stock. Following this offering, the Company intends to file a registration statement under the Securities Act to register approximately 8,025,395 shares (including 4,082,695 shares subject to outstanding options at March 31, 1998) reserved for issuance under the Company's stock plans. Shares of Common Stock issued under the Company's stock plans after the effective date of such registration will be freely tradeable in the public market, subject to the 180 day lock-up referred to above and subject in the case of sales by affiliates to the volume limitation, manner of sale, notice and public information requirements of Rule 144. In addition, after the consummation of this offering, the holders of approximately 18,665,548 shares of Common Stock are entitled to certain rights with respect to the registration of such shares under the Securities Act. Such registration rights terminate for each holder when all of such holder's shares may be sold within a given three month period under Rule 144 or other applicable exemption; other than 10,927,498 shares held by affiliates of the Company who will be subject to the volume limitations of Rule 144 following this offering, all of such shares will be eligible for sale 180 days following this offering. See "Description of Capital Stock--Registration Rights," "Shares Eligible for Future Sale" and "Underwriting." ANTI-TAKEOVER PROVISIONS Immediately after the closing of this offering, the Board of Directors will have the authority to issue up to 5,000,000 shares of Preferred Stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of holders of any Preferred Stock that may be issued in the future. The issuance of Preferred Stock may delay, defer or prevent a change in control of the Company as the terms of the Preferred Stock that might be issued could potentially prohibit the Company's consummation of any merger, reorganization, sale of substantially all of its assets, liquidation or other extraordinary corporate transaction without the approval of the holders of the outstanding shares of the Preferred Stock. Additionally, the issuance of Preferred Stock could have a dilutive effect on shareholders of the Company. The Company has no present plans to issue shares of Preferred Stock. In addition, 13 Section 203 of the Delaware General Corporation Law, to which the Company is subject, restricts certain business combinations with any "interested stockholder" as defined by such statute. The statute may delay, defer or prevent a change in control of the Company. In addition, certain provisions of the Company's Amended and Restated Certificate of Incorporation may have the effect of delaying or preventing a change of control of the Company, which could adversely affect the market price of the Company's Common Stock. These provisions provide, among other things, that the Board of Directors is divided into three classes with staggered three-year terms, that stockholders may not take action by written consent, that the ability of stockholders to call special meetings of stockholders and to raise matters at meetings of stockholders is restricted and that certain amendments of the Company's Amended and Restated Certificate of Incorporation, and certain amendments by the stockholders of the Company's Bylaws, require the approval of holders of at least 66 2/3% of the voting power of all outstanding shares. In addition, the Company is subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which will prohibit the Company from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 also could have the effect of delaying or preventing a change of control of the Company. See "Description of Capital Stock--Preferred Stock" and "--Delaware Law and Certain Charter and Bylaw Provisions" and "Description of Capital Stock." NO PRIOR PUBLIC MARKET; POSSIBLE VOLATILITY OF STOCK PRICE Prior to this offering, there has been no public market for the Company's Common Stock, and there can be no assurance that an active public market for the Common Stock will develop or be sustained after this offering. The initial public offering price will be determined by negotiation between the Company and the Underwriters based on several factors, and may bear no relationship to the price at which the Common Stock will trade upon completion of this offering. See "Underwriting" for a discussion of the factors to be considered in determining the initial public offering price. The market price of the Company's Common Stock is likely to be highly volatile and could be subject to wide fluctuations in response to quarterly variations in operating results, announcements of technological innovations or new products by the Company or its competitors, changes in financial estimates by securities analysts, or other events or factors. In addition, there has been significant volatility in the market price of securities of technology companies (especially those in new or emerging industries, such as the Company), which volatility is often unrelated to the operating performance of particular companies. In the future, the Company's operating results could fall below analysts' expectations, which would adversely affect the market price of the Company's Common Stock. In the past, following a period of volatility in the market price of a company's securities, securities class action lawsuits have often been instituted against companies. If brought against the Company, regardless of outcome, the costs and diversion of management resources of defending such litigation could have a material adverse effect on its business, operating results and financial condition. IMMEDIATE AND SUBSTANTIAL DILUTION The initial public offering price will be substantially higher than the book value per share of the currently outstanding Common Stock. Investors purchasing shares in this offering will therefore suffer immediate and substantial dilution of $6.63 per share in the pro forma net tangible book value of their Common Stock from the assumed initial public offering price of $8.00 per share. In addition, the exercise of any of the currently outstanding warrants or stock options would likely result in a dilution of the value of the Common Stock. Moreover, the Company may at any time in the future sell additional securities and/or rights to purchase such securities, grant additional warrants, stock options or other forms of equity-based incentive compensation to the Company's management and/or employees to attract and retain such personnel or in connection with the obtaining of financing, such as debt or leasing arrangements accompanied by warrants to purchase equity securities of the Company. Any of these actions would have a dilutive effect upon the holders of the Common Stock. See "Dilution." 14 BROAD MANAGEMENT DISCRETION AS TO USE OF PROCEEDS The net proceeds to be received by the Company in connection with this offering will be used for working capital and general corporate purposes. Accordingly, management will have broad discretion with respect to the expenditure of such proceeds. Purchasers of shares of Common Stock offered hereby will be entrusting their funds to the Company's management, upon whose judgment they must depend, with limited information concerning the specific working capital requirements and general corporate purposes to which the funds will ultimately be applied. See "Use of Proceeds." ABSENCE OF DIVIDENDS The Company has not paid cash dividends and does not anticipate paying cash dividends on the Common Stock in the foreseeable future. The Company intends to retain future earnings, if any, for use in its business. In addition, the Company's revolving line of credit agreement prohibits the payment of dividends other than stock dividends. See "Dividend Policy." 15 USE OF PROCEEDS The net proceeds to the Company from the sale of the 5,000,000 shares of Common Stock being offered hereby, based on an assumed initial public offering price of $8.00 per share and after deducting the underwriting discount and estimated offering expenses payable by the Company, are estimated to be approximately $36.5 million (approximately $42.1 million if the Underwriters' over-allotment option is exercised in full). The principal purposes of this offering are to increase the Company's equity capital, to create a public market for the Company's Common Stock, to facilitate future access by the Company to public equity markets and to provide increased visibility of the Company in a marketplace where many competitors are publicly-held companies. The Company currently has no specific plans for the net proceeds of this offering, but the Company expects to use such proceeds for general corporate purposes, including working capital and capital expenditures. The Company may also use a portion of such proceeds for possible acquisitions of businesses, products and technologies that are complementary to those of the Company. The Company has not identified any specific businesses, products or technologies that it may acquire and does not have any current agreements or negotiations with respect to any such transactions. Pending use of the net proceeds of this offering for the above purposes, the Company intends to invest such funds in short-term, interest- bearing, investment-grade securities. See "Risk Factors--Broad Management Discretion as to Use of Proceeds." DIVIDEND POLICY The Company has not paid any dividends on its capital stock and does not expect to pay any dividends in the foreseeable future. The Company currently intends to retain future earnings, if any, to finance the growth and development of its business and therefore does not anticipate paying any cash dividends in the foreseeable future. The payment of cash dividends in the future will be at the discretion of the Board of Directors and subject to certain limitations under the Delaware General Corporation Law, and will depend on such factors as the Company's earnings levels, capital requirements, financial condition and other factors deemed relevant by the Board of Directors. In addition, the Company's revolving line of credit agreement prohibits the payment of dividends other than stock dividends. There can be no assurance that the Company will pay any dividends in the future. See "Risk Factors--Absence of Dividends." 16 CAPITALIZATION The following table sets forth the capitalization of the Company as of March 31, 1998 (i) on an actual basis and (ii) as adjusted to reflect the receipt by the Company of the net proceeds from the sale and issuance of 5,000,000 shares of Common Stock by the Company at an assumed initial public offering price of $8.00 per share after deducting the underwriting discount and estimated offering expenses payable by the Company and the automatic conversion of all outstanding shares of Preferred Stock into Common Stock upon the closing of this offering. See "Certain Transactions" and "Description of Capital Stock." This information should be read in conjunction with the Company's Financial Statements and the Notes thereto included elsewhere in this Prospectus.
MARCH 31, 1998 --------------------- ACTUAL AS ADJUSTED -------- ----------- (IN THOUSANDS) Stockholders' equity(1): Preferred Stock, $.01 par value, 11,000,000 shares authorized, 7,887,381 shares issued and outstanding, actual; 5,000,000 shares authorized, no shares issued or outstanding, as adjusted........................... $ 79 $ -- Common Stock, $.01 par value, 50,000,000 shares authorized, 19,238,231 shares issued and outstanding, actual; 100,000,000 shares authorized, 32,125,612 shares issued and outstanding, as adjusted.............................................. 192 321 Additional paid-in capital............................. 94,530 130,980 Deferred compensation.................................. (519) (519) Cumulative translation adjustment...................... (415) (415) Accumulated deficit.................................... (86,385) (86,385) -------- -------- Total stockholders' equity........................... $ 7,482 $ 43,982 ======== ========
- -------- (1) Includes 1,802,438 shares of Common Stock issued under stock purchase agreements subject to repurchase by the Company at a weighted average price of $1.26 per share. Excludes (i) 4,082,695 shares of Common Stock issuable upon exercise of options outstanding as of March 31, 1998 at a weighted average exercise price of $1.33 per share, of which options to purchase 3,932,695 shares (including 3,167,780 shares subject to repurchase by the Company at a weighted average exercise price of $1.31 per share) were exercisable, (ii) 3,942,700 shares of Common Stock reserved for future issuance under the Company's stock option plans and (iii) 430,000 shares of Common Stock issuable upon exercise of warrants outstanding as of March 31, 1998 at a weighted average exercise price of $5.49 per share. See "Management--Stock Option Plans and Warrants," "Description of Capital Stock" and Note 6 of Notes to Consolidated Financial Statements. 17 DILUTION The pro forma net tangible book value of the Company as of March 31, 1998 assuming the conversion of all outstanding shares of Preferred Stock into Common Stock on a one-for-one basis upon the closing of this offering, was approximately $7.5 million, or $0.28 per share of Common Stock. Net tangible book value per share is determined by dividing the net tangible book value of the Company (total tangible assets less total liabilities) by the number of shares of Common Stock deemed outstanding at that date. After giving effect to the sale by the Company of the 5,000,000 shares of Common Stock offered hereby at an assumed initial public offering price of $8.00 per share and after deducting the underwriting discount and estimated offering expenses payable by the Company, the Company's pro forma net tangible book value at March 31, 1998 would have been $44.0 million, or $1.37 per share. This represents an immediate increase in net tangible book value to existing shareholders of $1.09 per share and an immediate dilution of $6.63 per share to new investors purchasing shares at the initial public offering price. The following table illustrates the per share dilution: Assumed initial public offering price per share.................... $8.00 Pro forma net tangible book value per share as of March 31, 1998............................................................ $0.28 Increase per share attributable to new investors................. 1.09 ----- Pro forma net tangible book value per share after this offering.... 1.37 ----- Dilution per share to new investors................................ $6.63 =====
The following table sets forth on a pro forma basis as of March 31, 1998 the number of shares of Common Stock purchased from the Company, the total consideration paid, and the average price per share paid by existing shareholders and by the new investors at an assumed initial public offering price of $8.00 per share (before deducting the underwriting discount and estimated offering expenses payable by the Company).
SHARES PURCHASED TOTAL CONSIDERATION AVERAGE ------------------ -------------------- PRICE PER NUMBER PERCENT AMOUNT PERCENT SHARE ---------- ------- ------------ ------- --------- Existing stockholders......... 27,125,612 84.4% $ 94,406,000 70.2% $3.48 New investors................. 5,000,000 15.6 40,000,000 29.8 8.00 ---------- ----- ------------ ----- Total....................... 32,125,612 100.0% $134,406,000 100.0% ========== ===== ============ =====
- -------- The foregoing tables assume no exercise of the Underwriters' over-allotment option and no exercise of stock options or warrants outstanding at March 31, 1998. As of March 31, 1998, there were options outstanding to purchase a total of 4,082,695 shares of Common Stock at a weighted average exercise price of $1.33 per share, of which options to purchase 3,932,695 shares (including 3,167,780 shares subject to repurchase by the Company at a weighted average exercise price of $1.31 per share) were exercisable and 3,942,700 shares were reserved for future issuance under the Company's stock option plans. In addition, as of March 31, 1998, there were warrants outstanding to purchase 430,000 shares of Common Stock at a weighted average exercise price of $5.49 per share and 1,802,438 shares of Common Stock issued under stock purchase agreements which were subject to repurchase by the Company at a weighted average price of $1.26 per share. To the extent that the over-allotment option or any of these options or warrants are exercised, there will be further dilution to new investors. See "Capitalization," "Management--Stock Option Plans and Warrants," "Description of Capital Stock" and Note 6 of Notes to Consolidated Financial Statements. 18 SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein. The consolidated statement of operations data for the years ended December 31, 1995, 1996 and 1997, and the consolidated balance sheet data at December 31, 1996 and 1997 are derived from, and are qualified by reference to, the Consolidated Financial Statements audited by Arthur Andersen LLP, independent public accountants, included elsewhere in this Prospectus. The consolidated statement of operations data for the years ended December 31, 1993 and 1994 and the consolidated balance sheet data at December 31, 1993, 1994 and 1995 are derived from the Company's consolidated financial statements audited by Arthur Andersen LLP that do not appear herein. The consolidated statement of operations data for the three months ended March 31, 1997 and 1998 and the consolidated balance sheet data at March 31, 1998 are derived from the unaudited consolidated financial statements appearing elsewhere herein and which, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results of the unaudited interim periods. The financial results for the three months ended March 31, 1998 are not necessarily indicative of the results to be expected for any other interim period or the fiscal year. The historical results are not necessarily indicative of the results of operations to be expected in the future.
THREE MONTHS YEAR ENDED DECEMBER 31, ENDED MARCH 31, ------------------------------------------------ ---------------- 1993 1994 1995 1996 1997 1997 1998 -------- -------- -------- -------- -------- ------- ------- CONSOLIDATED STATEMENT OF OPERATIONS DATA: (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) Revenues: Product................ $ 10,104 $ 14,368 $ 20,183 $ 20,708 $ 24,665 $ 6,548 $ 7,188 Service................ 1,441 2,364 3,160 3,282 3,637 926 771 -------- -------- -------- -------- -------- ------- ------- Total revenues......... 11,545 16,732 23,343 23,990 28,302 7,474 7,959 Cost of revenues: Cost of product........ 3,764 6,733 9,434 10,761 11,761 3,111 3,249 Cost of service........ 990 1,006 1,141 1,142 1,810 455 543 -------- -------- -------- -------- -------- ------- ------- Total cost of reve- nues.................. 4,754 7,739 10,575 11,903 13,571 3,566 3,792 -------- -------- -------- -------- -------- ------- ------- Gross profit........... 6,791 8,993 12,768 12,087 14,731 3,908 4,167 -------- -------- -------- -------- -------- ------- ------- Operating expenses: Product development.... 6,861 6,658 7,355 7,526 7,121 1,740 1,958 Sales and marketing.... 8,628 9,317 10,881 11,577 12,128 3,014 3,031 General and administra- tive.................. 2,575 3,268 4,386 3,921 4,004 1,098 935 -------- -------- -------- -------- -------- ------- ------- Total operating ex- penses................ 18,064 19.243 22,622 23,024 23,253 5,852 5,924 -------- -------- -------- -------- -------- ------- ------- Loss from operations... (11,273) (10,250) (9,854) (10,937) (8,522) (1,944) (1,757) Other income (expense): Interest income, net... 180 809 1,109 536 429 71 67 Other income (expense), net................... 9 44 175 (163) 68 21 8 -------- -------- -------- -------- -------- ------- ------- Total other income (ex- pense)................ 189 853 1,284 373 497 92 75 -------- -------- -------- -------- -------- ------- ------- Loss before provision for income taxes...... (11,084) (9,397) (8,570) (10,564) (8,025) (1,852) (1,682) Provision for income taxes.................. 49 86 143 152 189 55 55 -------- -------- -------- -------- -------- ------- ------- Net loss............... $(11,133) $ (9,483) $ (8,713) $(10,716) $ (8,214) $(1,907) $(1,737) ======== ======== ======== ======== ======== ======= ======= Basic net loss per share(1).............. $ (0.85) $ (0.67) $ (0.56) $ (0.62) $ (0.44) $ (0.10) $ (0.09) ======== ======== ======== ======== ======== ======= ======= Shares used in comput- ing basic net loss per share(1).............. 13,038 14,060 15,695 17,354 18,603 18,511 19,029 ======== ======== ======== ======== ======== ======= ======= Pro forma basic net loss per share(1)..... $ (0.32) $ (0.08) $ (0.06) ======== ======= ======= Shares used in comput- ing pro forma basic net loss per share(1).. 25,756 24,399 26,916 ======== ======= =======
DECEMBER 31, -------------------------------------- MARCH 31, 1993 1994 1995 1996 1997 1998 ------ ------- ------- ------- ------- ----------- CONSOLIDATED BALANCE SHEET DATA: (IN THOUSANDS) (UNAUDITED) Cash, cash equivalents and short-term investments.... $4,443 $24,210 $16,044 $ 8,051 $ 7,853 $ 5,165 Working capital............ 4,164 25,120 17,653 7,905 8,883 7,376 Total assets............... 9,913 31,124 24,547 15,855 16,816 15,695 Total stockholders' equi- ty........................ 1,529 22,799 15,978 7,138 8,800 7,482
- -------- (1) See Note 2 of Notes to Consolidated Financial Statements for an explanation of shares used in computing basic net loss per share and pro forma basic net loss per share. 19 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included elsewhere in this Prospectus. This Prospectus contains forward-looking statements that involve risks and uncertainties. The Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that may cause such a difference include, but are not limited to, those discussed in "Risk Factors." OVERVIEW The Company was founded and began operations in February 1988. The Company develops, markets and supports a family of hardware and software products and services that enables OEMs and systems integrators to design and implement open, interoperable, distributed control networks. The Company offers its products and services to OEMs and systems integrators in the building, industrial, transportation, home and other automation markets. The Company provides a variety of technical training related to its products and underlying technology as well as customer support to its customers on a per incident or annual contract basis. After incorporation, the Company initially focused on research that led to the development of LonWorks technology. The Company's first product, the LonBuilder Developer's Kit, was shipped in April 1991. In November 1991, the first LonUsers International Conference was held, and in December 1991, shipments of the Neuron Chip, which incorporates the Company's LonTalk protocol, began. In January 1992, the Company introduced LonManager API for DOS, which was its first software development product, and in February 1992, the Company shipped the first of its control and connectivity products. In May 1994, the LonMark Interoperability Association was founded. In January 1998, the Company signed its first Network Integrator Program participant. The Company markets its products and services in North America, Europe, Japan and selected Asia-Pacific countries through a direct sales organization augmented with the use of third-party distributors. International sales, which include both export sales and sales by the Company's international subsidiaries, accounted for 57.0% and 54.7% of total revenues for the three months ended March 31, 1998 and 1997, respectively, and 57.5%, 53.6% and 52.0% for fiscal 1997, 1996 and 1995, respectively. The Company believes that revenues from Asian operations may grow more slowly than for other international markets in part due to the current economic crisis in Asia. Revenues from Asian operations for the year-to-date are generally consistent with the Company's lowered expectations but are not expected to have a significant impact on the Company's liquidity or results of operations. In 1997, 10.7% of the Company's revenues were denominated in currencies other than the U.S. dollar, principally the Japanese Yen. However, this percentage may increase over time as the Company responds to market requirements to sell its products and services in local currencies, such as the forthcoming Euro. As a result, the Company's operations and the market price of its products may be directly affected by economic and political conditions in the countries where the Company does business. Additional risks inherent in the Company's international business activities include currency fluctuations, unexpected changes in regulatory requirements, tariffs and other trade barriers. The Company expects that international sales will continue to constitute a significant portion of total revenues. See "Risk Factors--International Operations; Currency Fluctuations." The Company derives its revenues primarily from the sale and licensing of its products and, to a lesser extent, from fees associated with training and technical support offered to its customers. Product revenues consist of revenues from sales of transceivers, control modules, routers, network interface devices and development tools and from licenses for network services software products. Revenues from software licensing arrangements have not been significant to date. Service revenues consist of product support (including software post-contract support services) and training. The Company recognizes revenue from product sales at the time of shipment to the customer. Estimated reserves for warranty costs as well as for sales returns and allowances related to anticipated return of products sold to distributors with limited rights of return, which have not been material to the Company's financial results, are recorded at the time of sale. Revenue from software sales is recognized upon 20 shipment of the software if there are no significant post-delivery obligations and if collection is probable, The Company generally has not had any significant post-delivery obligations associated with the sale of its products. Service revenues are generally recognized as the services are performed. See Note 2 of Notes to Consolidated Financial Statements. In connection with the issuance of stock options to employees during the three months ended March 31, 1998, the Company has recorded deferred compensation in the aggregate amount of approximately $530,000, representing the difference between the deemed fair value of the Company's Common Stock and the exercise price of the stock options at the date of grant. The Company is amortizing the deferred compensation expense over the shorter of the period in which the employee, director or consultant provides services or the applicable vesting period, which is typically 48 months. For the three-month period ended March 31, 1998, amortization expense was approximately $11,000. Deferred compensation is decreased in the period of forfeiture arising from the early termination of an option holder's services. No compensation expense related to any other periods presented has been recorded. The Company has experienced operating losses in each of its last five fiscal years. During this period, the Company has made significant investments in product development to implement open control networks. Such development projects included development of transceivers, control modules, routers, network interface devices, network management software and the LonPoint System. Furthermore, because the Company's strategy is significantly dependent upon achieving broad adoption of its LonWorks technology across many industries worldwide, the Company has incurred significant selling and marketing expense promoting its products. Additionally, the Company believes that it has priced its products at competitive levels to ensure broad adoption of LonWorks technology. The Company continues to invest significantly in product development, marketing and sales, and to the extent such expenditures do not result in significant increases in revenues the Company's business, operating results and financial condition will be materially and adversely affected. See "Risk Factors--History of Losses; Accumulated Deficit; Anticipated Continuing Losses; Uncertainty of Future Operating Results." The Company has experienced, and expects to continue to experience, significant variability in its quarterly and annual results due to a number of factors, many of which are outside of the Company's control. The Company believes that one of the factors in such variability is the fluctuation in the rates at which OEMs purchase the Company's products and services, which is impacted by OEMs' own business cycles. See "Risk Factors--Fluctuations in Operating Results." Another factor in such variability is the timely introduction of new products. From time to time, the introduction of new products by the Company has been delayed beyond the Company's projected shipping date. In each instance, such delays have resulted in increased costs and delayed revenues. Because future revenues are dependent on the timely introduction of new product offerings, any such future delays could have a material adverse effect on the Company's business, operating results and financial condition. See "Risk Factors--New Products and Rapid Technological Change." The Company's expense levels are based, in significant part, on expectations of future revenues. Consequently, if revenue levels are below expectations, expense levels could be disproportionately high as a percentage of total revenues, and operating results would be immediately and adversely affected. The Company has failed to meet its expectations of future revenues in the past. See "Risk Factors--Fluctuations in Operating Results." In addition, the growth of the Company's revenues has been adversely affected by declines in sales of existing products over time. For example, the LonBuilder Developer's Workbench represented approximately 18% of the Company's revenues during 1995 but has not represented a significant percentage of total revenues since that time. At March 31, 1998, the Company had an accumulated deficit of $86.4 million. As of December 31, 1997, the Company had net operating loss carryforwards for Federal and state income tax reporting purposes of approximately $76.0 million and $5.0 million, respectively, which expire at various dates through 2012. In addition, as of December 31, 1997, the Company had tax credit carryforwards of approximately $3.5 million, which expire at various dates through 2012. The Internal Revenue Code of 1986, as amended, contains provisions that may limit the net operating loss and credit carryforwards available for use in any given period upon the occurrence of certain events, including a significant change in ownership interests. The Company had deferred 21 tax assets, including its net operating loss carryforwards and tax credits, totaling approximately $33.6 million as of December 31, 1997. A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance due to the history of losses and the variability of operating results. See "Risk Factors--History of Losses; Accumulated Deficit; Anticipated Continuing Losses; Uncertainty of Future Operating Results" and Note 7 of Notes to Consolidated Financial Statements. RECENT RESULTS OF OPERATIONS The Company's second quarter ended on June 30, 1998. Total revenues for the quarter were $8.5 million, net loss was ($1.2 million), basic net loss per share was ($0.06) (based on weighted average shares outstanding of 19,381,151) and pro forma basic net loss per share was ($0.04) (based on weighted average shares outstanding of 27,268,532). RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the percentage of total revenues represented by each item in the Company's Consolidated Statement of Operations:
YEAR ENDED THREE MONTHS DECEMBER 31, ENDED MARCH 31, --------------------- ------------------ 1995 1996 1997 1997 1998 ----- ----- ----- -------- ------- Revenues: (UNAUDITED) Product......................... 86.5% 86.3% 87.1% 87.6% 90.3% Service......................... 13.5 13.7 12.9 12.4 9.7 ----- ----- ----- -------- ------- Total revenues................. 100.0 100.0 100.0 100.0 100.0 Cost of revenues: Cost of product................. 40.4 44.8 41.6 41.6 40.8 Cost of service................. 4.9 4.8 6.4 6.1 6.8 ----- ----- ----- -------- ------- Total cost of revenues......... 45.3 49.6 48.0 47.7 47.6 ----- ----- ----- -------- ------- Gross profit................... 54.7 50.4 52.0 52.3 52.4 ----- ----- ----- -------- ------- Operating expenses: Product development............. 31.5 31.4 25.1 23.3 24.6 Sales and marketing............. 46.6 48.3 42.9 40.3 38.1 General and administrative...... 18.8 16.3 14.1 14.7 11.7 ----- ----- ----- -------- ------- Total operating expenses....... 96.9 96.0 82.1 78.3 74.4 ----- ----- ----- -------- ------- Loss from operations........... (42.2) (45.6) (30.1) ( 26.0) (22.0) ----- ----- ----- -------- ------- Other income (expense): Interest income, net............ 4.8 2.2 1.5 0.9 0.8 Other income (expense), net..... 0.7 (0.6) 0.2 0.3 0.1 ----- ----- ----- -------- ------- Total other income (expense)... 5.5 1.6 1.7 1.2 0.9 ----- ----- ----- -------- ------- Loss before provision for in- come taxes.................... (36.7) (44.0) (28.4) (24.8) (21.1) Provision for income taxes........ 0.6 0.7 0.6 0.7 0.7 ----- ----- ----- -------- ------- Net loss........................ (37.3)% (44.7)% (29.0)% (25.5)% (21.8)% ===== ===== ===== ======== =======
THREE MONTHS ENDED MARCH 31, 1998 COMPARED TO THREE MONTHS ENDED MARCH 31, 1997 Revenues Total revenues for the three months ended March 31, 1998 increased to $8.0 million from $7.5 million in the same period of 1997, an increase of 6.5%. For the three months ended March 31, 1998, one customer, EBV, 22 the sole distributor of the Company's products in Europe since December 1997, accounted for 20.6% of total revenues. For the three months ended March 31, 1997, no customer accounted for greater than 10% of total revenues. Product. Product revenues for the three months ended March 31, 1998 increased to $7.2 million from $6.5 million in the same period of 1997, an increase of 9.8%. For the three months ended March 31, 1998, product revenues as a percentage of total revenues increased to 90.3% from 87.6% in the same period of 1997. This increase was primarily due to the market's growing acceptance of the Company's products and underlying technology, especially its control and connectivity products, and an expansion of the Company's product offerings. Service. Service revenues for the three months ended March 31, 1998 decreased to $771,000 from $926,000 in the same period of 1997, a decrease of 16.7%. For the three months ended March 31, 1998, service revenues as a percentage of total revenues decreased to 9.7% from 12.4% in the same period of 1997. This decrease was due primarily to the timing and the number of technical training courses offered by the Company. Cost of Revenues Cost of product. Cost of product revenues consist of costs associated with the purchase of components and subassemblies, as well as allocated labor, overhead and manufacturing variances associated with the packaging, preparation and shipment of products. Cost of product revenues for the three months ended March 31, 1998 increased to $3.2 million from $3.1 million in the same period of 1997, an increase of 4.4%, representing product gross margins of 54.8% and 52.5%, respectively. The increase in product gross margins was primarily due to a change in product mix as a result of the expansion of new product offerings as well as, to a lesser extent, a general increase in volumes of products shipped by the Company. Cost of service. Cost of service revenues consist of employee-related costs as well as direct costs incurred in providing training and customer support services. Cost of service revenues for the three months ended March 31, 1998 increased to $543,000 from $455,000 in the same period of 1997, an increase of 19.3%, representing service gross margins of 29.6% and 50.9%, respectively. The decrease in service gross margins was due primarily to the decline in service revenues. Operating Expenses Product development. Product development expenses consist primarily of payroll and related expenses, expensed material and facility costs associated with the development of new technologies and products. Product development expenses for the three months ended March 31, 1998 increased to $2.0 million from $1.7 million in the same period of 1997, representing 24.6% and 23.3%, respectively, of total revenues. The dollar amount and percentage increases were primarily the result of increased salaries and other costs related to the hiring of additional engineering personnel to support the development of new and existing products. Sales and marketing. Sales and marketing expenses consist primarily of payroll and related expenses including commissions to sales personnel, travel and entertainment, advertising and product promotion and facilities costs associated with the Company's sales and support offices. Sales and marketing expenses for the three months ended March 31, 1998 remained flat at $3.0 million from the same period of 1997, representing 38.1% and 40.3%, respectively, of total revenues. The decrease in sales and marketing expense as a percentage of total revenues was due primarily to the larger revenue base in 1998. General and administrative. General and administrative expenses consist primarily of payroll and related expenses for executive, accounting and administrative personnel, insurance, professional fees and other general corporate expenses. General and administrative expenses for the three months ended March 31, 1998 decreased to $935,000 from $1.1 million in the same period in 1997, representing 11.7% and 14.7%, respectively, of total revenues. The dollar amount and percentage decreases were attributable to a decrease in administrative personnel and outside services. 23 Interest income, net. Interest income, net reflects interest earned by the Company on its cash and short-term investment balances. Interest income, net for the three months ended March 31, 1998 decreased to $67,000 from $71,000 in the same period of 1997. Other income (expense), net. Other income (expense), net consists primarily of purchase discounts and foreign transaction gains and losses. Other income (expense), net for the three months ended March 31, 1998 decreased to $8,000 from $21,000 in the same period of 1997. Provision for income taxes. Income taxes consist of income taxes related to certain of the Company's foreign subsidiaries. Income taxes were $55,000 for each of the three months ended March 31, 1998 and 1997. FISCAL YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 Revenues Total revenues for fiscal 1997, 1996 and 1995 were $28.3 million, $24.0 million and $23.3 million, respectively, representing increases of 18.0% and 2.8%, respectively. EBV accounted for 10.9% and 12.0% of total revenues in fiscal 1997 and 1995, respectively. In 1996, no single customer accounted for 10% or more of total revenues. Product. Product revenues for fiscal 1997, 1996 and 1995 were $24.7 million, $20.7 million and $20.2 million, respectively, representing increases of 19.1% and 2.6%, respectively. Product revenues as a percentage of total revenues were 87.1%, 86.3% and 86.5%, for fiscal 1997, 1996 and 1995, respectively. The increase in 1997 as compared to 1996 was due to the market's growing acceptance of the Company's products and underlying technology and an expansion of the Company's product offerings. For both dollar amounts and as a percentage of total revenues, product revenues were relatively flat between 1996 and 1995 due to the fact that increases in sales of control and connectivity products were partially offset by decreases in sales of development tools. Service. Service revenues for fiscal 1997, 1996 and 1995 were $3.6 million, $3.3 million and $3.2 million, respectively, representing increases of 10.8% and 3.9% respectively. Service revenues as a percentage of total revenues were 12.9%, 13.7% and 13.5% for fiscal 1997, 1996 and 1995, respectively. The increase in 1997 service revenues as compared to 1996 reflects increased customer support revenues as a result of the increased installed base of the Company's products. Cost of Revenues Cost of product. Cost of product revenues for fiscal 1997, 1996 and 1995 were $11.8 million, $10.8 million and $9.4 million, respectively, representing product gross margins of 52.3%, 48.0% and 53.3%, respectively. The increases in dollar amounts were due primarily to the additional product costs associated with increased volumes. The increase in product gross margin in 1997 as compared to 1996 was due primarily to decreased operations spending as a percentage of revenue and lower manufacturing variances. The decrease in product gross margin in 1996 as compared to 1995 was due to flat revenue growth and increased cost of products related primarily to a change in product mix towards lower margin volume products. Cost of service. Cost of service revenues for fiscal 1997, 1996 and 1995 were $1.8 million, $1.1 million and $1.1 million, respectively, representing service gross margins of 50.2%, 65.2% and 63.9%, respectively. The increase in dollar amount in fiscal 1997 as compared to 1996 was primarily the result of an increase in the number of customer support and training personnel. The decrease in service gross margin in 1997 as compared to 1996 was due primarily to higher cost of service growth compared to service revenue growth. The increase in service gross margin in 1996 as compared to 1995 was due to slightly higher revenue growth in 1996 as the spending levels over the same period remained unchanged. 24 Operating Expenses Product development. Product development expenses for fiscal 1997, 1996 and 1995 were $7.1 million, $7.5 million and $7.4 million, respectively, representing 25.1%, 31.4% and 31.5% of total revenues, respectively. The decrease in product development expenses in 1997 as compared to 1996 was due primarily to the transition of Company personnel from product development to the direct support of the Company's existing customers. The increase in product development expenses in 1996 as compared to 1995 was due primarily to investments made by the Company in technology development. Sales and marketing. Sales and marketing expenses for fiscal 1997, 1996 and 1995 were $12.1 million, $11.6 million and $10.9 million, respectively, representing 42.9%, 48.3% and 46.6% of total revenues, respectively. The dollar amount increases, in each succeeding year, were primarily due to personnel related expenses. The Company's expenses in international sales offices in 1997 were lower than 1996 primarily due to an overall strengthening of the U.S. dollar against most of the functional currencies used in the international sales office operations. The increase in percentage of total revenues in 1996 as compared to 1995 reflected an increase in fixed selling expenses to support anticipated revenue growth in 1996. General and administrative. General and administrative expenses for fiscal 1997, 1996 and 1995 were $4.0 million, $3.9 million and $4.4 million, respectively, representing 14.1%, 16.3% and 18.8% of total revenues, respectively. The decrease in percentage of total revenues in 1997 compared to 1996 was due to relatively similar spending levels spread over a larger revenue base. The decreases in dollar amounts and percentage of total revenues in 1996 compared to 1995 were due primarily to reduced spending related to regulatory measures associated with an FCC rulemaking related to cable compatibility. See "Risk Factors--Regulatory Actions." Interest Income, net. Interest income, net for fiscal 1997, 1996 and 1995 was $429,000, $536,000 and $1.1 million, respectively, representing 1.5%, 2.2% and 4.8% of total revenues, respectively. The decreases in interest income were due to lower cash and short-term investment balances. Other income (expense), net. Other income (expense), net for fiscal 1997, 1996 and 1995 was $68,000, ($163,000) and $175,000, respectively. The amount in other income (expense), net in 1997 was primarily due to income from purchase discounts taken in 1997. The amount in other income (expense), net in 1996 as compared to 1995 was due primarily to foreign transaction losses incurred in 1996 and foreign transaction gains incurred in 1995 both primarily related to the fluctuations of the U.S. dollar against the Japanese Yen. Provision for income taxes. Income taxes for 1997, 1996 and 1995, which consists of income taxes related to certain of the Company's foreign subsidiaries, were $189,000, $152,000 and $143,000, respectively. 25 QUARTERLY RESULTS OF OPERATIONS The following table sets forth certain consolidated statement of operations data for each of the five quarters in the period ended March 31, 1998, as well as the percentage of total revenues for the periods indicated. This information has been derived from the Company's unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements contained herein and include all adjustments, consisting only of normal recurring adjustments, which the Company considers necessary for a fair presentation of this information when read in conjunction with the Company's Consolidated Financial Statements and Notes thereto appearing elsewhere in this Prospectus. The results of operations for any quarter and any quarter-to- quarter trends are not necessarily indicative of the results to be expected for any future period.
THREE MONTHS ENDED ----------------------------------------------- MARCH JUNE SEPT. DEC. MARCH 1997 1997 1997 1997 1998 ------- ------- ------- ------- ------- (IN THOUSANDS) Revenues: Product.................. $ 6,548 $ 5,944 $ 5,487 $ 6,686 $ 7,188 Service.................. 926 1,036 862 813 771 ------- ------- ------- ------- ------- Total revenues........... 7,474 6,980 6,349 7,499 7,959 Cost of revenues: Cost of product.......... 3,111 2,840 2,724 3,086 3,249 Cost of service.......... 455 445 408 502 543 ------- ------- ------- ------- ------- Total cost of revenues... 3,566 3,285 3,132 3,588 3,792 ------- ------- ------- ------- ------- Gross profit............. 3,908 3,695 3,217 3,911 4,167 ------- ------- ------- ------- ------- Operating expenses: Product development...... 1,740 1,724 1,751 1,906 1,958 Sales and marketing...... 3,014 3,140 2,890 3,084 3,031 General and administra- tive.................... 1,098 981 983 942 935 ------- ------- ------- ------- ------- Total operating ex- penses.................. 5,852 5,845 5,624 5,932 5,924 ------- ------- ------- ------- ------- Loss from operations..... (1,944) (2,150) (2,407) (2,021) (1,757) ------- ------- ------- ------- ------- Other income (expense): Interest income, net...... 71 109 143 106 67 Other income (expense), net...................... 21 13 18 16 8 ------- ------- ------- ------- ------- Total other income (ex- pense).................. 92 122 161 122 75 ------- ------- ------- ------- ------- Loss before provision for income taxes............ (1,852) (2,028) (2,246) (1,899) (1,682) Provision for income tax- es....................... 55 35 34 65 55 ------- ------- ------- ------- ------- Net loss................. $(1,907) $(2,063) $(2,280) $(1,964) $(1,737) ======= ======= ======= ======= ======= AS A PERCENTAGE OF TOTAL REVENUES: Revenues: Product.................. 87.6% 85.2% 86.4% 89.2% 90.3% Service.................. 12.4 14.8 13.6 10.8 9.7 ------- ------- ------- ------- ------- Total revenues........... 100.0 100.0 100.0 100.0 100.0 Cost of revenues: Cost of product.......... 41.6 40.7 42.9 41.1 40.8 Cost of service 6.1 6.4 6.4 6.7 6.8 ------- ------- ------- ------- ------- Total cost of revenues... 47.7 47.1 49.3 47.8 47.6 ------- ------- ------- ------- ------- Gross profit............. 52.3 52.9 50.7 52.2 52.4 ------- ------- ------- ------- ------- Operating expenses: Product development...... 23.3 24.7 27.6 25.5 24.6 Sales and marketing...... 40.3 45.0 45.6 41.1 38.1 General and administra- tive.................... 14.7 14.0 15.4 12.6 11.7 ------- ------- ------- ------- ------- Total operating ex- penses.................. 78.3 83.7 88.6 79.2 74.4 ------- ------- ------- ------- ------- Loss from operations..... (26.0) (30.8) (37.9) (27.0) (22.0) ------- ------- ------- ------- ------- Other income (expense): Interest income, net..... 0.9 1.6 2.3 1.4 0.8 Other income (expense), net..................... 0.3 0.1 0.2 0.3 0.1 ------- ------- ------- ------- ------- Total other income (ex- pense).................. 1.2 1.7 2.5 1.7 0.9 ------- ------- ------- ------- ------- Loss before provision for income taxes............ (24.8) (29.1) (35.4) (25.3) (21.1) Provision for income tax- es....................... 0.7 0.5 0.5 0.9 0.7 ------- ------- ------- ------- ------- Net loss................. (25.5)% (29.6)% (35.9)% (26.2)% (21.8)% ======= ======= ======= ======= =======
26 The Company's revenues, expenses and results of operations have been subject to quarterly fluctuations due to a variety of factors. These factors make the estimation and forecast of revenues difficult on a quarterly basis. The Company plans to continue to increase its product development and sales and marketing expenses on a quarterly basis in an effort to increase its market share. These increases will be based in significant part on expectations of future revenues. As a result of these and other factors, the Company believes that its revenues and operating results are difficult to predict and are subject to fluctuations from period to period, and that period-to-period comparisons of its results of operations are not meaningful and should not be relied upon as indications of future performance. See "Risk Factors-- Fluctuations in Operating Results." LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has financed its operations and met its capital expenditure requirements primarily from the private sale of Preferred Stock and Common Stock. From inception through March 31, 1998, the Company had raised $94.4 million from the sale of Preferred Stock and Common Stock. Net cash used in operating activities was $2.9 million for the three months ended March 31, 1998 and 1997. For fiscal 1997, 1996 and 1995, net cash used in operating activities was $9.5 million, $9.0 million and $9.2 million, respectively. Net cash used in operations is attributable primarily to the losses from operations in each of the periods. Net cash used in investing activities was $3.6 million in fiscal 1997 and $70,000 for the three months ended March 31, 1997. The net cash used in investing activities reflected the shortfall of cash proceeds from the maturities of short-term investments offset by the purchases of short-term investments and capital expenditures. Net cash provided by investing activities was $2.8 million for the three months ended March 31, 1998, and $11.2 million and $6.5 million in fiscal 1996 and 1995, respectively. The net cash provided by investing activities reflected the excess of cash proceeds from the maturities of short-term investments offset by the purchases of short-term investments and capital expenditures. Net cash provided by financing activities was $472,000 and $16,000 for the three months ended March 31, 1998 and 1997, respectively, and was $10.2 million, $1.9 million and $2.0 million in fiscal 1997, 1996 and 1995, respectively. Net cash provided by financing activities consisted primarily of proceeds from private sales of Preferred Stock and Common Stock and the exercise of employee stock options. At March 31, 1998, the Company's principal sources of liquidity included cash and cash equivalents of $5.2 million. In May 1998, the Company entered into a revolving line of credit agreement with a bank, whereby the Company may borrow up to 85% of eligible accounts receivable, not to exceed $5.0 million. If the credit agreement had been in effect as of April 30, 1998, the amount available to be borrowed thereunder would have been $2.6 million. Advances under the credit agreement bear interest at the bank's reference rate or, at the option of the Company, at a fixed rate of interest equal to the London interbank offered rate plus 150 basis points. As of May 31, 1998, there was approximately $65,000 outstanding under this line of credit in the form of a letter of credit. The credit agreement, which expires in May 1999, contains certain negative covenants restricting the Company's ability to pay dividends or enter into certain financial transactions. The credit agreement also contains a minimum tangible net worth requirement, determined on a quarterly basis. The Company believes that the proceeds from this offering, together with its existing sources of liquidity, will satisfy the Company's projected working capital and other cash requirements for at least the next 24 months. However, there can be no assurance that the Company will not require additional financing within this period or that any such financing will be available to the Company in the amounts or at the times required by the Company, or on acceptable terms, if at all. The failure of the Company to obtain additional financing could have a material adverse effect on the Company's business, operating results and financial condition. 27 NEW PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and presentation of comprehensive income. SFAS No. 130, which was adopted by the Company in the first quarter of 1998, requires companies to report a new measurement of income. "Comprehensive Income (loss)" is required to include foreign currency translation gains and losses and other unrealized gains and losses that have historically been excluded from net income and reflected instead in equity. The following table reconciles comprehensive net loss under the provisions of SFAS No. 130 for the years ended December 31, 1995, 1996 and 1997 and for the three months ended March 31, 1997 and 1998 (in thousands):
DECEMBER 31, MARCH 31, -------------------------- ---------------- 1995 1996 1997 1997 1998 ------- -------- ------- ------- ------- (UNAUDITED) Net loss..................... $(8,713) $(10,716) $(8,214) $(1,907) $(1,737) Foreign currency translation adjustments................. (62) (35) (320) (201) (64) ------- -------- ------- ------- ------- Comprehensive net loss....... $(8,775) $(10,751) $(8,534) $(2,108) $(1,801) ======= ======== ======= ======= =======
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes standards for disclosure of segment information and which will be adopted by the Company in the fourth quarter of 1998. The Company anticipates that SFAS No. 131 will not have a material impact on its financial statements. In December 1997, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 97-2 which superseded SOP 91-1, "Software Revenue Recognition." SOP 97-2 is effective for transactions entered into in the Company's fiscal year beginning January 1, 1998. Management has assessed this new statement and its adoption in the first quarter of fiscal 1998 did not have a material effect on the Company's financial statements or on the timing of the Company's revenue recognition, or cause changes to its revenue recognition policies. In April 1998, the AICPA issued SOP 98-5 "Reporting the Costs of Start-up Activities." SOP 98-5 is effective for the Company's fiscal year beginning January 1, 1999. SOP 98-5 provides guidance on the financial reporting of start-up costs and organization costs and requires such costs to be expensed as incurred. Management believes the adoption of SOP 98-5 will not have a material effect on the Company's financial statements. 28 BUSINESS OVERVIEW Echelon develops, markets and supports a family of hardware and software products and services that enables OEMs and systems integrators to design and implement open, interoperable, distributed control networks. A control network enables any group of electrical devices, called nodes, to be linked together to implement sensing, monitoring, control and communications capabilities for a variety of applications. Control networks, an alternative to the traditional approach of centralized control, offer decreased costs of installation and maintenance and the ability to implement multi-vendor systems, thereby increasing competition while providing expanded features, flexibility and functionality. Echelon's control networking technology allows intelligence and communications capabilities to be embedded into individual control devices that can be connected together through a variety of communications media, such as a twisted pair of wires (data cable) and the existing power lines in a facility. The intelligent, networked control devices are then able to communicate with each other, peer-to-peer, to perform the desired control functions. In effect, the network becomes the controller, eliminating the need for central controllers, significantly reducing wiring costs and enhancing system functionality and flexibility. The Company markets its products and services to OEMs and systems integrators in the building, industrial, transportation, home and other automation markets. The Company sells primarily through a direct sales force in North America and other countries where it has operations, and augments its direct sales efforts with distributors in Europe, Japan and Asia Pacific. Representative customers include Bombardier, Edwards, Fuji Electric, Hitachi, Honeywell, Johnson Controls, Kawasaki, Landis & Staefa and Raytheon. INDUSTRY BACKGROUND Control systems manage key functions in virtually every type of facility that affects our daily lives, such as buildings, factories, transportation systems and homes. These functions can be as simple as turning a light on and off and as complex as operating a chemical production line. For example, a common application of a control system is to enable a thermostat to communicate with other equipment in a building to automatically adjust temperature and airflow. In addition to interconnecting and monitoring heating, ventilation and air conditioning ("HVAC"), control systems are used within buildings to manage such functions as elevators, lighting, security and access control. In industrial facilities, these systems are used to automate semiconductor manufacturing equipment, oil pumping stations, textile dyeing machinery and hundreds of other applications. In transportation systems, control systems are used to regulate such features as propulsion, braking and heating systems. Control systems consist of an array of hardware devices and software used to collect data from the physical world and convert that data to electrical signals. These signals, in turn, provide information that can be used to effect responses based upon pre-programmed rules and logic. Traditionally, most control systems have incorporated closed, centrally-controlled architectures. These systems share many of the same drawbacks of centralized computing architectures that rely upon mainframes and minicomputers to communicate to "dumb" terminals that lack independent processing capabilities. Products for control systems are typically designed and manufactured by OEMs that focus on one or more vertical markets, such as HVAC systems for buildings, or braking control systems for trains. Control systems are typically installed and maintained by specialty contractors, or "systems integrators," and in some instances by the in-house installation and maintenance divisions of OEMs. Closed, centralized control systems have a number of inherent disadvantages for OEMs, systems integrators and end-users. OEMs, as the designers of control systems and, in some instances, developers of their own protocols, incur significant development and ongoing support expense to implement and maintain their closed infrastructures. In addition, supporting such a closed infrastructure takes valuable resources away from developing competitive applications and limits the OEM's ability to leverage the product development efforts of third party companies who use open platforms. Finally, centralized systems also risk complete shutdown if the central controller fails. 29 For systems integrators, the installation of closed, centralized control systems is typically characterized by the time-consuming and costly physical task of installing large amounts of wire and conduit to connect each component to one or more central controllers. Once the physical infrastructure is installed, specially-trained and highly-skilled personnel must program, install and "debug" detailed control logic software into the controllers in order to manage the disparate components. To the extent that a facility incorporates control systems from more than one OEM, systems integrators also spend considerable time connecting systems that were not designed to interoperate, such as HVAC and fire/life/safety systems. This complex process also makes modifications to the system expensive and time consuming. Because of the excessive costs of installing and modifying closed, centrally- controlled systems, end-users, who ultimately must pay for these products and services, often cannot acquire new applications at an affordable cost. The Company believes that these factors have reduced the market opportunity for both OEMs and systems integrators to sell new products, functions and applications to end-users. OEMs, systems integrators and end-users are increasingly seeking to overcome the limitations of closed, centralized systems. As with the computer industry's move away from centralized computing architectures, the Company believes that across a broad range of control applications, the control industry is moving away from custom, wiring-intensive and closed interconnection schemes among various system components, towards open, interoperable, distributed architectures in which the control intelligence resides among the sensors and actuators in an intelligent network, rather than in central controllers. THE ECHELON SOLUTION Echelon develops, markets and supports a family of hardware and software products and services that enables OEMs and systems integrators to design and implement open, interoperable, distributed control networks. Echelon's networking technology allows intelligence and communications capabilities to be embedded into individual control devices that can be connected together through a variety of communications media such as a twisted pair of wires (data cable) and the existing power lines in a facility. The intelligent, networked control devices are then able to communicate with each other, peer- to-peer, to perform the desired control functions. For example, a temperature sensor might detect a change in temperature and send a message over the network that is received and acted upon by other devices that have been configured to accept the message. In effect, the network becomes the controller, eliminating the need for central controllers, significantly reducing wiring costs and enhancing system functionality and flexibility. The Company offers a comprehensive set of products and services that provides the infrastructure and support required to build and implement open, multi-vendor, interoperable, control network solutions for building, industrial, transportation, home and other automation markets. The Company's products are based on its LonWorks networking technology, an open standard for interoperable networked control. In a LonWorks control network, intelligent control devices, called nodes, communicate using the Company's LonTalk protocol. Each node in the network contains embedded intelligence that implements the protocol and performs local sense and control functions. At the core of this embedded intelligence is the Neuron Chip, an integrated circuit that was initially designed by Echelon and is currently manufactured and sold by Motorola and Toshiba. In addition, the Company offers transceivers that couple the Neuron Chip to the communications medium; control modules that can significantly reduce OEM development cost; intelligent LonWorks routers that allow users to build large systems containing different networking media; network interfaces that connect computers to the network; development tools that allow OEMs to design LonWorks technology into their products; and software tools and toolkits that allow users to install, monitor, maintain and control their systems. 30 The diagrams below compare a control application implemented in a closed, centralized control system architecture with the same application implemented using Echelon's LonWorks distributed control network solution. [GRAPHIC DEPICTING CLOSED CENTRAL ARCHITECTURE] TRADITIONAL CLOSED, CENTRALLY-CONTROLLED SYSTEM ARCHITECTURE [GRAPHIC DEPICTING OPEN CONTROL NETWORK] ECHELON'S OPEN, DISTRIBUTED CONTROL NETWORK ARCHITECTURE The Company believes that its family of products and services provides the following benefits to its customers: . Installation Cost Savings. LonWorks based open control networks are less expensive to install than closed, centrally-controlled systems. By replacing individual hard-wired connections with shared network channels, wiring and conduit material and labor costs can be substantially reduced. By eliminating the need to program and debug complex control logic software, systems can be designed and commissioned more quickly by personnel with less specialized training. In addition, LonWorks based networks do not require expensive, performance-limiting gateways (which are used to enable communication between disparate systems) to connect control systems from multiple vendors. . Life-Cycle Cost Savings. LonWorks networks can eliminate many of the sources of high life-cycle costs found in traditional control systems. By providing an open, interoperable platform, LonWorks networks allow end- users to select the most cost-effective products and services for their applications from a broad range of OEMs. In addition, the inherent flexibility of the LonWorks network architecture permits modifications to the control system, including adding new products, features and functions, to be made at significantly lower cost. LonWorks technology also enables devices to be logically "rewired" across the network without the need to run new physical wire or to replace or reprogram devices. . Improved Quality and Functionality. With LonWorks networks, end-users may customize their control networks to their specific needs by incorporating products and applications from an array of applications providers. In open LonWorks networks, any piece of information from any device can easily be shared with any other device in the same control system, in a different control system, or in a computer system, without the need for custom programming or additional hardware. For example, a measurement system can analyze information from a manufacturing system and send back improvements within seconds 31 if the two systems communicate directly, rather than through a process where information is gathered and communicated manually over days or even weeks. . Improved Reliability. In a fully-distributed LonWorks control network, there is no single point of failure. Typically, the failure of a device on the network only affects a small subset of devices with which it interacts. Unlike devices in a centrally-controlled system, devices in a LonWorks network are "self-aware" and can take appropriate actions, such as returning to default set-points, to adapt to the error condition. In addition, by utilizing its built-in processing power, each device can keep track of its own status and can report problems before they occur. . Increased Market Demand. The Company believes that by eliminating high-cost centralized controllers and fostering interoperability between devices, LonWorks technology enables both OEMs and systems integrators to create low- cost, customized solutions to satisfy market demands that have not been met by traditional control systems. STRATEGY Echelon's objective is to be the leading supplier of products and services used in the growing market for open, interoperable control networks. Key elements of the Company's strategy to accomplish this objective include: . Extend Technological Leadership. Echelon's LonWorks networking technology is the foundation for a low-cost, flexible, interoperable and reliable platform for implementing networked control applications. The Company intends to leverage its position as the developer of the LonWorks platform, along with its expertise in networking software, distributed control systems and digital and analog circuit design, to deliver a full range of highly- functional and cost-effective products and systems that meet its customers' needs. . Target Industry-Leading OEM Customers. The Company seeks to develop broad industry support for its LonWorks platform. To help accomplish this objective, the Company works closely with industry-leading OEMs, such as Bombardier, Edwards and Honeywell, in the product design process and invests in programs that enable these customers to develop, market and support their products. The Company believes that close collaborative relationships with OEM customers will continue to accelerate the transition of its targeted industries toward open, multi-vendor architectures for control networks. . Develop Systems Integrator Distribution Channel. The Company believes that end-users increasingly prefer multi-vendor control networks in order to decrease life-cycle costs and improve the functionality of their control systems. In order to capitalize on this opportunity, the Company complements its OEM distribution channel by aggressively targeting independent systems integrators as an additional channel to install, configure and maintain highly-functional control networks for end-users. To more effectively meet the needs of systems integrators, the Company recently released its LonPoint System, which provides the infrastructure needed to implement open, interoperable, distributed control networks. The Company intends to continue promoting the benefits of the LonWorks technology and products to systems integrators and end-users as a means to create stronger demand for its control network solutions. . Increase Penetration of Existing Vertical Markets. While the Company's control network products are applicable across a broad range of industries, the Company intends to continue to focus its marketing efforts on those vertical markets in which it has established a large customer base, namely the building, industrial, transportation and home automation industries. The Company works closely with OEMs and systems integrators in these vertical markets to identify market needs, and targets its product development efforts to meet those needs. For instance, in 1997, the Company began shipping its network operating system, LonWorks Network Services, in response to the needs of OEMs for a multi-user platform to install, maintain, monitor and interface with control networks. In addition, the Company established the LonMark Interoperability Association in May 1994 to facilitate the development and implementation of interoperable LonWorks based control systems within various industries. Several industry leaders in the Company's targeted markets have announced and currently promote products that conform to these standards. 32 . Integrate LonWorks Control Networks with Enterprise Data Networks. The Company believes that the seamless integration between LonWorks control networks and enterprise data networks is important to enable end-users to remotely monitor and manage their control networks, as well as to collect and analyze data generated by their control networks. To meet this market demand, the Company is developing systems and technology that combine standard data networking and communications protocols with the Company's products and technology. In support of this effort, the Company recently entered into a strategic agreement with Toshiba and a non-binding memorandum of understanding with Cisco to develop products that integrate LonWorks control networks with enterprise data networks. . Leverage International Market Opportunities. With sales and marketing operations in 10 countries and 57.5% of the Company's total revenues in 1997 attributable to international sales, the Company has established a significant international presence. The Company plans to continue to devote significant resources to international sales, marketing and product development efforts to capitalize on markets for control networks outside of the United States. For example, the Company's most popular power line transceiver was designed to meet the requirements imposed by regulators in both North America and Europe, enabling OEMs to leverage their product development programs across these markets. MARKETS, APPLICATIONS AND CUSTOMERS The Company markets its products and services primarily in North America, Europe, Japan and selected Asia Pacific countries. The Company's target markets include: Building Automation. Companies worldwide are using LonWorks control networks in most facets of the building automation industry, including access control, automatic doors, elevators, energy management, fire/life/safety, HVAC, lighting, metering, security and window blinds. The Company believes that LonWorks networks are widely accepted because they lower installed system cost, reduce ongoing life-cycle costs and increase functionality. For example, a major automation project is currently being completed for British Airways' new combined business center, BA Waterside, near Heathrow Airport. The project uses LonWorks control networks throughout the six building campus to connect the building management, lighting and access control systems together in a unified system. Key customers in the building automation market include Honeywell, Johnson Controls, Landis & Staefa, Philips Lighting B.V., Schindler Elevator Corp. and Siebe. Industrial Automation. LonWorks control networks are found in semiconductor fabrication plants, gas compressor stations, gasoline tank farms, oil pumping stations, water pumping stations, textile dyeing machinery, pulp and paper processing equipment, automated conveyor systems and many other industrial environments. In such industrial installations, LonWorks networks can replace complex wiring harnesses, reduce installation costs, eliminate expensive programmable logic controllers and distribute control among sensors, actuators and other devices, thereby reducing system costs, improving control and eliminating the problem of a single point of failure, among other things. For example, Edwards, a leading supplier of vacuum pumping systems to the semiconductor industry, is using LonWorks control networks within each pumping station to replace complex wiring used to connect various motors, sensors, actuators and displays. The same control network is extended to connect up to 400 pumping stations together in a semiconductor fabrication plant to form a complete pumping system. Echelon's key customers in the industrial automation market include Brooks Instrument, Edwards, Fuji Electric, Hitachi, Lam Research Corporation and Marley Pump. Transportation. Echelon's technology is used in important transportation applications, including railcars, light rail, buses, motor coaches, fire trucks, naval vessels and aircraft. LonWorks networks can be used in these transportation systems to improve efficiency, reduce maintenance costs and increase safety and comfort. LonWorks technology has been specified as the standard for electro-pneumatic braking for freight transportation trains by the American Association of Railroads, and as one of the standards by the New York City Transit Authority for the replacement of its subway cars. Key OEMs in the transportation market include Bombardier, Cummins Engine, Kawasaki and Raytheon. 33 Home Automation and Other. While the home automation market is still in its infancy, numerous companies are now selling LonWorks based products for HVAC, lighting, security, utility meters and whole house automation. A number of utility companies located throughout the world, including CSW Communications (the holding company for Central and Southwest Utilities), Detroit Edison and Enron Energy Services in the United States, and Sydkraft and Scottish Hydro Electric in Europe, currently are pursuing residential projects involving LonWorks networks. Other industries in which LonWorks control networks have been utilized or are being developed for use include telecommunications (including alarm systems for switching equipment), agriculture (including feeding and watering systems) and medical instrumentation (including the use of CAT scans to create holographic images). PRODUCTS AND SERVICES The Company offers a comprehensive set of over 80 products and services marketed under the LonWorks brand name that provide the infrastructure and support required to implement and deploy open, interoperable, control network solutions. All of the Company's products either incorporate or operate with the Neuron Chip and the LonTalk protocol. While the Company recommends broad use of various of its products with other Echelon products, there is no inherent requirement for a customer to do so, given the Company's open networking technology. For instance, a customer's product could incorporate a transceiver purchased from the Company but could be installed with software that did not incorporate the Company's network operating system. LonWorks Control and Connectivity Products. This suite of hardware products, some with embedded firmware, serves as the physical interface between the control software resident on the managed devices and the cabling and wiring infrastructure. These products include a variety of transceivers, control modules, routers and network interface devices. Standard, off-the-shelf LonWorks transceivers and control modules simplify the development of LonWorks nodes, provide the foundation for interoperability and reduce the development cost and time for an OEM's product development. LonWorks routers provide transparent support for multiple media, which makes it possible to signal between different types of media, such as twisted pair, power line, radio frequency, optical fiber and infrared. Routers can also be used to control network traffic and partition sections of the network from traffic in another area, increasing the total throughput and speed of the network. Network interfaces can be used to connect computers to a LonWorks network. The Company's FTT-10 transceiver product, one of the LonWorks Control and Connectivity products, and the FTT-10A successor product, which permits communication over a twisted pair of wires, together have generated approximately 19% and 21% of the Company's revenues during the year ended December 31, 1997 and the three month period ended March 31, 1998, respectively. The FTT-10 was released in May 1994 and the FTT-10A was released in May 1997. LonWorks Network Services ("LNS"). Echelon's network operating system, LNS, serves as the platform for installing, maintaining, monitoring and interfacing with control networks. The LNS family of products adds the power of client- server architecture and component-based software design into control systems and allows tools from multiple vendors to work together. The Company's most recent release of LNS is version 1.5, which was first shipped in December 1997. The LonMaker for Windows tool, built on the LNS network operating system and the Visio technical drawing package, gives users a familiar, CAD-like environment in which to design their network's control system. The graphical nature of the LonMaker tool provides an intuitive interface for designing, installing and maintaining multi-vendor, open, interoperable LonWorks control networks. LNS also allows multiple users, each running their own copy of LonMaker for Windows or other LNS-based tools, to utilize the system in parallel, thereby streamlining the design and commissioning process, and facilitating future adds, moves and changes. LonMaker for Windows, released in version 1.0, was first shipped in June 1998. LonPoint System Products. In the second quarter of 1998, the Company began shipment of the LonPoint System, which provides the infrastructure to implement open, interoperable, distributed control networks. In contrast to traditional closed, centrally-controlled systems, the LonPoint System offers a flat network architecture 34 in which every device performs control processing. Distributing the processing throughout the network lowers installation and overall life-cycle costs, increases reliability by eliminating central points of failure, and provides the flexibility to adapt the system to a wide variety of applications. The LonPoint System includes a family of hardware and software products. Hardware products include interface modules (which convert a variety of legacy digital and analog sensors and actuators into intelligent and interoperable network devices), routers (which provide transparent connectivity and intelligent message passing between various combinations of standard LonWorks media), and scheduler modules (which provide system timekeeping and state coordination). The LonPoint System is installed using the LonMaker for Windows tool and includes LNS software plug-ins that provide end-users with a customized configuration view of each LonPoint module, thereby reducing the time and training required to configure LonPoint interface modules. Development Tools. Echelon provides development tools that are used by an OEM to design LonWorks technology into the OEM's products. The LonBuilder Developer's Workbench integrates a complete set of tools for developing LonWorks based control networks. These tools include an environment for developing and debugging applications at multiple nodes, a network manager to install and configure these nodes, and a protocol analyzer to examine network traffic to ensure adequate capacity and to debug errors. The LonBuilder Developer's Workbench represented approximately 18% of the Company's revenues during 1995. The Company's most recent release of this product is version 3.01, which was first shipped in July 1996. The NodeBuilder development tool is designed to make it easy for OEMs to develop and test individual LonWorks nodes. It uses a familiar Windows based development environment with easy-to-use on-line help. The NodeBuilder tool can complement the development capabilities of the LonBuilder Developer's Workbench, since the NodeBuilder tool can be used to develop individual nodes that are then integrated and tested as a system using the LonBuilder tool. The Company's most recent release of the NodeBuilder development tool is version 1.5, which was first shipped in August 1996. Training and Support. The Company conducts a variety of technical training courses covering its LonWorks network technology and products. These courses are designed to provide hands-on, in-depth and practical experience that can be used immediately by OEMs and systems integrators of LonWorks systems. The Company also offers technical support to its customers on a per incident and annual contract basis. These support services are intended to ensure proper use of the Company's products and to shorten development time for the customer's products that use Echelon's technology through timely resolution of the customer's technical problems. As of May 31, 1998, the Company had 14 employees in the United States, Japan and the United Kingdom engaged in training and support. SALES AND MARKETING The Company markets and sells its products and services to OEMs and increasingly to systems integrators to promote the widespread use of its LonWorks technology. In addition, the Company believes that awareness of the benefits of LonWorks networks among end-users will increase demand "pull" for the Company's products. In North America, the Company sells its products through a direct sales organization. Outside the United States, direct sales, applications engineering and customer support are conducted through the Company's operations in China, France, Germany, Hong Kong, Italy, Japan, the Netherlands, South Korea and the United Kingdom. Each of these offices is staffed primarily with local employees. The Company supplements its worldwide sales personnel with application engineers and technical and industry experts working in the Company's headquarters. The Company also leverages its selling efforts through the use of an in-house telephone sales staff. Internationally, the Company augments its direct sales with the use of distributors. These distributors tend to specialize in certain geographical markets. The Company sells its products in Europe principally through EBV, its sole independent European distributor, and through its direct sales force. The Company relies solely on distributors in certain countries in the Asia Pacific region, including Australia and Taiwan, and in Latin America, through its distributor in Argentina. See "Risk Factors--Dependence on OEMs and Distribution Channels." 35 The Company has recently implemented an authorized network integrator program to increase the distribution of its products through systems integrators worldwide. These systems integrators design, install and service control systems using the Company's LonPoint System with legacy devices and other manufacturers' products that meet the certification guidelines of the LonMark Interoperability Association, thereby reducing dependence on single- vendor products, eliminating the risks of centralized, closed controllers and supporting less complex, peer-to-peer system architectures. The Company provides these systems integrators with access to the training, tools and products required to cost-effectively install, commission and maintain open, multi-vendor distributed control systems based on LonWorks control networks. The Company's marketing efforts are augmented by the LonMark Interoperability Association and the LonUsers International group. The LonMark Interoperability Association was formed by Echelon in May 1994 and has over 200 members. This Association defines the technical standards for interoperability for LonWorks technology and promotes the use of open control networks based on the LonMark standard. The purpose of LonUsers International, established by Echelon in 1991, is to provide a forum in which parties can share recent information concerning LonWorks technology and applications, build alliances and support the LonWorks standard for control networking. In 1997, LonUsers International meetings in North America, Europe and Asia drew nearly 4,000 participants. STRATEGIC ALLIANCES Neuron Chips, which are important components in control network nodes, are manufactured and sold by both Motorola and Toshiba. The Company has entered into licensing agreements with each of Motorola and Toshiba. Among other things, the agreements grant Motorola and Toshiba the worldwide right to manufacture and distribute Neuron Chips using technology licensed from the Company and require the Company to provide support and unspecified updates to the licensed technology over the terms of the agreements. The Motorola and Toshiba agreements expire in December 1999 and January 2000 respectively, unless renewed. However, both Motorola and Toshiba have the right to terminate the agreements at any time. While the Company developed the first version of the Neuron Chip, Motorola and Toshiba subsequently developed improved, lower- cost versions of the Neuron Chip that are presently utilized in products developed and sold by the Company and its customers. The Company currently has no other source of supply for Neuron Chips and has neither the resources nor the skills to replace either Motorola or Toshiba as a designer, manufacturer or distributor of Neuron Chips. Motorola and Toshiba have played, and are expected to continue to play, a key role in the development and marketing of LonWorks technology. The loss of either Motorola or Toshiba as a supplier of the Neuron Chip would have a material adverse effect on the business, operating results and financial condition of the Company, and in such event there can be no assurance that the Company would be able to locate an alternate source for the design, manufacture or distribution of Neuron Chips. See "Risk Factors--Dependence on Key Manufacturers" and "Certain Transactions." The Company has an agreement with Toshiba and a non-binding memorandum of understanding with Cisco to develop products that integrate LonWorks control networks into enterprise data networks. Echelon's joint development agreement with Toshiba is intended to enable products and technologies to be developed using the Java programming language to program LonWorks control devices. The Company expects that its relationship with Cisco will result in jointly- developed products that simplify enterprise-wide integration of LonWorks control and Internet protocol data networks. PRODUCT DEVELOPMENT The Company's future success depends in large part on its ability to enhance existing products, lower product cost and develop new products that maintain technological competitiveness. The Company has made and intends to continue to make substantial investments in product development. The Company recently has made significant engineering investments in bringing its LNS network operating system and LonPoint System products to market. Extensive product development input is obtained from customers and by monitoring end-user needs and changes in the marketplace. See "Risk Factors--New Products and Rapid Technological Change." 36 The Company's total expenses for product development for the three months ended March 31, 1998 and for fiscal 1997 and 1996 were $2.0 million, $7.1 million and $7.5 million, respectively. The Company anticipates that it will continue to commit substantial resources to product development in the future and that product development expenses may increase in the future. To date, the Company's development efforts have not resulted in any capitalized software development costs. As of May 31, 1998, the Company's product development organization consisted of 44 personnel. COMPETITION Competition in the Company's markets is intense and involves rapidly changing technologies, evolving industry standards, frequent new product introductions and rapid changes in customer requirements. To maintain and improve its competitive position, the Company must continue to develop and introduce, on a timely and cost-effective basis, new products, features and services that keep pace with the evolving needs of its customers. The principal competitive factors affecting the markets for the Company's control network products are customer service and support, product reputation, quality, performance and price, and product features such as adaptability, scalability, ability to integrate with other products, functionality and ease of use. The Company believes it has in the past generally competed favorably with offerings of its competitors on the basis of these factors. However, there can be no assurance that the Company will continue to be able to compete effectively based on these or any other competitive factors in the future. In each of its markets, the Company competes with a wide array of manufacturers, vendors, strategic alliances, systems developers and other businesses. The Company's competitors include some of the largest companies in the electronics industry, such as Siemens in the building and industrial automation industries and Allen-Bradley and Schneider in the industrial automation industry. Many of the Company's competitors, alone or together with their trade associations and partners, have longer operating histories, significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition and broader product offerings. As a result, such competitors may be able to devote greater resources to the development, marketing and sale of their products, and may be able to respond more quickly to changes in customer requirements or product technology. In addition, those competitors that manufacture and promote closed, centralized proprietary systems may enjoy a captive customer base dependent on such competitors for service, maintenance, upgrades and enhancements. Accordingly, there can be no assurance that the Company will be able to compete successfully with existing or new competitors, or that competition will not have a material adverse effect on the business, operating results or financial condition of the Company. Many of the Company's current and prospective competitors are dedicated to promoting closed or proprietary systems, technologies, software and network protocols or product standards that differ from, or are incompatible with, those of the Company. In some cases, companies have established associations or cooperative relationships to enhance the competitiveness and popularity of their products, or to promote such different or incompatible technologies, protocols and standards. For example, in the building automation market, the Company faces widespread reluctance by vendors of traditional closed or proprietary control systems (who enjoy a captive market for servicing and replacing equipment) to utilize the Company's interoperable technologies, as well as strong competition by large trade associations that promote alternative technologies and standards in their native countries, such as the BatiBus Club International in France and the European Installation Bus Association in Germany (each of which has over 100 members and licensees). Other examples include the CEBus Industry Council, which is the proponent of an alternative protocol to the Company's LonTalk protocol for use in the home automation industry, and a group comprised of Asea Brown Boveri, ADtranz AB, Siemens, GEC Alstrom and other manufacturers that support an alternative rail transportation protocol to LonWorks networks. The Company works with standards-setting organizations to establish open markets for LonWorks products in the Company's targeted markets. There can be no assurance that the Company's technologies, protocols or standards will be successful in any of its markets, or that the Company will be able to compete with new or enhanced products or standards introduced by existing or future competitors. Any increase in competition or failure by the Company to effectively compete with new or enhanced products or standards could result in fewer customer 37 orders, price reductions, reduced order size, reduced operating margins and loss of market share, any of which could have a material adverse effect on the business, operating results or financial condition of the Company. See "Risk Factors--Competition." LonWorks technology is open, meaning that many of the Company's key technology patents are broadly licensed without royalties or license fees. As a result, the Company's customers are capable of developing products that compete with some of the Company's products. Because some of the Company's customers are OEMs that develop and market their own control systems, these customers in particular could develop competing products based on the Company's open technology. This could decrease the market for the Company's products, increase competition, and have a material adverse effect on the Company's business, operating results and financial condition. See "Business-- Products and Services." MANUFACTURING The Company's manufacturing strategy is to outsource production to third parties where it is more cost- effective and to limit its internal manufacturing to such tasks as quality inspection, system integration, testing and order fulfillment. Echelon maintains manufacturing agreements with Motorola and Toshiba related to the Neuron Chip, an important component in many of the Company's products. Additionally, for certain key products, the Company utilizes outsourced manufacturers including GET, Hi-Tech, muRata and Quadrus. These outsourced manufacturers procure material and assemble, test and inspect the final products to the Company's specifications. The Company's future success will depend, in significant part, on its ability to successfully manufacture its products cost-effectively and in sufficient volumes. To date, the Company has not experienced any significant delays or material unanticipated costs resulting from the use of third party manufacturing; however, such a strategy involves certain risks, including the potential absence of adequate capacity and reduced control over delivery schedules, manufacturing yields, quality and costs. The loss of either Motorola or Toshiba as a supplier of the Neuron Chip would have a material adverse effect on the business, operating results and financial condition of the Company, and in such event there can be no assurance that the Company would be able to locate an alternate source for the design, manufacture or distribution of Neuron Chips. Further, several key components are currently purchased only from sole or limited sources. Any interruption in the supply of these components, or the inability of the Company to procure these components from alternate sources at acceptable prices and within a reasonable time, could have a material adverse effect upon the Company's business, operating results and financial condition. See "Risk Factors--Dependence on Key Manufacturers." GOVERNMENT REGULATION Many of the Company's products and the industries in which they are used are subject to U.S. and foreign regulation. Government regulatory action could greatly reduce the market for the Company's products. For example, the power line medium (the communications medium used by some of the Company's products) is subject to special regulations in North America, Europe and Japan. These regulations limit the ability of companies in general to use power lines as a communication medium. In addition, some of the Company's competitors have attempted to use regulatory actions to reduce the market opportunity for the Company's products or to increase the market opportunity for the competitors' products. For example, CEMA, a trade association that developed the CEBus protocol for use in home automation applications, has proposed that the FCC adopt a standard for television-cable compatibility that encompasses CEBus. CEMA has also proposed the use of such standard with respect to an FCC rule making relating to the commercial availability of navigation devices, such as set-top boxes. The Company has resisted these efforts and will continue to oppose competitors' efforts to use regulation to impede competition in the markets for the Company's products. There can be no assurance that existing or future regulations or regulatory actions would not adversely affect the market for the Company's products or require significant expenditures of management or financial resources, any of which could have a material adverse effect on the Company's business, operating results and a financial condition. See "Risk Factors--Regulatory Actions." 38 PROPRIETARY RIGHTS The Company is the owner of numerous patents, trademarks and logos. As of May 31, 1998, the Company had received 65 United States patents, and has 21 patent applications pending. Some of these patents have also been granted in selected foreign countries. Many of the specific patents that are fundamental to LonWorks technology have been licensed to the Company's customers with no license fee or royalties. The principal value of the remaining patents relates to the Company's specific implementation of its products. See "Risk Factors-- Competition" and "--Limited Protection of Intellectual Property Rights." The Company holds several registered trademarks in the United States, including Echelon, LonBuilder, LonMark, LonTalk, LonUsers, LonWorks, Neuron and NodeBuilder. The Company has also registered some of its trademarks and logos in foreign countries. EMPLOYEES As of May 31, 1998, the Company had 154 employees worldwide, of which 44 were in product development, 23 were in operations, 51 were in sales and marketing, 14 were in customer support and training and 22 were in general and administrative. Approximately 115 employees are located at the Company's headquarters in Palo Alto, California. The Company has employees in 10 countries worldwide, with the largest concentrations outside the United States in Japan, the Netherlands and the United Kingdom. None of the Company's employees is represented by a labor union. The Company has not experienced any work stoppages and considers its relations with its employees to be good. FACILITIES The Company leases approximately 55,000 square feet of office, manufacturing and distribution facilities in Palo Alto, California under two leases that expire on June 30, 2000. The Company has an option to extend the lease of a portion of the facilities for a five year period. The aggregate rental expense under these leases will be approximately $1.4 million during 1998. The Company also leases office space for its employees in China, France, Germany, Hong Kong, Italy, Japan, the Netherlands and the United Kingdom. The aggregate rental expense for such office space will be approximately $348,000 during 1998. The Company believes that additional office space will be available as required on acceptable terms. LEGAL PROCEEDINGS There are no material legal proceedings to which the Company is a party or to which any of its properties are subject, nor are there any material legal proceedings known to the Company to be contemplated by any governmental authority against the Company or any of its properties. 39 MANAGEMENT EXECUTIVE OFFICERS AND DIRECTORS
NAME AGE POSITION ---- --- -------- M. Kenneth Oshman........... 58 Chairman of the Board, President & Chief Executive Officer, Director Gibson Anderson............. 56 Vice President, Human Resources Frederik Bruggink........... 43 Vice President, Europe, Middle East and Africa Lawrence Y.H. Chan.......... 47 Vice President, Asia Pacific and Japan Robert A. Dolin............. 43 Vice President and Chief Technology Officer James M. Kasson............. 55 Vice President, Chief Information Officer Kenneth E. Lavezzo.......... 56 Vice President of Operations Peter A. Mehring............ 36 Vice President, Engineering Oliver R. Stanfield......... 49 Vice President, Finance & Chief Financial Officer Edwin R. Sterbenc........... 53 Vice President, Americas Beatrice Yormark............ 53 Vice President of Marketing and Sales Armas Clifford Markkula, Jr.(1)..................... 56 Vice Chairman of the Board, Director Bertrand F. Cambou.......... 42 Director Robert R. Maxfield(2)....... 56 Director Richard M. Moley(2)......... 59 Director Arthur Rock(1).............. 71 Director Larry W. Sonsini............ 57 Director
- -------- (1) Member of the Audit Committee. (2) Member of the Compensation Committee. The Board of Directors is divided into three classes, designated as Class A, Class B and Class C. The term of the Class A directors expires at the Company's annual meeting of stockholders in 1999 and each third annual meeting thereafter. M. Kenneth Oshman and Larry W. Sonsini have been designated as Class A directors. The term of the Class B directors expires at the Company's annual meeting of stockholders in 2000 and each third annual meeting thereafter. Bertrand Cambou, Clifford Markkula, Jr. and Robert R. Maxfield have been designated as Class B directors. The term of the Class C directors expires at the Company's annual meeting of stockholders in 2001 and each third annual meeting thereafter. Richard M. Moley and Arthur Rock have been designated as Class C directors. Officers are appointed by the Board of Directors and serve at the discretion of the Board. There are no family relationships among the officers and directors of the Company. M. Kenneth Oshman has been President and Chief Executive Officer of the Company since December 1988. Mr. Oshman, with three associates, founded ROLM Corporation ("ROLM"), a telecommunications equipment company, in 1969. He was Chief Executive Officer, President, and a director at ROLM from its founding until its merger with IBM in 1984. Following the merger, he became a Vice President of IBM and a member of the Corporate Management Board. He remained in that position until he left IBM in 1986. Prior to founding ROLM, Mr. Oshman was a member of the technical staff at Sylvania Electric Products from 1963 to 1969. In addition to his responsibilities at Echelon, Mr. Oshman serves as a director of Sun Microsystems, Knight-Ridder, Inc. and CMC Industries, Inc. Mr. Oshman earned B.A. and B.S.E.E. degrees from Rice University and M.S. and Ph.D. degrees in Electrical Engineering at Stanford University. Gibson Anderson has been Vice President, Human Resources of the Company since February 1997 and was the Director of Human Resources of the Company from 1990 to 1997. Mr. Anderson was employed by ROLM from 1971 to 1986, where he held positions in engineering, marketing, manufacturing and human resources. Before joining ROLM, he spent three years at Hewlett-Packard developing data acquisition systems and three years at IBM performing analog and digital circuit design and research in computerized speech recognition. 40 Mr. Anderson holds B.A. and B.S.E.E. degrees from Rice University and a M.S. degree in Electrical Engineering from Stanford University. Frederik Bruggink has been Vice President, Europe, Middle East and Africa, since April 1996. Mr. Bruggink joined the Company from Banyan Systems, where he was Vice President, Europe. From 1985 to 1993, Mr. Bruggink held several positions at Stratus Computer, including General Manager positions for Holland, Benelux, and Northern Europe. His last position at Stratus was Vice President, Northern Europe (including Germany). Prior to joining Stratus, he held sales positions at Burroughs Computers. Mr. Bruggink attended the University of Leiden. Lawrence Y.H. Chan joined the Company in April 1997 as Vice President of Asia Pacific and Japan and is based in Hong Kong. Prior to joining the Company, Mr. Chan was Vice President of Asia Pacific and Japan for Banyan Systems. Prior to that, he held management positions at Stratus Computer, both in the U.S. and Hong Kong. Prior to joining Stratus, he held positions with ComputerVision, Oriental Data Systems, Ltd., Hong Kong Terminals, John Swire and Sons, Ltd., Kowloon Container Terminals Ltd. and NCR Hong Kong Ltd. Mr. Chan received a General Certificate of Education from the University of London, a degree in Electrical Engineering from Hong Kong Technical College and a degree in Computer Programming from Hong Kong University. Robert A. Dolin has been Vice President and Chief Technology Officer of the Company since May 1995. From 1989 until 1995, Mr. Dolin was the Director of Systems Engineering of the Company. Before joining the Company, Mr. Dolin was Manager of Architecture at ROLM where he worked for 12 years. He has a B.S. degree in Electrical Engineering and Computer Science from the University of California at Berkeley. James M. Kasson has been Vice President, Chief Information Officer of the Company since November 1997. He served as Vice President of Engineering of the Company from May 1995 to November 1997. From 1988 until May 1995, he was an IBM Fellow, first as Director of IBM's Advanced Telecommunications Research Laboratory and later at the Almaden Research Center in San Jose where he worked in research on a wide variety of electronic imaging systems. Mr. Kasson joined ROLM in 1973, which was purchased by IBM in 1984. Mr. Kasson received a B.S. degree in Electrical Engineering from Stanford University and an M.S. degree in Electrical Engineering from the University of Illinois. Kenneth E. Lavezzo has been Vice President of Operations of the Company since September 1990 and has been employed by the Company since 1989. Mr. Lavezzo joined the Company from ROLM, where he was the Director responsible for Phonemail and Voice Applications. He also served as General Manager of the Phones Division. Mr. Lavezzo joined ROLM in 1973 and held a variety of other positions ranging from product design and program management to production and manufacturing management. Prior to joining ROLM, he spent seven years at Hewlett-Packard as a member of the technical staff developing medical products and high-speed data acquisition products. Mr. Lavezzo received a B.S. degree in Electrical Engineering from the University of California at Berkeley. Peter A. Mehring has been Vice President, Engineering of the Company since March 1998. From January 1996 to March 1998, Mr. Mehring held a variety of positions at Umax Computer Corporation ("Umax") where he was a Founder, General Manager, and Vice President of research and development. From March 1995 to December 1995, Mr. Mehring held engineering management positions at Radius, Inc., Power Computing Corporation, Sun Microsystems, Inc., and Wang Laboratories, Inc. Mr. Mehring received a B.S. degree in Electrical Engineering from Tufts University, Massachusetts. Oliver R. Stanfield has been Vice President of Finance & Chief Financial Officer of the Company since March 1989. Mr. Stanfield joined the Company from ROLM, where he served in several positions since 1980, including Director of Pricing; Vice President, Plans and Controls; Vice President, Business Planning; Vice President, Financial Planning and Analysis; Treasurer; and Controller, Mil Spec Division. Prior to joining ROLM, Mr. Stanfield worked for ITEL Corporation, Computer Automation and Rockwell International. Mr. Stanfield began his business career with Ford Motor Company in 1969 in various accounting positions while completing a B.S. in Business Administration and an M.B.A. degree from the University of Southern California. 41 Edwin R. Sterbenc joined the Company in April 1997 as Vice President, Americas. Prior to joining the Company, Mr. Sterbenc was with Tandem Computers, Inc. from 1987 to 1997. At Tandem, he held positions in sales, international sales and marketing. Prior to joining Tandem Computers, Inc., Mr. Sterbenc was Vice President of Sales at Syntelligence. He was a Sales Manager for Cullinet Software from 1984 to 1986, and held positions in sales, marketing and sales management at IBM from 1973 to 1984. Mr. Sterbenc worked at Inland Steel prior to joining IBM. Mr. Sterbenc holds a B.S. degree in Industrial Management and an A.A.S. degree in Computer Science from Purdue University. Beatrice Yormark has been Vice President of Marketing and Sales of the Company since January 1990. Ms. Yormark joined the Company from Connect, Inc., an on-line information services company, where she was the company's Chief Operating Officer. Before joining Connect, Ms. Yormark held a variety of positions, including Executive Director of Systems Engineering for Telaction Corporation, Director in the role of Partner at Coopers & Lybrand, Vice President of Sales at INTERACTIVE Systems Corporation, and various staff positions at the Rand Corporation. Ms. Yormark received a B.S. degree in Mathematics from City College of New York and an M.S. degree in Computer Science from Purdue University. Armas Clifford Markkula, Jr. is the founder of the Company and has served as a director since 1988. He has been Vice Chairman of the Company's Board since 1989. Mr. Markkula was Chairman of the Board of Directors of Apple Computer, Inc. from October 1993 to February 1996 and was a director from 1977 to 1997. A founder of Apple, he held a variety of positions there, including President/Chief Executive Officer and Vice President of Marketing. Prior to founding Apple, Mr. Markkula was with Intel Corporation as Marketing Manager, Fairchild Camera and Instrument Corporation as Marketing Manager in the Semiconductor Division, and Hughes Aircraft as a member of the technical staff in the company's research and development laboratory. Mr. Markkula received B.S. and M.S. degrees in Electrical Engineering from the University of Southern California. Bertrand F. Cambou has been a director of the Company since 1998. He has been Senior Vice President and General Manager of the Networking and Computing System Group of Motorola since 1997. Between 1984 and 1997 he held various management positions within Motorola in Operations and Research and Development. From 1980 to 1984, he participated in the founding of Matra Harris Semiconductor. Dr. Cambou received a B.S. degree in Electrical Engineering from Supelec University, France, a Masters degree in Physics from Toulouse University and a Doctorate degree in Electronics from Paris University. Robert R. Maxfield has been a director of the Company since 1989. He was a co-founder of ROLM in 1969, and served as Executive Vice President and a director until ROLM's merger with IBM in 1984. Following the merger, he continued to serve as Vice President of ROLM until 1988. Since 1988, he has been a consulting professor in the Electrical Engineering and Engineering- Economic Systems Departments at Stanford University, and was a venture partner with Kleiner, Perkins, Caufield & Byers from 1989 to 1992. He serves as a director of Cedro Group Inc. Dr. Maxfield received B.A. and B.S.E.E. degrees from Rice University, and M.S. and Ph.D. degrees in Electrical Engineering from Stanford University. Richard M. Moley has been a director of the Company since February 1997. Mr. Moley was Senior Vice President, Wide Area Business Unit, of Cisco Systems, Inc. from July 1996 to July 1997. He served as President and Chief Executive Officer of StrataCom, Inc. from June 1986 to July 1996, when StrataCom was acquired by Cisco. Mr. Moley serves on the Board of Directors of Linear Technology, Inc. and Cidco, Inc. Mr. Moley received a B.S. degree in Electrical Engineering from Manchester University, an M.S. degree in Electrical Engineering from Stanford University and an M.B.A. from the University of Santa Clara. Arthur Rock has been a director of the Company since December 1988. Mr. Rock has been Principal of Arthur Rock & Co., a venture capital firm, since 1969. He has been a director of Intel since its founding in 1968, and is presently Chairman of the Executive Committee and Lead Director of the Board of Directors of Intel. He is also a director of Argonaut Group, Inc. and AirTouch Communications, Inc., and a trustee of California Institute of Technology. Mr. Rock received a B.S. degree in Political Science and Finance from Syracuse University and an M.B.A. from Harvard University. 42 Larry W. Sonsini has been a director of the Company since August 1993. Mr. Sonsini serves as Chairman of the Executive Committee of the law firm of Wilson Sonsini Goodrich & Rosati, where he has practiced since 1966. Mr. Sonsini serves as a director of Novell, Inc., Lattice Semiconductor Corporation and PIXAR Inc. Mr. Sonsini received an A.B. degree in Political Science and Economics and an L.L.B. degree from the University of California at Berkeley. BOARD COMMITTEES The Board of Directors of the Company has an Audit Committee and a Compensation Committee. The Audit Committee, which is comprised of Messrs. Markkula and Rock, approves the Company's independent auditors, reviews the results and scope of annual audits and other accounting related services and evaluates the Company's internal control functions. The Compensation Committee, comprised of Messrs. Maxfield and Moley, reviews and makes recommendations to the Board of Directors regarding the compensation policy for executive officers, directors and consultants of the Company. The Compensation Committee also administers the Company's stock plans. The Audit and Compensation Committees were established in May 1996. DIRECTOR COMPENSATION The Company does not pay any compensation to directors for serving in that capacity. Non-employee directors are automatically eligible to participate in the 1998 Director Option Plan. See "Management--Stock Option Plans and Warrants." LIMITATION OF LIABILITY AND INDEMNIFICATION MATTERS The Company's Certificate of Incorporation limits the liability of directors to the maximum extent permitted by Delaware law. Delaware law provides that directors of a company will not be personally liable for monetary damages for breach of their fiduciary duties as directors, except for liability (i) for any breach of their duty of loyalty to the company or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) for unlawful payments of dividends or unlawful stock repurchases or redemptions as provided in Section 174 of the Delaware General Corporation Law, or (iv) for any transaction from which the director derived an improper personal benefit. The Company's Bylaws provide that the Company shall indemnify its officers and directors and may indemnify its employees and other agents to the fullest extent permitted by law. The Company believes that indemnification under its Bylaws covers at least negligence and gross negligence on the part of indemnified parties. The Company's Bylaws also permit it to secure insurance on behalf of any officer, director, employee or other agent for any liability arising out of his or her actions in such capacity, regardless of whether the Bylaws would permit indemnification. The Company has entered into agreements to indemnify its directors and officers, in addition to the indemnification provided for in the Company's Bylaws. These agreements, among other things, indemnify the Company's directors and officers for certain expenses (including attorneys' fees), judgments, fines and settlement amounts incurred by any such person in any action or proceeding, including any action by or in the right of the Company, arising out of such person's services as a director or officer of the Company, any subsidiary of the Company or any other company or enterprise to which the person provides services at the request of the Company. The Company believes that these provisions and agreements are necessary to attract and retain qualified persons as directors and officers. At present, there is no pending litigation or proceeding involving any director, officer, employee or agent of the Company, where indemnification will be required or permitted. The Company is not aware of any threatened litigation or proceeding which may result in a claim for such indemnification. 43 EXECUTIVE COMPENSATION The following table sets forth certain summary information regarding compensation earned in the fiscal year ended December 31, 1997 by the Company's Chief Executive Officer and each of the Company's four other most highly paid executive officers (collectively, the "Named Executive Officers").
LONG-TERM ANNUAL COMPENSATION COMPENSATION ---------------------------- ------------- SECURITIES NAME AND PRINCIPAL OTHER ANNUAL UNDERLYING ALL OTHER POSITION SALARY BONUS COMPENSATION OPTIONS(#)(1) COMPENSATION(2) - ------------------ -------- ------ ------------ ------------- --------------- M. Kenneth Oshman Chairman of the Board, President and CEO...... $270,000 $ -- $ -- -- $1,636 Oliver R. Stanfield Vice President of Fi- nance and CFO.......... 260,000 -- -- 150,000 1,438 Beatrice Yormark Vice President of Mar- keting and Sales....... 260,000 -- -- 150,000 1,584 James M. Kasson Vice President, Chief Information Officer.... 230,000 -- -- 100,000 1,122 Kenneth E. Lavezzo Vice President of Oper- ations................. 220,000 -- -- 75,000 998
- -------- (1) The options were granted under the Company's 1997 Stock Plan. See "--Stock Option Plans and Warrants" for a description of the 1997 Stock Plan. (2) Consists of premiums paid by the Company for life insurance coverage. OPTION GRANTS DURING THE FISCAL YEAR ENDED DECEMBER 31, 1997 The following table sets forth certain information regarding the stock options granted during the fiscal year ended December 31, 1997 to each of the Named Executive Officers. No stock appreciation rights were granted to those individuals during the fiscal year ended December 31, 1997.
INDIVIDUAL GRANTS(1) ----------------------------------------------- POTENTIAL REALIZABLE VALUE AT ASSUMED ANNUAL RATES OF NUMBER OF STOCK PRICE SECURITIES % OF TOTAL APPRECIATION FOR UNDERLYING OPTIONS EXERCISE OPTION TERM (4) OPTIONS GRANTED TO PRICE EXPIRATION -------------------- NAMED EXECUTIVE OFFICER GRANTED EMPLOYEES(2) PER SHARE(3) DATE 5% 10% - ----------------------- ---------- ------------ ------------ ---------- --------- ---------- M. Kenneth Oshman....... -- -- -- -- -- -- Oliver R. Stanfield..... 150,000 6.9% $1.40 6/10/02 $58,019 $128,207 Beatrice Yormark........ 150,000 6.9 1.40 6/10/02 58,019 128,207 James M. Kasson......... 100,000 4.6 1.40 6/10/02 38,679 85,471 Kenneth E. Lavezzo...... 75,000 3.4 1.40 6/10/02 29,010 64,104
- -------- (1) All options granted during the fiscal year were granted under the 1997 Stock Plan. Each option is immediately exercisable and vests according to a vesting schedule, subject to the employee's continued employment with the Company. See "--Stock Option Plans and Warrants." (2) Based on a total of 2,185,700 options granted to all employees during the fiscal year ended December 31, 1997. (3) The exercise price per share of options granted represented the fair market value as determined by the Board of Directors on June 10, 1997, the date the options were granted. 44 (4) Potential gains are net of the exercise price but before taxes associated with the exercise. The 5% and 10% assumed annual rates of compounded stock appreciation based upon the deemed fair market value as mandated by the rules of the Securities and Exchange Commission and do not represent the Company's estimate or projection of the future common stock price. Actual gains, if any, on stock option exercises are dependent on the future financial performance of the Company, overall market conditions and the option holders' continued employment through the vesting period. This table does not take into account any appreciation in the deemed fair market value of the Common Stock from the date of grant to the date of this Prospectus, other than the columns reflecting assumed rates of appreciation of 5% and 10%. AGGREGATE OPTION EXERCISES IN 1997 AND 1997 FISCAL YEAR-END OPTION VALUES There were no option exercises by the Named Executive Officers in the fiscal year ended December 31, 1997. The following table sets forth for each Named Executive Officer the number of shares covered by exercisable stock options as of December 31, 1997. Also reported are values for "in-the-money" options that represent the positive spread between the respective exercise prices of outstanding options and the fair market value of the Company's Common Stock as of December 31, 1997, as determined by the Board of Directors of the Company. No stock appreciation rights to those individuals were outstanding during the fiscal year ended December 31, 1997.
NUMBER OF SECURITIES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED OPTIONS AT FISCAL YEAR- IN-THE-MONEY OPTIONS AT END FISCAL YEAR-END(1)(2) ------------------------- ------------------------- EXERCISABLE UNEXERCISABLE NAME EXERCISABLE UNEXERCISABLE ($) ($) - ---- ----------- ------------- ----------- ------------- M. Kenneth Oshman........... -- -- $ -- $ -- Oliver R. Stanfield......... 300,000(3) -- -- -- Beatrice Yormark............ 300,000(3) -- -- -- James M. Kasson............. 175,000(4) -- -- -- Kenneth E. Lavezzo.......... 75,000(5) -- -- --
- -------- (1) Options granted under the 1988 Stock Option Plan and 1997 Stock Plan may be exercised immediately upon grant and prior to full vesting, subject to the optionee's entering into a restricted stock purchase agreement with the Company with respect to any unvested shares. (2) Calculated by determining the difference between fair market value of the securities underlying the option at December 31, 1997 ($1.40 per share, as determined by the Board of Directors) and the exercise price ($1.40 per share) of the options. (3) Includes 37,500 vested shares and 262,500 unvested shares as of December 31, 1997. (4) Includes 18,750 vested shares and 156,250 unvested shares as of December 31, 1997. (5) Includes no vested shares and 75,000 unvested shares as of December 31, 1997. STOCK OPTION PLANS AND WARRANTS 1988 Stock Option Plan. A total of 8,900,000 shares of Common Stock were reserved for issuance under the Company's 1988 Stock Option Plan (the "1988 Plan"), the reservation of which shares was approved by the Company's stockholders. The 1988 Plan was terminated as to new option grants, effective as of April 23, 1997. Outstanding options granted and unvested stock issued under the 1988 Plan remain subject to the terms and conditions of the agreements evidencing those grants or issuances. The Board currently administers the 1988 Plan with respect to the outstanding options and stock issuances and has full authority to interpret and construe the provisions of those options and issuances. As of March 31, 1998, 4,996,813 shares of Common Stock had been issued upon the exercise of stock options granted under the 1988 Plan, 2,072,770 shares were outstanding (the "Outstanding 1988 Plan Options"), no shares had been issued upon the exercise of stock purchase rights, and as a result of the termination of the 1988 Plan, all shares that had been available for future grant were returned to the status of authorized and unissued shares. Of the Outstanding 1988 Plan Options, the per share 45 exercise prices range from $0.15 to $1.40 and the expiration dates range from May 19, 1998 to November 12, 2001. The 1988 Plan provides that options and stock purchase rights may be granted to employees (including officers and employee directors) and consultants (including non-employee directors) of the Company and its majority-owned subsidiaries. Options intended to qualify as incentive stock options ("ISOs") within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended, may only be granted to employees, while options not intended to qualify as ISOs, also known as nonstatutory stock options ("NSOs"), may be granted to both employees and consultants. The exercise price of any ISOs granted under the 1988 Plan were at least equal to the fair market value of the shares of Common Stock on the date of grant; provided, however, that the exercise price of ISOs granted to an employee holding stock representing more than 10% of the voting power of the Company (a "10% Stockholder") had to be 110% of the fair market value of the shares of Common Stock on the date of grant. The exercise price of NSOs and stock purchase rights granted under the 1988 Plan had to be at least equal to 85% of the fair market value of the shares of Common Stock on the date of grant; provided, however, that the exercise price of NSOs to a 10% Stockholder had to be 110% of the fair market value of the shares of Common Stock on the date of grant. The Board has the authority to reprice options outstanding under the 1988 Plan at a lower exercise price than the original exercise price in the event the fair market value of the Common Stock declines after the date the option was granted. The maximum term of each option must not exceed 10 years; however, the term of an ISO granted to a 10% Stockholder must not exceed five years. Options granted under the 1988 Plan generally have a term of five years. Options granted under the 1988 Plan are subject to vesting, which generally occurs at the rate of one-fourth of the shares each year following the date of hire or grant. Generally, shares which have not yet vested may be exercised pursuant to a restricted stock purchase agreement subject to a repurchase option in favor of the Company which lapses at the same rate as the vesting schedule set forth in the option agreement. In the event of termination of an optionee's employment or consulting relationship, ISOs may be exercised, to the extent vested, within 30 days following such termination, and any outstanding NSOs may be exercised, to the extent vested, during such period of time, as determined by the Board not to exceed six months following termination; provided, however, that in the event of termination due to disability or death, both ISOs and NSOs may be exercised, to the extent vested, within 12 months following termination due to disability or death. Options granted under the 1988 Plan may not be transferred other than by will or by the laws of descent or distribution. In the event of the dissolution or liquidation of the Company, unexercised options shall terminate immediately prior to the consummation of such proposed action. In the event of a merger of the Company with or into another corporation, the 1988 Plan provides that each outstanding option shall be assumed or an equivalent option shall be substituted by the successor corporation; provided, however, that if such successor corporation refuses to assume or substitute the then outstanding options, (i) any options granted prior to October 19, 1993 shall become fully exercisable, and (ii) any options granted on or after October 19, 1993 will terminate as of the closing of the merger. 1997 Stock Plan. The Company's 1997 Stock Plan, as amended and restated (the "1997 Plan"), provides for the granting to employees of incentive stock options within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), and for the granting to employees and consultants of nonstatutory stock options and stock purchase rights ("SPRs"). The 1997 Plan was approved by the Board of Directors in February 1997 and by the stockholders in April 1997. Unless terminated sooner, the 1997 Plan will terminate automatically in 2007. A total of 6,200,000 shares of Common Stock are currently reserved for issuance pursuant to the 1997 Plan, plus annual increases on the first day of the Company's fiscal year (beginning in 1999) not to exceed the lesser of (i) 5,000,000 shares or (ii) 5% of the outstanding shares on such date. As of March 31, 1998, 247,375 shares of Common Stock had been issued upon the exercise of stock options granted under the 1997 Plan, and 2,009,925 options were outstanding. The 1997 Plan may be administered by the Board of Directors or a committee of the Board (as applicable, the "Administrator"), which committee shall, in the case of options intended to qualify as "performance-based 46 compensation" within the meaning of Section 162(m) of the Code, consist of two or more "outside directors" within the meaning of Section 162(m) of the Code. The Administrator has the power to determine the terms of the options or SPRs granted, including the exercise price, the number of shares subject to each option or SPR, the exercisability thereof, and the form of consideration payable upon such exercise. In addition, the Administrator has the discretion to reprice outstanding options or to cancel and regrant options with the exercise price lower than the original exercise price. The Administrator has the authority to amend, suspend or terminate the 1997 Plan, provided that no such action may affect any share of Common Stock previously issued and sold or any option previously granted under the 1997 Plan. Options and SPRs granted under the 1997 Plan are not generally transferable by the optionee, and each option and SPR is exercisable during the lifetime of the optionee only by such optionee. Options granted under the 1997 Plan must generally be exercised within three months of the end of optionee's status as an employee or consultant of the Company, or within 12 months after such optionee's termination by death or disability, but in no event later than the expiration of the option's term. In the case of SPRs, unless the Administrator determines otherwise, the Restricted Stock Purchase Agreement shall grant the Company a repurchase option exercisable upon the voluntary or involuntary termination of the purchaser's employment with the Company for any reason (including death or disability). The purchase price for shares repurchased pursuant to the Restricted Stock Purchase Agreement shall be the original price paid by the purchaser and may be paid by cancellation of any indebtedness of the purchaser to the Company. The repurchase option shall lapse at a rate determined by the Administrator. The exercise price of all incentive stock options granted under the 1997 Plan must be at least equal to the fair market value of the Common Stock on the date of grant. The exercise price of nonstatutory stock options and SPRs granted under the 1997 Plan is determined by the Administrator, but will also be at least equal to 100% of the fair market value per share of Common Stock on the grant or issue date, except that up to 10% of the aggregate number of shares reserved for issuance under the 1997 Plan (including shares that have been issued or are issuable in connection with options exercised or granted under the 1997 Plan) may have exercise prices that are from 0% to 100% of the fair market value of the Common Stock on the date of grant. With respect to any participant who owns stock possessing more than 10% of the voting power of all classes of the Company's outstanding capital stock, the exercise price of any incentive stock option granted must equal at least 110% of the fair market value on the grant date and the term of such incentive stock option must not exceed five years. The term of all other options granted under the 1997 Plan may not exceed 10 years. The 1997 Plan provides that in the event of a merger of the Company with or into another corporation, a sale of substantially all of the Company's assets or a like transaction involving the Company, each option or right shall be assumed or an equivalent option or right substituted by the successor corporation. If the outstanding options or rights are not assumed or substituted as described in the preceding sentence, the Administrator shall provide for the Optionee to have the right to exercise the option or SPR as to all of the optioned stock, including shares as to which it would not otherwise be exercisable for a period of 15 days from the date of such notice, and the option or SPR will terminate upon the expiration of such period. In the event of involuntary termination of employment (or termination of status as a director of a successor corporation) within 12 months following a change of control merger pursuant to which options and SPRs are assumed or substituted by a successor corporation, the optionee shall have the right to exercise the option or SPR as to all of the optioned stock, including shares as to which it would not otherwise be exercisable. 1998 Director Option Plan. Non-employee directors are entitled to participate in the 1998 Director Option Plan (the "Director Plan"). The Director Plan was adopted by the Board of Directors in May 1998, and is subject to stockholder approval, but it will in no event become effective until the date of this offering. The Director Plan has a term of 10 years, unless terminated sooner by the Board. A total of 300,000 shares of Common Stock have been reserved for issuance under the Director Plan. The share reserve under the Director Plan will increase each year on the first day of the Company's fiscal year, beginning in 1999, by an amount equal to 100,000 shares or a lesser amount determined by the Board. The Director Plan provides for the automatic grant of an option to purchase 25,000 shares of Common Stock (the "First Option") to each non-employee director who first becomes a non-employee director after May 29, 47 1998, whether by appointment by the Board or election by the stockholders, provided such non-employee director has not previously been in the employ of the Company. Each non-employee director shall also automatically be granted an option to purchase 10,000 shares (a "Subsequent Option") on both the effective date of this offering and on the date of the Company's Annual Stockholder Meeting provided that he or she is re-elected to the Board or otherwise remains on the Board, if on such date he or she shall have served on the Board for at least the preceding six months. Each First Option and each Subsequent Option shall have a term of five years and the shares subject to the option will become exercisable in four equal annual installments subject to the optionee's completion of each year of Board service over the four year period measured from the grant date. The exercise price of any option granted under the Director Plan will be equal to the fair market value per share of Common Stock on the grant date. The fair market value per share will be equal to the closing sales price per share of Common Stock on the Nasdaq National Market on the last market trading day prior to the grant date. However, for automatic options granted on the effective date of this offering, the fair market value will be equal to the initial price per share offered to the public in this offering. On the effective date of this offering options to purchase an aggregate of 60,000 shares will be granted under the Director Plan. Options granted under the Director Plan must be exercised within three months of the end of the optionee's tenure as a director of the Company, or within 12 months after such director's termination by death or disability, but in no event later than the expiration of the option's five year term. Options outstanding at the end of an optionee's tenure as a director may only be exercised to the extent exercisable at the time of such cessation of service as a director. However, if the optionee has served as a director for at least five years at the time of such cessation of service as a director, then the option will accelerate and become immediately exercisable for all of the option shares at the time subject to the option as fully-vested shares and will remain exercisable for those shares until the end of the five year term. No option granted under the Director Plan is transferable by the optionee other than by will or the laws of descent and distribution, and each option is exercisable, during the lifetime of the optionee, only by such optionee. In the event of a merger of the Company or the sale of substantially all of the assets of the Company, each outstanding option will become fully-vested and exercisable for all of the option shares, unless such outstanding options are assumed or substituted by the successor corporation. In the event outstanding options are either assumed or substituted by the successor corporation, each outstanding option will continue to become exercisable in accordance with its original exercise schedule. If an outstanding option is assumed or substituted and the optionee's status as a director or as a director of the successor corporation terminates other than upon a voluntary resignation by the optionee, then the option will become immediately exercisable for all of the option shares at the time of such termination as fully-vested shares. Warrants. Warrants to purchase an aggregate of 30,000 shares of Common Stock at a per share exercise price of $12.00 are outstanding and unexercised (the "Common Stock Warrants"). The Common Stock Warrants are exercisable at any time until their expiration on the earlier of February 2, 1999 or the consummation of a merger of the Company with another entity or the sale of substantially all of the Company's assets, whereby the holders of the Company's voting securities prior to such transaction do not hold more than 50% of the voting securities of the surviving entity following such transaction (a "Change in Control"). In addition, warrants to purchase an aggregate of 400,000 shares of Series E Preferred Stock (or Common Stock, if all Series E Preferred Stock has then been converted into Common Stock) at a per share exercise price of $5.00 are outstanding and unexercised (the "Series E Warrants"; and together with the Common Stock Warrants, the "Warrants"). The Series E Warrants are exercisable at any time until their expiration on the earlier of May 15, 2002 or a Change in Control. Each Warrant contains a cashless conversion right that allows the holder to receive a number of shares of the Company's Common Stock or Series E Preferred Stock, as applicable, equal to the quotient obtained by dividing (x) the value of the Warrant on the date of exercise, which value is determined by subtracting (a) the aggregate exercise price of the Warrant from (b) the aggregate fair market value of the Warrant shares on the date of exercise, by (y) the fair market value of one share of the Company's Common Stock or Series E Preferred Stock, as applicable, on the date of exercise, as determined by the Company's Board of Directors. The issuance of the Warrants did not require stockholder approval. Upon the closing of this offering, the Series E Preferred Stock will be converted into Common Stock and the Series E Warrants will be exercisable for Common Stock. 48 CERTAIN TRANSACTIONS In June and July 1995, the Company sold shares of Common Stock to the following officers of the Company at a per share purchase price of $1.10, the then fair market value of the Company's Common Stock as determined by the Company's Board of Directors: James M. Kasson--150,000 shares; Kenneth E. Lavezzo--75,000 shares; M. Kenneth Oshman--250,000 shares, Oliver R. Stanfield--175,000 shares; Beatrice Yormark--200,000 shares. These shares are subject to a repurchase option by the Company, which repurchase option lapses at the rate of one-fourth of the shares on May 23, 1996 and each one year anniversary thereafter, subject to the continued employment with the Company of each such officer. In December 1995, the Company sold 100,000 shares of Common Stock to James M. Kasson at a per share purchase price of $1.29, the then fair market value of the Company's Common Stock as determined by the Company's Board of Directors. These shares are subject to a repurchase option by the Company, which repurchase option lapses at the rate of one-fourth of the shares on November 17, 1996 and each one year anniversary thereafter, subject to Mr. Kasson's continued employment with the Company. In November 1996, the Company sold 1,000,000 shares of Common Stock to M. Kenneth Oshman at a per share purchase price of $1.40, the then fair market value of the Company's Common Stock as determined by the Company's Board of Directors. These shares are subject to a repurchase option by the Company, which repurchase option lapses at the rate of one-fourth of the shares on September 17, 1997 and each one year anniversary thereafter, subject to Mr. Oshman's continued employment with the Company. In May 1997, the Company sold an aggregate of 2,000,000 shares of Series E Preferred Stock, at a per share purchase price of $5.00, and issued warrants to purchase an aggregate of 400,000 shares of Series E Preferred Stock at a per share exercise price of $5.00 each in a private placement financing with existing stockholders of the Company, including (i) an aggregate of 1,022,428 shares purchased by M. Kenneth Oshman and Barbara S. Oshman, Trustees of the Oshman Trust dated July 10, 1979 (the "Oshman Trust"), and O-S Ventures, of which Dr. Oshman is general partner ("O-S Ventures"), and a warrant to purchase 249,713 shares issued to the Oshman Trust, (ii) an aggregate of 186,011 shares purchased by Armas Clifford Markkula, Jr. and Linda Kathryn Markkula, Trustees of the Restated Arlin Trust Dated December 12, 1990 (the "Arlin Trust"), and Markkula Family Limited Partnership (the "Markkula Partnership"), and a warrant to purchase 40,183 shares issued to the Arlin Trust, (iii) 121,029 shares purchased by Arthur Rock and a warrant to purchase 29,187 shares issued to Mr. Rock, (iv) 66,230 shares purchased by a trust for the benefit of Robert R. Maxfield (the "Maxfield Trust") and a warrant to purchase 15,736 shares issued to the Maxfield Trust, and (v) 37,803 shares purchased by Richard M. Moley and a warrant to purchase 10,000 shares issued to Mr. Moley. In March 1998, Peter Mehring was granted an option to purchase 200,000 shares of Common Stock pursuant to the Company's 1997 Stock Plan at a per share exercise price of $2.00. The option vests at the rate of one-fourth of the shares on March 9, 1999 and each one-year anniversary thereafter, subject to Mr. Mehring's continued employment with the Company. Mr. Mehring's stock option agreement provides that at any time in 1998, following the date of grant of the option, Mr. Mehring may exercise the option for 50,000 shares which vest on March 9, 1999; at any time in 1999 Mr. Mehring may exercise the option for 50,000 shares which vest on March 9, 2000; at any time in 2000 Mr. Mehring may exercise the option for 50,000 shares which vest on March 9, 2001; and at any time in 2001 Mr. Mehring may exercise the option for 50,000 shares which vest on March 9, 2002. In April 1998, Mr. Mehring exercised 50,000 unvested option shares and executed a promissory note in the principal amount of $100,000 payable to the Company. The note is a full recourse note and is secured by the shares, bears interest at the annual rate of 5.7% and is due in April 2003. The Company has entered into licensing agreements with Motorola, which is a principal stockholder of the Company and Motorola has had a representative on the Company's Board of Directors from time to time since 1991. Pursuant to this agreement, Motorola has the right to manufacture and distribute Neuron Chips using technology licensed from the Company and the Company is required to provide support and unspecified updates to the licensed technology. The Motorola agreement expires in December 1999 unless renewed. However, 49 Motorola has the right to terminate the agreement at any time. Further, pursuant to the terms of the stock purchase agreement under which Motorola initially acquired its shares, Motorola has agreed to vote (i) all of its shares in favor of the slate of director nominees recommended by the Board of Directors, and (ii) a number of shares equal to at least that percentage of shares voted by all other stockholders for or against any given matter, as recommended by the Board of Directors (except certain matters relating to certain changes to the Company's charter, liquidations, a sale of the Company or a merger of the Company into another entity), as recommended by a majority of the Board of Directors. See "Risk Factors--Dependence on Key Manufacturers" and "-- Control by Existing Stockholders" and "Business--Strategic Alliances." From time to time beginning April 1998, Dr. Oshman uses private air travel services for business trips for himself and for any employees accompanying him. These private air travel services are provided by certain entities controlled by Dr. Oshman or Mr. Markkula. The net cash outlay to the Company with respect to such private air travel services is no greater than comparable first class commercial air travel services. Such net outlays to date have not been material. 50 PRINCIPAL STOCKHOLDERS The following table sets forth the beneficial ownership of the Company's Common Stock as of June 30, 1998, by all persons known to the Company to be the beneficial owners of more than 5% of the Company's Common Stock, by each director, by each of the Named Executive Officers, and by all directors and executive officers as a group. Except as otherwise indicated in the footnotes to the table, the persons and entities named in the table have sole voting and investment power with respect to all shares beneficially owned, subject to community property laws, where applicable.
PERCENTAGE OF SHARES BENEFICIALLY OWNED(1) ------------------------ NUMBER OF SHARES BEFORE AFTER NAME OF BENEFICIAL OWNER BENEFICIALLY OWNED(1) OFFERING OFFERING - ------------------------ --------------------- ---------- ---------- M. Kenneth Oshman(2)........ 5,180,413 18.7% 15.8% Echelon Corporation 4015 Miranda Avenue Palo Alto, CA 94304 Motorola, Inc. Bertrand F. Cambou(3)....... 3,912,381 14.3 12.1 1303 East Algonquin Road Schaumburg, IL 60196 Armas Clifford Markkula, 1,577,038 5.8 4.9 Jr.(4)..................... c/o ACM Investments P.O. Box 620170 Woodside, CA 94062 Beatrice Yormark(5)......... 1,018,000 3.7 3.1 Oliver R. Stanfield(6)...... 975,000 3.5 3.0 Arthur Rock(7).............. 717,716 2.6 2.2 Kenneth E. Lavezzo(8)....... 500,000 1.8 1.4 Robert R. Maxfield(9)....... 436,966 1.6 1.4 James M. Kasson(10)......... 437,500 1.6 1.3 Richard M. Moley(11)........ 85,303 * * Larry W. Sonsini(12)........ 82,500 * * All Officers and Directors as a Group (17 persons) (13)....................... 16,440,317 55.3% 47.3%
- -------- * Represents less than 1% of the Company's Common Stock outstanding as of June 30, 1998. (1) The number of shares outstanding and percent of ownership is based on: (i) 27,358,206 shares of Common Stock outstanding as of June 30, 1998; and (ii) 32,358,206 shares of Common Stock outstanding upon the closing of this offering. Unless otherwise indicted below, the persons and entities named in the table have sole voting and sole investment power with respect to all shares of Common Stock beneficially owned, subject to community property laws where applicable. The shares of Common Stock issuable pursuant to options and warrants that are currently exercisable or exercisable within 60 days of June 30, 1998 are deemed to be outstanding and to be beneficially owned by the person holding such options for the purpose of computing the percentage ownership of such person, but are not deemed to be outstanding and to be beneficially owned for the purpose of computing the percentage ownership of any other person. (2) Includes 4,395,700 shares of Common Stock held by M. Kenneth Oshman and Barbara S. Oshman, Trustees of the Oshman Trust dated July 10, 1979, and 435,000 shares held by O-S Ventures, of which Mr. Oshman is general partner, and excludes an aggregate of 36,000 shares held by trusts, not for the benefit of Mr. Oshman, of which Mr. Oshman serves as trustee. Includes a warrant to purchase 249,713 shares of Common Stock exercisable within 60 days of June 30, 1998. Includes an option to purchase 100,000 shares of Common Stock exercisable within 60 days of June 30, 1998, none of which are vested at June 30, 1998. The Company has the right, but not the obligation, to repurchase 812,500 shares owned by Mr. Oshman if he should discontinue his employment with the Company. This repurchase right expires on various future dates through September 17, 2000. 51 (3) All 3,912,381 shares are held by Motorola, Inc. Dr. Cambou, a director of the Company, is Senior Vice President and General Manager of the Networking and Computing Group of Motorola, Inc. and may be deemed to be a beneficial owner of shares held by such corporation. Dr. Cambou disclaims beneficial ownership of such shares. (4) Includes 1,379,927 shares of Common Stock held by Armas Clifford Markkula, Jr. and Linda Kathryn Markkula, Trustees of the Restated Arlin Trust Dated December 12, 1990, and 151,928 shares held by Markkula Family Limited Partnership (the "Markkula Partnership"). Mr. and Mrs. Markkula disclaim beneficial ownership of all but 27,500 of the shares held by the Markkula Partnership. Includes a warrant to purchase 40,183 shares of Common Stock exercisable within 60 days of June 30, 1998. The Company has the right, but not the obligation, to repurchase 7,500 shares owned by Mr. Markkula if he should cease to serve on the Company's Board of Directors. This repurchase right expires on various future dates through April 23, 2002. (5) Includes 668,000 shares held by Justin C. Walker and Beatrice Yormark, Trustees of the Walker-Yormark Family Trust Dated October 2, 1992 (the "Walker-Yormark Trust"). Includes options to purchase 350,000 shares of Common Stock exercisable within 60 days of June 30, 1998, of which 112,500 shares are vested at June 30, 1998. The Company has the right, but not the obligation, to repurchase 50,000 shares owned by the Walker- Yormark Trust if Ms. Yormark should discontinue her employment with the Company. This repurchase right expires on various future dates through May 23, 1999. (6) Includes an aggregate of 170,600 shares held in individual retirement accounts for the benefit of Mr. Stanfield and his wife. Includes options to purchase 350,000 shares of Common Stock exercisable within 60 days of June 30, 1998, of which 112,500 shares are vested at June 30, 1998. The Company has the right, but not the obligation, to repurchase 43,750 shares owned by Mr. Stanfield if he should discontinue his employment with the Company. This repurchase right expires on various future dates through May 23, 1999. (7) Includes 20,000 shares held by a trust for the benefit of Mr. Rock's wife, of which Mr. Rock serves as trustee, and as to which Mr. Rock disclaims beneficial ownership. Includes 2,000 shares held by a trust, not for the benefit of Mr. Rock, of which Mr. Rock has sole voting and dispositive power, and as to which Mr. Rock disclaims beneficial ownership. Includes a warrant to purchase 29,187 shares of Common Stock exercisable within 60 days of June 30, 1998. The Company has the right, but not the obligation, to repurchase 7,500 shares owned by Mr. Rock if he should cease to serve on the Company's Board of Directors. This repurchase right expires on various future dates through April 23, 2002. (8) Includes options to purchase 43,750 shares of Common Stock exercisable within 60 days of June 30, 1998, none of which shares are vested at June 30, 1998. The Company has the right, but not the obligation, to repurchase 93,750 shares owned by Mr. Lavezzo if he should discontinue his employment with the Company. This repurchase right expires on various future dates through June 10, 2001. (9) Includes a warrant to purchase 15,736 shares of Common Stock exercisable within 60 days of June 30, 1998. The Company has the right, but not the obligation, to repurchase 7,500 shares owned by Mr. Maxfield if he should cease to serve on the Company's Board of Directors. This repurchase right expires on various future dates through April 23, 2002. (10) Includes options to purchase 187,500 shares of Common Stock exercisable within 60 days of March 31, 1998, of which 62,500 shares are vested at June 30, 1998. The Company has the right, but not the obligation, to repurchase 87,500 shares owned by Mr. Kasson if he should discontinue his employment with the Company. This repurchase right expires on various future dates through November 17, 1999. (11) Includes a warrant to purchase 10,000 shares of Common Stock exercisable within 60 days of June 30, 1998. Includes an option to purchase 25,000 shares of Common Stock exercisable within 60 days of June 30, 1998, 6,250 of which shares are vested at June 30, 1998. (12) Includes 60,000 shares held by investment accounts of Wilson Sonsini Goodrich & Rosati, Professional Corporation ("WSGR"). Mr. Sonsini is Chairman of the Executive Committee of WSGR and disclaims beneficial ownership of such shares except as to those shares in which he has a pecuniary interest. Includes options to purchase 20,000 shares of Common Stock exercisable within 60 days of June 30, 1998, of which 12,500 shares are vested at June 30, 1998. 52 (13) Includes warrants to purchase an aggregate of 344,819 shares of Common Stock exercisable within 60 days of June 30, 1998. Includes options to purchase an aggregate of 2,046,250 shares of Common Stock exercisable within 60 days of June 30, 1998, of which 588,750 shares are vested at June 30, 1998. The Company has the right, but not the obligation, to repurchase an aggregate of 1,270,000 shares owned by the Company's officers and directors if such officers and directors should discontinue their employment with the Company or cease to serve on the Company's Board of Directors. This repurchase right expires on various future dates through April 23, 2002. 53 DESCRIPTION OF CAPITAL STOCK Upon the closing of this Offering, the authorized capital stock of the Company will consist of 100,000,000 shares of Common Stock and 5,000,000 shares of Preferred Stock. The following summary of certain provisions of the Common Stock and Preferred Stock does not purport to be complete and is subject to, and qualified in its entirety by, the provisions of the Company's Amended and Restated Certificate of Incorporation which is included as an exhibit to the Registration Statement of which this Prospectus is a part and by the provisions of applicable law. COMMON STOCK The holders of Common Stock are entitled to one vote for each share held of record on all matters submitted to a vote of stockholders. Subject to the preferences that may be applicable to any outstanding Preferred Stock, the holders of Common Stock are entitled to receive ratably the dividends, if any, that may be declared from time to time by the Board of Directors out of funds legally available for such dividends. The Company has never declared a dividend and does not anticipate doing so in the foreseeable future. In the event of a liquidation, dissolution or winding up of the Company, subject to the prior rights of any outstanding shares of Preferred Stock, the holders of Common Stock are entitled to share ratably in any remaining assets after payment of liabilities. The Common Stock has no preemptive rights or redemption or sinking fund provisions applicable to shares of Common Stock. All of the outstanding shares of Common Stock are fully paid and nonassessable. PREFERRED STOCK Pursuant to the Company's Amended and Restated Certificate of Incorporation effective after conversion of previously outstanding shares of Preferred Stock into an aggregate of 7,887,381 shares of Common Stock, which conversion will be effected simultaneously with the consummation of this offering, the Board of Directors has the authority, without further action by the stockholders, to issue up to 5,000,000 shares of Preferred Stock in one or more series and to fix the designations, powers, preferences, privileges, and relative participating, optional or special rights and the qualifications, limitations or restrictions thereof, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights of the Common Stock. The Board of Directors, without stockholder approval, can issue Preferred Stock with voting, conversion or other rights that could adversely affect the voting power and other rights of the holders of Common Stock. Preferred Stock could thus be issued quickly with terms calculated to delay or prevent a change in control of the Company or make removal of management more difficult. Additionally, the issuance of Preferred Stock may have the effect of decreasing the market price of the Common Stock, and may adversely affect the voting and other rights of the holders of Common Stock. At present, there are no shares of Preferred Stock outstanding and the Company has no plans to issue any of the Preferred Stock. See "Risk Factors--Anti-Takeover Provisions." COMMON STOCK WARRANTS As of the date of this Prospectus, the Company has warrants outstanding exercisable to purchase an aggregate of 430,000 shares of Common Stock. In February 1994, the Company issued warrants to purchase an aggregate of 30,000 shares of Common Stock at a per share exercise price of $12.00. These warrants are exercisable at any time until their expiration on the earlier of February 2, 1999 or the consummation of a merger of the Company with another entity or the sale of substantially all of the Company's assets, whereby the holders of the Company's voting securities prior to such transaction do not hold more than 50% of the voting securities of the surviving entity following such transaction (a "Change in Control"). In addition, in May 1997, the Company issued warrants to purchase an aggregate of 400,000 shares of Common Stock at a per share exercise price of $5.00. These warrants are exercisable at any time until their expiration on the earlier of May 15, 2002 or a Change in Control. Each warrant contains a cashless conversion right that allows the holder to receive a number of shares of the Company's Common Stock equal to the quotient 54 obtained by dividing (x) the value of the warrant on the date of exercise, which value is determined by subtracting (a) the aggregate exercise price of the warrant from (b) the aggregate fair market value of the warrant shares on the date of exercise, by (y) the fair market value of one share of the Company's Common Stock. Registration Rights. After this offering, the holders of approximately 18,665,548 shares of Common Stock will be entitled to certain rights with respect to the registration of such shares under the Securities Act (the "Registrable Securities"). Under the terms of the Company's Amended and Restated Modification Agreement (the "Modification Agreement"), subject to certain conditions, if the Company proposes to register any of its securities under the Securities Act, either for its own account or for the account of other security holders, other than in connection with a registration relating to shares of capital stock of the Company under employee benefit plans (such as shares of Common Stock issuable upon exercise of Options granted under the 1997 Plan), the Company is required to include the Registrable Securities in such registration. In addition, beginning one year after the date of this Prospectus and subject to certain conditions, the holders of not less than 50% of the Registrable Securities may also require the Company, on not more than two occasions, to file a registration statement under the Securities Act with respect to at least 1,500,000 of Registrable Securities. Further, if the Company is a registrant entitled to use Form S-3, the holders of Registrable Securities may require the Company to file a registration statement on Form S- 3 under the Securities Act with respect to such Registrable Securities, subject to certain conditions and limitations. See "Risk Factors--Shares Eligible for Future Sale" and "Shares Eligible for Future Sale." DELAWARE LAW AND CERTAIN CHARTER AND BYLAW PROVISIONS The Company is subject to Section 203 of the Delaware General Corporation Law ("Section 203"), which, subject to certain exceptions, prohibits a Delaware corporation from engaging in any business combination with any "interested stockholder" for a period of three (3) years following the date that such stockholder became an interested stockholder, unless: (i) prior to such date, the board of directors of the corporation approved either the business combination or the transaction that resulted in the stockholder becoming an interested stockholder; (ii) upon consummation of the transaction that resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding, for purposes of determining the number of shares outstanding, those shares owned (x) by persons who are directors and also officers and (y) by employee stock plans in which employee participants do not have the right to determine confidentially whether shares held subject to the plan will be tendered in a tender or exchange offer; or (iii) on or subsequent to such date, the business combination is approved by the board of directors and authorized at an annual or special meeting of stockholders, and not by written consent, by the affirmative vote of at least 66 2/3% of the outstanding voting stock that is not owned by the interested stockholder. Section 203 defines business combination to include: (i) any merger or consolidation involving the corporation and the interested stockholder; (ii) any sale, transfer, pledge or other disposition of 10% or more of the assets of the corporation involving the interested stockholder; (iii) subject to certain exceptions, any transaction that results in the issuance or transfer by the corporation of any stock of the corporation to the interested stockholder; (iv) any transaction involving the corporation that has the effect of increasing the proportionate share of the stock of any class or series of the corporation beneficially owned by the interested stockholder; or (v) the receipt by the interested stockholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or through the corporation. In general, Section 203 defines an interested stockholder as any entity or person beneficially owning 15% or more of the outstanding voting stock of the corporation and any entity or person affiliated with or controlling or controlled by such entity or person. The Company's Amended and Restated Certificate of Incorporation requires that any action required or permitted to be taken by the stockholders of the Company must be effected at a duly called annual or special meeting of the stockholders and may not be effected by a consent in writing. In addition, as provided by the Company's Bylaws, special meetings of the stockholders of the Company may be called only by the Board of Directors. The Amended and Restated Certificate of Incorporation also provides that, beginning upon the closing of this offering, the Board of Directors will be divided into three classes, with each class serving staggered three- 55 year terms, and that certain amendments of the Company's Amended and Restated Certificate of Incorporation and certain amendments by the stockholders of the Company's Bylaws, require the approval of holders of at least 66 2/3% of the voting power of all outstanding stock. These provisions may have the effect of deferring hostile takeovers or delaying changes in control or management of the Company. See "Risk Factors--Antitakover Provisions." TRANSFER AGENT AND REGISTRAR The Transfer Agent and Registrar for the Company's Common Stock is ChaseMellon Shareholder Services, L.L.C. LISTING The Company's Common Stock has been approved for listing on the Nasdaq National Market under the symbol ELON. 56 SHARES ELIGIBLE FOR FUTURE SALE Upon completion of this offering, based on the outstanding shares of Common Stock at March 31, 1998, the Company will have outstanding 32,125,612 shares of Common Stock (32,875,612 if the Underwriters' over-allotment option is exercised in full). Of these shares, the 5,000,000 shares sold in this offering (5,750,000 if the Underwriters' over-allotment option is exercised in full) will be freely tradeable without restriction or further registration under the Securities Act unless such shares are owned by "affiliates" of the Company as that term is defined under Rule 144 under the Securities Act. 247,375 shares are held by existing stockholders pursuant to a Regulation A Offering Statement and will become eligible for sale 180 days after the date of this Prospectus upon the expiration of contractual lock-up agreements which provide that the holders of these shares shall not sell or otherwise transfer such shares for a period of 180 days after the date of this Prospectus. The remaining 26,878,237 shares of Common Stock held by existing stockholders are deemed to be "restricted" securities within the meaning of the Securities Act and may be publicly sold only if registered under the Securities Act or sold in accordance with an applicable exemption from registration, such as those provided by Rule 144 promulgated under the Securities Act, as described below. In addition to the 5,000,000 shares sold in this offering, 483,674 shares of Common Stock held by existing stockholders will be immediately eligible for sale in the public market without restriction pursuant to Rule 144(k). The remaining 26,641,938 shares of Common Stock (including 247,375 shares covered by the Regulation A Offering Statement) will be eligible for sale beginning 180 days after the date of this Prospectus upon the expiration of contractual lock-up agreements which provide that the holders of these shares shall not sell or otherwise transfer such shares for a period of 180 days after the date of this Prospectus. See "Risk Factors--Shares Eligible for Future Sale." In general, under Rule 144 as currently in effect, if one year has elapsed since the later of the date of acquisition of restricted securities from the Company or from an "affiliate" of the Company, as that term is defined under the Securities Act, the acquiror or subsequent holder would be entitled to sell within any three-month period commencing 90 days after the date of this Prospectus a number of those shares that does not exceed the greater of one percent of the number of shares of such class of stock then outstanding or the average weekly trading volume of the shares of such class of stock during the four calendar weeks preceding the filing of a Form 144 with respect to such sale. Sales under Rule 144 are also subject to certain manner of sale provisions and notice requirements and to the availability of current public information about the Company. In addition, if two years have elapsed since the later of the date of acquisition of restricted securities from the Company or from any affiliate of the Company, and the acquirer or subsequent holder thereof is deemed not to have been an affiliate of the Company of such restricted securities at any time during the 90 days preceding a sale, such person would be entitled to sell such restricted securities under Rule 144(k) without regard to the requirements described above. Following this offering, the Company intends to file a registration statement under the Securities Act covering shares of Common Stock reserved for issuance under the Company's stock plans (other than shares issued upon the exercise of options prior to the effective date of such registration statement). Based on the number of shares of Common Stock subject to outstanding options as of March 31, 1998 and the number of shares of Common Stock reserved for issuance, such registration statement would cover approximately 8,025,395 shares (including 4,082,695 shares subject to outstanding options at March 31, 1998). Such registration statement will automatically become effective upon filing. Shares of Common Stock issued under the Company's Stock Plans after the effective date of such registration will be freely tradeable in the public market, subject to the 180 day lock-up referred to above and subject in the case of sales by affiliates to the volume limitation, manner of sale, notice and public information requirements of Rule 144. No prediction can be made of the effect, if any, that sales of shares under Rule 144 or the availability of shares for sale will have on the market price of the Common Stock prevailing from time to time after this offering. The Company is unable to estimate the number of shares that may be sold in the public market under Rule 144, because such amount will depend on the trading volume in, and market price for, the Common Stock 57 and other factors. Nevertheless, sales of substantial amounts of shares in the public market, or the perception that such sales could occur, could adversely affect the market price of the Common Stock. See "Underwriting." After this offering, the holders of approximately 18,665,548 shares of Common Stock will be entitled to certain rights with respect to registration of such shares under the Securities Act. Registration of such shares under the Securities Act would result in such shares becoming freely tradeable without restriction under the Securities Act (except for shares purchased by affiliates of the Company pursuant to any such registration) immediately upon the effectiveness of such registration. Such registration rights terminate for each holder to the extent such holder's shares may be sold within a given three month period under Rule 144 or other applicable exemption. See "Description of Capital Stock--Registration Rights." 58 UNDERWRITING The Underwriters named below, represented by NationsBanc Montgomery Securities LLC, BancAmerica Robertson Stephens and Volpe Brown Whelan & Company, LLC (the "Representatives"), have severally agreed, subject to the terms and conditions set forth in the Underwriting Agreement, to purchase from the Company the number of shares of Common Stock indicated below opposite their respective names at the initial public offering price less the underwriting discount set forth on the cover page of this Prospectus. The Underwriting Agreement provides that the obligations of the Underwriters to pay for and accept delivery of the shares of Common Stock are subject to certain conditions precedent, and that the Underwriters are committed to purchase all of such shares, if any are purchased.
NUMBER UNDERWRITERS OF SHARES ------------ --------- NationsBanc Montgomery Securities LLC.............................. BancAmerica Robertson Stephens..................................... Volpe Brown Whelan & Company, LLC.................................. --------- Total............................................................ 5,000,000 =========
The Representatives have advised the Company that the Underwriters initially propose to offer the shares of Common Stock to the public on the terms set forth on the cover page of this Prospectus. The Underwriters may allow to selected dealers a concession of not more than $ per share, and the Underwriters may allow, and such dealers may reallow, a concession of not more than $ per share to certain other dealers. After this offering, the offering price and concessions and reallowances to dealers may be changed by the Representatives. The Common Stock is offered subject to receipt and acceptance by the Underwriters and to certain other conditions, including the right to reject orders in whole or in part. The Company has granted an option to the Underwriters, exercisable during the 30-day period after the date of this Prospectus, to purchase up to a maximum of 750,000 additional shares of Common Stock to cover over-allotments, if any, at the same price per share as the initial 5,000,000 shares to be purchased by the Underwriters. To the extent that the Underwriters exercise this option, each of the Underwriters will be committed, subject to certain conditions, to purchase such additional shares in approximately the same proportion as set forth in the above table. The Underwriters may purchase such shares only to cover over-allotments made in connection with this offering. The directors, officers and certain stockholders of the Company holding in the aggregate 20,558,361 shares of Common Stock after this offering have agreed that, for a period of 180 days after the date of this Prospectus, they will not, without the prior written consent of NationsBanc Montgomery Securities LLC, directly or indirectly sell, offer to sell or otherwise dispose of any such shares of Common Stock or any right to acquire such shares. In addition, the Company has agreed that, for a period of 180 days after the date of this Prospectus, it will not, without the prior written consent of NationsBanc Montgomery Securities LLC, issue, offer, sell, grant options to purchase or otherwise dispose of any of the Company's equity securities or any other securities convertible into or exercisable or exchangeable for the Common Stock or other equity security, other than the grant of options to purchase Common Stock or the issuance of shares of Common Stock under the Company's stock option and stock purchase plans and the issuance of shares of Common Stock pursuant to the exercise of outstanding options and warrants. Under the terms of the Company's Stock Option Plans, the Modification Agreement and representations made by various stockholders, the holders of approximately 6,118,963 additional shares of the Company's 59 Common Stock have agreed not to sell or transfer their shares prior to the expiration of 180 days after the date of this Prospectus. The Company has agreed not to waive any such restriction without the prior written consent of NationsBanc Montgomery Securities LLC. The Underwriting Agreement provides that the Company will indemnify the several Underwriters against certain liabilities, including civil liabilities under the Securities Act, or will contribute to payments the Underwriters may be required to make in respect thereof. Prior to this offering, there has been no public market for the Common Stock. Consequently, the initial public offering price was determined by negotiations between the Company and the Representatives. Among the factors considered in such negotiations were the history of, and the prospects for, the Company and the industry in which it competes, an assessment of the Company's management, the Company's past and present operations, its past and present financial performance, the prospects for future earnings of the Company, the present state of the Company's development, the general condition of the securities markets at the time of this offering and the market prices of and demand for publicly traded common stock of comparable companies in recent periods and other factors deemed relevant. Certain persons participating in this offering may engage in transactions that stabilize, maintain or otherwise affect the price of the Common Stock offered hereby. Such transactions may include stabilizing, the purchase of Common Stock to cover syndicate short positions and the imposition of penalty bids. A stabilizing bid means the placing of any bid or the effecting of any purchase for the purpose of pegging, fixing or maintaining the price of the Common Stock. A syndicate covering transaction means the placing of any bid on behalf of the underwriting syndicate or the effecting of any purchase to reduce a short position created in connection with this offering. A penalty bid means an arrangement that permits the Underwriters to reclaim a selling concession from a syndicate member in connection with this offering when shares of Common Stock sold by the syndicate member are purchased in syndicate covering transactions. Such transactions may stabilize or maintain the market price of the Common Stock at a level above that which otherwise might prevail in the open market and, if commenced, may be discontinued at any time. The Underwriters have reserved for sale, at the initial public offering price, up to 250,000 shares of the Common Stock offered hereby for certain individuals designated by the Company who have expressed an interest in purchasing such shares of Common Stock in the offering. The number of shares available for sale to the general public will be reduced to the extent such persons purchase such reserved shares. Any reserved shares not so purchased will be offered by the Underwriters to the general public on the same basis as other shares offered hereby. The Representatives have informed the Company that the Underwriters do not expect to make sales to accounts over which they exercise discretionary authority in excess of 5% of the number of shares of Common Stock offered hereby. Mr. Arthur Rock, one of the Company's directors, has an ownership interest in Volpe Brown Whelan & Company, LLC. 60 LEGAL MATTERS Certain legal matters with respect to the legality of the issuance of the shares of Common Stock offered hereby will be passed upon for the Company by Wilson Sonsini Goodrich & Rosati, Professional Corporation ("WSGR"), Palo Alto, California. Certain legal matters in connection with this offering will be passed upon for the Underwriters by Brobeck, Phleger & Harrison LLP. Messrs. Larry W. Sonsini and John V. Roos, who are members of WSGR, own 22,500 and 5,000 shares, respectively, of Common Stock. In addition, 60,000 shares of Common Stock are held by investment accounts of WSGR, in which Messrs. Sonsini and Roos are participants. EXPERTS The Consolidated Financial Statements included in this Prospectus have been audited by Arthur Andersen LLP, independent public accountants, to the extent and for the periods indicated in their report and are included herein in reliance upon the authority of said firm as experts in giving said report. ADDITIONAL INFORMATION The Company has filed with the Securities and Exchange Commission (the "Commission") a Registration Statement (of which this Prospectus is a part and which term shall encompass any amendments thereto) on Form S-1 pursuant to the Securities Act with respect to the Common Stock offered hereby. This Prospectus does not contain all the information set forth in the Registration Statement and the exhibits and schedules thereto, certain portions of which are omitted as permitted by the rules and regulations of the Commission. Statements made in this Prospectus as to the contents of any contract, agreement or other document referred to are not necessarily complete. With respect to any such contract, agreement or other document filed as an exhibit to the Registration Statement, reference is made to the exhibit for a more complete description of the matters involved, and each such statement shall be deemed qualified in its entirety by such reference. Upon completion of the Offering, the Company will be subject to the information requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance therewith, will file reports and other information with the Commission. The Registration Statement, the exhibits and schedules forming a part thereof and the report and other information filed by the Company with the Commission in accordance with the Exchange Act may be inspected and copied at the public reference facilities maintained by the Commission at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549; 7 World Trade Center, 13th Floor, New York, New York 10048; and Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661-2511. Copies of such material can also be obtained at prescribed rates from the Public Reference Section of the Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. Such material may also be accessed electronically by means of the Commission's home page on the Internet at http://www.sec.gov. The Company intends to furnish to its stockholders annual reports containing audited consolidated financial statements examined by an independent accounting firm and quarterly reports for the first three quarters of each fiscal year containing interim unaudited consolidated financial information. 61 ECHELON CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Public Accountants.................................... F-2 Consolidated Balance Sheets................................................. F-3 Consolidated Statements of Operations....................................... F-4 Consolidated Statements of Stockholders' Equity............................. F-5 Consolidated Statements of Cash Flows....................................... F-6 Notes to Consolidated Financial Statements.................................. F-7
F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Echelon Corporation: We have audited the accompanying consolidated balance sheets of Echelon Corporation (a Delaware corporation) and subsidiaries as of December 31, 1996 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Echelon Corporation and subsidiaries as of December 31, 1996 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP San Jose, California February 17, 1998 F-2 ECHELON CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
MARCH 31, 1998 DECEMBER 31, PRO FORMA ------------------ MARCH 31, STOCKHOLDERS' 1996 1997 1998 EQUITY -------- -------- --------- ------------- (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents......... $ 8,051 $ 4,872 $ 5,165 Short-term investments............ -- 2,981 -- Accounts receivable, net of allowances of $819, $562 and $857, respectively............... 3,231 3,810 4,486 Inventories....................... 1,592 2,444 3,176 Other current assets.............. 1,346 1,196 1,382 -------- -------- -------- Total current assets............ 14,220 15,303 14,209 -------- -------- -------- PROPERTY AND EQUIPMENT: Computer and other equipment...... 6,486 6,816 6,832 Furniture and fixtures............ 1,297 1,323 1,337 Leasehold improvements............ 543 548 526 -------- -------- -------- 8,326 8,687 8,695 Less: Accumulated depreciation and amortization..................... (6,691) (7,174) (7,209) -------- -------- -------- Net property and equipment...... 1,635 1,513 1,486 -------- -------- -------- $ 15,855 $ 16,816 $ 15,695 ======== ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable.................. $ 1,800 $ 2,081 $ 2,758 Accrued payroll and related expenses......................... 1,045 1,081 1,027 Accrued liabilities............... 617 907 793 Current portion of deferred revenues......................... 2,853 2,351 2,255 -------- -------- -------- Total current liabilities....... 6,315 6,420 6,833 -------- -------- -------- LONG-TERM LIABILITIES: Deferred rent, net of current portion.......................... 377 246 198 Deferred revenues, net of current portion.......................... 2,025 1,350 1,182 -------- -------- -------- Total long-term liabilities..... 2,402 1,596 1,380 -------- -------- -------- STOCKHOLDERS' EQUITY: Convertible preferred stock, $.01 par value; aggregate liquidation preference of $60,294 at December 31, 1997: Authorized--11,000,000 shares Outstanding--(Series B, C, D and E)--5,887,381 shares in 1996, 7,887,381 shares in 1997 and at March 31, 1998; 5,000,000 shares authorized, none issued and outstanding pro forma (Note 8).. 59 79 79 $ -- Common stock, $.01 par value: Authorized--50,000,000 shares Outstanding--18,494,020, 18,832,430 and 19,238,231 shares in 1996, 1997 and at March 31, 1998, respectively; 100,000,000 shares authorized, 27,125,612 shares outstanding pro forma.... 185 188 192 271 Additional paid-in capital........ 83,359 93,532 94,530 94,530 Deferred compensation............. -- -- (519) (519) Cumulative translation adjustment....................... (31) (351) (415) (415) Accumulated deficit............... (76,434) (84,648) (86,385) (86,385) -------- -------- -------- -------- Total stockholders' equity...... 7,138 8,800 7,482 $ 7,482 -------- -------- -------- ======== $ 15,855 $ 16,816 $ 15,695 ======== ======== ========
The accompanying notes are an integral part of these consolidated balance sheets. F-3 ECHELON CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FOR THE THREE MONTHS FOR THE YEAR ENDED DECEMBER 31, ENDED MARCH 31, ----------------------------------- ---------------------- 1995 1996 1997 1997 1998 ---------- ----------- ---------- ---------- ---------- (UNAUDITED) REVENUES: Product................ $ 20,183 $20,708 $ 24,665 $ 6,548 $ 7,188 Service................ 3,160 3,282 3,637 926 771 ---------- ----------- ---------- ---------- ---------- Total revenues........ 23,343 23,990 28,302 7,474 7,959 ---------- ----------- ---------- ---------- ---------- COST OF REVENUES: Cost of product........ 9,434 10,761 11,761 3,111 3,249 Cost of service........ 1,141 1,142 1,810 455 543 ---------- ----------- ---------- ---------- ---------- Total cost of revenues............. 10,575 11,903 13,571 3,566 3,792 ---------- ----------- ---------- ---------- ---------- Gross profit.......... 12,768 12,087 14,731 3,908 4,167 ---------- ----------- ---------- ---------- ---------- OPERATING EXPENSES: Product development.... 7,355 7,526 7,121 1,740 1,958 Sales and marketing.... 10,881 11,577 12,128 3,014 3,031 General and administrative........ 4,386 3,921 4,004 1,098 935 ---------- ----------- ---------- ---------- ---------- Total operating expenses............. 22,622 23,024 23,253 5,852 5,924 ---------- ----------- ---------- ---------- ---------- Loss from operations.. (9,854) (10,937) (8,522) (1,944) (1,757) ---------- ----------- ---------- ---------- ---------- OTHER INCOME (EXPENSE): Interest income, net... 1,109 536 429 71 67 Other income (expense), net................... 175 (163) 68 21 8 ---------- ----------- ---------- ---------- ---------- Total other income (expense)............ 1,284 373 497 92 75 ---------- ----------- ---------- ---------- ---------- Loss before provision for income taxes..... (8,570) (10,564) (8,025) (1,852) (1,682) PROVISION FOR INCOME TAXES.................. 143 152 189 55 55 ---------- ----------- ---------- ---------- ---------- Net loss............... $ (8,713) $ (10,716) $ (8,214) $ (1,907) $ (1,737) ========== =========== ========== ========== ========== Basic net loss per share................. $ (0.56) $ (0.62) $ (0.44) $ (0.10) $ (0.09) ========== =========== ========== ========== ========== Shares used in computing basic net loss per share........ 15,695 17,354 18,603 18,511 19,029 ========== =========== ========== ========== ========== Pro forma basic net loss per share........ $ (0.32) $ (0.08) $ (0.06) ========== ========== ========== Shares used in computing pro forma basic net loss per share.... 25,756 24,399 26,916 ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. F-4 ECHELON CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
CONVERTIBLE PREFERRED STOCK COMMON STOCK ADDITIONAL CUMULATIVE ----------------- -------------- PAID-IN DEFERRED TRANSLATION ACCUMULATED SHARES AMOUNT SHARES AMOUNT CAPITAL COMPENSATION ADJUSTMENT DEFICIT TOTAL -------- ------- ------ ------ ---------- ------------ ----------- ----------- -------- BALANCE AT DECEMBER 31, 1994................... 5,858 $ 59 14,830 $148 $79,531 $ -- $ 66 $(57,005) $ 22,799 Exercise of stock op- tions................. -- -- 1,072 11 558 -- -- -- 569 Sale of common stock... -- -- 975 10 1,082 -- -- -- 1,092 Sale of Series D pre- ferred stock.......... 29 -- -- -- 293 -- -- -- 293 Foreign currency trans- lation adjustment..... -- -- -- -- -- -- (62) -- (62) Net loss............... -- -- -- -- -- -- -- (8,713) (8,713) -------- ------ ------ ---- ------- ------ ----- -------- -------- BALANCE AT DECEMBER 31, 1995................... 5,887 59 16,877 169 81,464 -- 4 (65,718) 15,978 Exercise of stock op- tions................. -- -- 630 6 514 -- -- -- 520 Sale of common stock, net................... -- -- 987 10 1,381 -- -- -- 1,391 Foreign currency trans- lation adjustment..... -- -- -- -- -- -- (35) -- (35) Net loss............... -- -- -- -- -- -- -- (10,716) (10,716) -------- ------ ------ ---- ------- ------ ----- -------- -------- BALANCE AT DECEMBER 31, 1996................... 5,887 59 18,494 185 83,359 -- (31) (76,434) 7,138 Exercise of stock op- tions................. -- -- 354 3 289 -- -- -- 292 Repurchase of common stock, net............ -- -- (16) -- (16) -- -- -- (16) Sale of Series E pre- ferred stock.......... 2,000 20 -- -- 9,900 -- -- -- 9,920 Foreign currency trans- lation adjustment..... -- -- -- -- -- -- (320) -- (320) Net loss............... -- -- -- -- -- -- -- (8,214) (8,214) -------- ------ ------ ---- ------- ------ ----- -------- -------- BALANCE AT DECEMBER 31, 1997................... 7,887 79 18,832 188 93,532 -- (351) (84,648) 8,800 unaudited: Exercise of stock options.............. -- -- 405 4 467 -- -- -- 471 Sale of common stock, net.................. -- -- 1 -- 1 -- -- -- 1 Deferred compensation......... -- -- -- -- 530 (530) -- -- -- Amortization of deferred compensation......... -- -- -- -- -- 11 -- -- 11 Foreign currency translation adjustment........... -- -- -- -- -- -- (64) -- (64) Net loss.............. -- -- -- -- -- -- -- (1,737) (1,737) -------- ------ ------ ---- ------- ------ ----- -------- -------- BALANCE AT MARCH 31, 1998 (unaudited)............ 7,887 $ 79 19,238 $192 $94,530 $(519) $(415) $(86,385) $ 7,482 ======== ====== ====== ==== ======= ====== ===== ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-5 ECHELON CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
FOR THE THREE MONTHS FOR THE YEAR ENDED DECEMBER 31, ENDED MARCH 31, ---------------------------------- ---------------- 1995 1996 1997 1997 1998 ---------- ---------- ---------- ------- ------- (UNAUDITED) CASH FLOWS FROM OPERATING ACTIVITIES: Net loss................ $ (8,713) $ (10,716) $ (8,214) $(1,907) $(1,737) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization.......... 988 771 715 141 194 Deferred compensation expense............... -- -- -- -- 11 Loss (gain) on disposal of fixed assets....... 10 (13) -- -- -- Change in operating assets and liabilities: Accounts receivable... (929) 332 (579) (216) (676) Inventories........... (476) 319 (852) (18) (732) Other current assets.. (300) 149 150 123 (186) Accounts payable...... 887 (439) 281 (142) 677 Accrued liabilities... 231 104 252 (57) (186) Deferred revenues..... (788) 552 (1,177) (853) (264) Deferred rent......... (86) (69) (57) (14) (30) ---------- ---------- ---------- ------- ------- Net cash used in operating activities........... (9,176) (9,010) (9,481) (2,943) (2,929) ---------- ---------- ---------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of held-to- maturity short-term investments............ (31,974) (10,068) (10,740) -- -- Proceeds from maturities of held-to-maturity short-term investments............ 39,313 22,117 7,759 -- 2,981 Capital expenditures.... (882) (872) (628) (84) (167) Proceeds from sale of fixed assets........... -- 13 35 14 -- ---------- ---------- ---------- ------- ------- Net cash provided by (used in) investing activities.. 6,457 11,190 (3,574) (70) 2,814 ---------- ---------- ---------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of preferred and common stock........... 1,954 1,911 10,196 16 472 ---------- ---------- ---------- ------- ------- EFFECT OF EXCHANGE RATES ON CASH................. (62) (35) (320) (201) (64) ---------- ---------- ---------- ------- ------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........ (827) 4,056 (3,179) (3,198) 293 CASH AND CASH EQUIVALENTS: Beginning of period..... 4,822 3,995 8,051 8,051 4,872 ---------- ---------- ---------- ------- ------- End of period........... $ 3,995 $ 8,051 $ 4,872 $ 4,853 $ 5,165 ========== ========== ========== ======= ======= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid for income taxes.................. $ 111 $ 123 $ 185 $ 14 $ 42 ========== ========== ========== ======= =======
The accompanying notes are an integral part of these consolidated financial statements. F-6 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997 (ALL INFORMATION FOR THE THREE MONTHS ENDED MARCH 31, 1997 AND 1998 IS UNAUDITED) 1. ORGANIZATION OF THE COMPANY: Echelon Corporation (the "Company") was incorporated in Delaware in January 1989. The Company develops, markets and supports a family of hardware and software products and services that enable OEMs and systems integrators to design and implement open, interoperable, distributed control networks. The Company's products are based on its LonWorks networking technology, an open standard for interoperable networked control developed by the Company. In a LonWorks control network, intelligent control devices, called nodes, communicate using the Company's LonTalk protocol. The Company sells its products and services to the building, industrial, transportation, home and other automation markets. The Company emerged from the development stage during 1990. However, the Company continues to be subject to the risks and challenges associated with other companies in a comparable stage of development including among others: history of losses; fluctuation in operating results; dependence on OEMs and distribution channels; dependence on key manufacturers; competition; dependence on key personnel; new products and rapid technological change; market acceptance of interoperability; international operations and currency fluctuations; lengthy sales cycle; limited protection of intellectual property rights; risks of product defects or misuse; regulatory actions. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation The Company's consolidated financial statements reflect operations of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated. Unaudited Interim Financial Data The unaudited financial statement data as of March 31, 1998 and for the three months ended March 31, 1997 and 1998 has been prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, include all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial information set forth therein, in accordance with generally accepted accounting principles. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition and Product Warranty The Company's revenues are derived from the sale and license of its products and to a lesser extent, from fees associated with training and technical support offered to its customers. Product revenues consist of revenues from hardware sales and software licensing arrangements. Revenues from software licensing arrangements have not been significant to date. Service revenues consist of product support (including software post-contract support services) and training. Revenue from hardware sales are recognized upon shipment to the customer. Estimated reserves for warranty costs as well as reserves for sales returns and allowances related to anticipated return of products sold to distributors with limited rights of return, which are not material to the consolidated financial statements, are F-7 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) recorded at the time of sale. Revenue from software sales, including sales to distributors, are recognized upon shipment of the software if there are no significant post-delivery obligations and if collection is probable. The Company generally has not had any significant post-delivery obligations associated with the sale of its products. Service revenue is recognized as the training services are performed, or ratably over the term of the support period. During 1990, the Company entered into separate licensing agreements with Motorola, Inc. ("Motorola") and one other major semiconductor company which expire in December 1999 and January 2000, respectively, unless renewed. Motorola and the other major semiconductor company have the right to terminate the agreement at any time. Motorola is a significant stockholder and is also a related party to the Company due to its representation on the Company's Board of Directors during 1995, 1996 and part of 1997. The agreements provide, among other things, for the worldwide right to manufacture and distribute products subject to the licensed technology and requires the Company to provide support and unspecified updates to the licensed technology over the terms of the agreements. The agreements also provide for nonrefundable advance royalty payments. As of December 31, 1997, the Company has deferred $2,025,000 (of which $1,350,000 is classified as a long-term liability) of royalty payments that will be recognized in future periods. These payments are being recognized as revenue ratably over the ten-year royalty period due to the ongoing obligation to provide support and unspecified updates to the licensed technology. Any additional royalties that are reported by Motorola or the other company are recognized as revenue upon receipt of such royalties by the Company. Product revenues for the years ended December 31, 1995, 1996 and 1997 each include $675,000 related to these advance royalty payments. For the years ended December 31, 1995, 1996 and 1997, Motorola accounted for approximately $595,000, $845,000 and $360,000 of total revenues, respectively. Cash and Cash Equivalents The Company considers bank deposits, money market investments and U.S. government securities with an original maturity of three months or less as cash and cash equivalents. Short-Term Investments At December 31, 1997, short-term investments consist of U.S. government securities with original maturities of approximately five months. These short- term investments are classified as held-to-maturity and valued using the amortized cost method, which approximated the fair market value. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and manufacturing overhead. Inventories consist of the following (in thousands):
DECEMBER 31, ------------- MARCH 31, 1996 1997 1998 ------ ------ ----------- (UNAUDITED) Purchased materials................................ $1,079 $1,791 $2,286 Work-in-process.................................... 129 130 133 Finished goods..................................... 384 523 757 ------ ------ ------ $1,592 $2,444 $3,176 ====== ====== ======
Property and Equipment Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of two to five years for computer and other equipment and furniture and fixtures. Leasehold improvements are amortized over the shorter of the remaining lease term or the estimated useful life of the improvements using the straight-line method. F-8 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Software Development Costs The Company capitalizes eligible computer software development costs upon the establishment of technological feasibility, which the Company has defined as completion of a working model. For the years ended December 31, 1995, 1996 and 1997, and for the three months ended March 31, 1997 and 1998, costs that were eligible for capitalization were insignificant and, thus, the Company has charged all software development costs to product development expense in the accompanying consolidated statements of operations. Foreign Currency Translation The functional currency of the Company's subsidiaries is the local currency. Accordingly, all assets and liabilities are translated into U.S. dollars at the current exchange rate as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rate prevailing during the period. Gains and losses resulting from the translation of the financial statements are reported as a separate component of stockholders' equity. Concentrations of Credit Risk Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and trade receivables. The Company has cash investment policies that limit the amount of credit exposure to any one financial institution and restrict placement of these investments to financial institutions evaluated as highly creditworthy. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across many different industries and geographies. With respect to trade receivables, the Company performs ongoing credit evaluations of its customers' financial condition. Additionally, the Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other available information. Computation of Basic Net Loss Per Share and Pro Forma Basic Net Loss Per Share Historical net loss per share has been calculated under Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share." SFAS No. 128 requires companies to compute earnings per share under two different methods (basic and diluted). Basic net loss per share is calculated by dividing net loss by the weighted average shares of common stock outstanding during the period. No diluted loss per share information has been presented in the accompanying consolidated statements of operations since potential common shares from the conversion of preferred stock, stock options and warrants are antidilutive. The Company evaluated the requirements of the Securities and Exchange Commission Staff Accounting Bulletin No. 98 ("SAB 98"), and concluded that there are no nominal issuances of common stock or potential common stock which would be required to be shown as outstanding for all periods as outlined in SAB 98. Pro forma basic net loss per share has been calculated assuming the conversion of the outstanding preferred stock into an equivalent number of shares of common stock, as if the shares had been converted on the dates of their issuance. New Pronouncements In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and presentation of comprehensive income. SFAS No. 130, which was adopted by the Company in the first quarter of 1998, requires companies to report a new measurement of income. "Comprehensive Income (Loss)" is to include foreign currency translation gains and losses and other unrealized gains and losses that have historically been excluded from net income (loss) and reflected instead in equity. The following table reconciles comprehensive net loss under the provisions of SFAS No. 130 for F-9 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) the years ended December 31, 1995, 1996 and 1997 and for the three months ended March 31, 1997 and 1998 (in thousands):
DECEMBER 31, MARCH 31, -------------------------- ---------------- 1995 1996 1997 1997 1998 ------- -------- ------- ------- ------- (UNAUDITED) Net loss..................... $(8,713) $(10,716) $(8,214) $(1,907) $(1,737) Foreign currency translation adjustments................. (62) (35) (320) (201) (64) ------- -------- ------- ------- ------- Comprehensive net loss....... $(8,775) $(10,751) $(8,534) $(2,108) $(1,801) ======= ======== ======= ======= =======
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes standards for disclosure of segment information and which will be adopted by the Company in the fourth quarter of 1998. The Company anticipates that SFAS No. 131 will not have a material impact on its financial statements. In December 1997, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 97-2 which superseded SOP 91-1, "Software Revenue Recognition." SOP 97-2 is effective for transactions entered into in the Company's fiscal year beginning January 1, 1998. Management has assessed this new statement and the adoption in the first quarter of fiscal 1998 did not have a material effect on the Company's financial statements or on the timing of the Company's revenue recognition, or cause changes to its revenue recognition policies. In April 1998, the AICPA issued SOP 98-5 "Reporting the Costs of Start-up Activities". SOP 98-5 is effective for the Company's fiscal year beginning January 1, 1999. SOP 98-5 provides guidance on the financial reporting of start-up costs and organization costs and requires such costs to be expensed as incurred. Management believes the adoption of SOP 98-5 will not have a material effect on the Company's financial statements. 3. COMMITMENTS: The Company leases its facilities under operating leases which expire on various dates through 2002. As of December 31, 1997, future minimum lease payments under such agreements were as follows (in thousands): 1998.................................. $1,579 1999.................................. 1,593 2000.................................. 804 2001.................................. 35 2002.................................. 35 ------ $4,046 ======
Rent expense for the years ended December 31, 1995, 1996 and 1997 was approximately $1,645,000, $1,768,000 and $1,818,000, respectively. Certain lease agreements provide for escalating rent payments over the term of the lease. Rent expense under these agreements is recognized on a straight-line basis. As of December 31, 1996 and 1997, the Company has accrued approximately $440,000 and $383,000, respectively, of deferred rent related to these agreements of which $63,000 and $137,000 is included in accrued liabilities as of December 31, 1996 and 1997, respectively, in the accompanying consolidated balance sheets. 4. MAJOR CUSTOMER AND GEOGRAPHIC AREA: In 1996, no single customer accounted for 10% or more of total revenues. In 1995, 1997 and the three months ended March 31, 1998, one customer, who is also a distributor of the Company's products, accounted for 12.0%, 10.9% and 20.6% of total revenues, respectively. For the three months ended March 31, 1997, no single customer accounted for 10% or more of total revenues. F-10 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Company operates in the control network industry segment. The Company's operations by geographic area were as follows (in thousands):
DECEMBER 31, MARCH 31, -------------------------- ---------------- 1995 1996 1997 1997 1998 ------- -------- ------- ------- ------- (UNAUDITED) Revenues from customers: United States............... $20,323 $ 21,445 $25,610 $ 6,805 $ 7,244 Japan....................... 3,020 2,545 2,692 669 715 ------- -------- ------- ------- ------- Total...................... $23,343 $ 23,990 $28,302 $ 7,474 $ 7,959 ======= ======== ======= ======= ======= Intercompany revenues between geographic areas: United States............... $ 1,405 $ 2,085 $ 2,455 $ 741 $ 693 Japan....................... -- -- -- -- -- Europe and Other............ 3,257 4,025 4,523 1,024 1,031 Eliminations................ (4,662) (6,110) (6,978) (1,765) (1,724) ------- -------- ------- ------- ------- Total...................... $ -- $ -- $ -- $ -- $ -- ======= ======== ======= ======= ======= Income (loss) from operations: United States............... $(6,974) $ (6,414) $(3,413) $ (777) $ (642) Japan....................... 118 (854) (1,084) (158) (174) Europe and Other............ 250 380 350 75 83 Eliminations................ (3,248) (4,049) (4,375) (1,084) (1,024) ------- -------- ------- ------- ------- Total...................... $(9,854) $(10,937) $(8,522) $(1,944) $(1,757) ======= ======== ======= ======= ======= Identifiable assets: United States............... $22,741 $ 13,789 $14,203 $13,044 Japan....................... 1,264 1,191 1,800 1,886 Europe and Other............ 542 875 813 765 ------- -------- ------- ------- Total...................... $24,547 $ 15,855 $16,816 $15,695 ======= ======== ======= =======
Revenues from export sales (primarily to Europe) accounted for approximately 39.1%, 43.0%, 48.0%, 45.7% and 48.0% of total revenues for the years ended December 31, 1995, 1996 and 1997 and for the three months ended March 31, 1997 and 1998, respectively. The Company's operations are structured to achieve consolidated objectives. As a result, significant interdependencies and overlaps exist among the Company's operating units. Accordingly, the revenues from customers, income (loss) from operations and identifiable assets shown for each geographic area may not be indicative of the amounts that would have been reported if the operating units were independent of one another. Intercompany sales and transfers of manufacturing materials and finished goods between areas are accounted for based on established intercompany sales prices. F-11 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 5. PREFERRED STOCK: Preferred stock outstanding consists of the following (in thousands, except share amounts):
DECEMBER 31, --------------------------------- MARCH 31, 1996 1997 1998 ---------------- ---------------- ---------------- ADDITIONAL ADDITIONAL ADDITIONAL PAR PAID-IN PAR PAID-IN PAR PAID-IN VALUE CAPITAL VALUE CAPITAL VALUE CAPITAL ----- ---------- ----- ---------- ----- ---------- (UNAUDITED) Series B, 1,250,000 shares authorized, 1,250,000 shares outstanding in 1996, 1997 and 1998, liquidation preference of $7,500....... $13 $ 7,463 $13 $ 7,463 $13 $ 7,463 Series C, 1,608,000 shares authorized, 1,608,000 shares outstanding in 1996, 1997 and 1998, liquidation preference of $12,500...... 16 12,483 16 12,483 16 12,483 Series D, 3,172,000 shares authorized, 3,029,381 shares outstanding in 1996, 1997 and 1998, liquidation preference of $30,294...... 30 30,234 30 30,234 30 30,234 Series E, 2,400,000 shares authorized, no shares outstanding in 1996, 2,000,000 shares outstanding in 1997 and 1998, liquidation preference of $10,000...... -- -- 20 9,900 20 9,900 --- ------- --- ------- --- ------- Total...................... $59 $50,180 $79 $60,080 $79 $60,080 === ======= === ======= === =======
In February 1992, the Company completed a stock purchase agreement with Motorola whereby it sold 1,250,000 shares of its authorized Series B preferred stock at $6.00 per share for total gross proceeds of $7,500,000 to the Company. In January 1993, the Company completed a stock purchase agreement with Motorola whereby it sold 1,608,000 shares of its authorized Series C preferred stock at $7.77 per share for total gross proceeds of $12,500,000 to the Company. In 1994, the Company completed a stock purchase agreement with Motorola and two new investors whereby it sold 1,000,000 shares of its authorized Series D preferred stock at $10.00 per share to each investor for total gross proceeds of $30,000,000 to the Company. In May 1997, the Company completed a stock purchase agreement with existing shareholders whereby it sold 2,000,000 shares of its authorized Series E preferred stock at $5.00 per share for total gross proceeds of $10,000,000 to the Company. Motorola is a party to certain licensing agreements discussed in Note 2. In connection with the issuance of the Series D preferred stock to Motorola in 1994, Motorola was granted the right to purchase additional shares of Series D preferred stock in order to maintain its ownership percentage (the "Motorola Purchase Right"). The Motorola Purchase Right expires upon the closing of an underwritten public offering of the common stock which results in gross proceeds to the Company of not less than $15,000,000. The exercise price of the stock purchase right is the last sales price per share of preferred stock sold by the Company. During 1995, Motorola purchased 29,381 shares of Series D preferred stock at $10.00 per share under this agreement. During 1996 and 1997, Motorola did not purchase any shares of preferred stock under this agreement. As of December 31, 1997, Motorola had the right to purchase approximately 49,000 additional shares of Series D preferred stock under this agreement which expired in February 1998. The rights and preferences of the Series B, C, D and E convertible preferred stock are as follows: (A) Each holder of Series B, C, D and E convertible preferred stock is entitled to receive noncumulative dividends at a rate of $0.48, $0.622, $0.80 and $0.40 per share, respectively, per annum, when and as declared by the Board of Directors, prior to payment of dividends on common stock. To date, no dividends have been declared by the Board of Directors for the preferred stock. (B) Each share of Series B, C, D and E preferred stock is convertible at the option of the holder, at any time after the issuance of such share, into such number of fully paid and nonassessable shares of common stock as is determined by the conversion rate. The initial conversion rate shall be one for one and is subject to adjustment upon the occurrence of specific events. The preferred shares automatically convert into shares of common stock upon the earlier of (1) the affirmative vote of the holders of a majority of the F-12 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Series B, C, D and E preferred stock to cause all outstanding shares of Series B, C, D and E preferred stock to be converted; or (2) the closing of an underwritten public offering of the common stock which results in gross proceeds to the Company of not less than $15,000,000. (C) In the event of any liquidation, dissolution or winding up of the Company, either voluntary or involuntary, the holders of the Series B, C, D and E preferred stock shall be entitled to receive $6.00, $7.7736, $10.00 and $5.00 per share, respectively, plus any declared but unpaid dividends, prior to any distribution to the holders of common stock. (D) The holder of each share of Series B, C, D and E preferred stock is entitled to vote in an amount equivalent to the number of shares of common stock into which the preferred stock could be converted. (E) Without the approval of a majority of the holders of the outstanding shares of Series B, C, D and E preferred stock, the Company cannot, among other things, materially alter or change the powers, preferences or special rights of the Series B, C, D and E preferred stock so as to affect them adversely. 6. COMMON STOCK: The Company sold 975,000, 1,005,000 and 5,000 shares of common stock during 1995, 1996 and 1997, respectively, at the fair value, as determined by the Board of Directors, of $1.00 per share to $1.29 per share during 1995, $1.29 per share to $1.40 per share during 1996 and $1.40 per share during 1997 under stock purchase agreements, primarily to certain officers of the Company. The stock purchased under these agreements vests annually over four years. As of December 31, 1997, 1,322,500 shares of common stock issued and outstanding under these stock purchase agreements and previous stock purchase agreements were unvested and subject to repurchase by the Company, at the Company's discretion, at prices ranging from $0.77 to $1.40 per share and a weighted average price of $1.26 per share. Warrants In connection with the issuance of the Series D preferred stock in 1994, the Company granted certain investment bankers warrants to purchase 30,000 shares of the Company's common stock at $12.00 per share (the "Common Stock Warrants"). The Common Stock Warrants expire upon the earlier of (i) February 2, 1999 or (ii) the consummation of any transaction resulting in the sale, transfer or disposition of all or substantially all of the Company's assets or the merger of the Company with or into, or consolidation with, any other corporation, whereby the holders of the Company's voting securities prior to the transaction do not hold more than 50% of the voting securities of the surviving entity following consummation of the transaction ("Change in Control"). At December 31, 1997, these Common Stock Warrants were exercisable but no warrants had been exercised. In addition, in connection with the issuance of the Series E preferred stock in 1997, warrants to purchase an aggregate of 400,000 shares of Series E preferred stock (or common stock, if all Series E preferred stock has then been converted into common stock) at a per share exercise price of $5.00 were issued (the "Series E Warrants" and together with the Common Stock Warrants, the "Warrants"). The Series E Warrants are exercisable at any time until their expiration on the earlier of May 15, 2002 or a Change in Control. Each Warrant contains a cashless conversion right that allows the holder to receive a number of shares of the Company's common stock or Series E preferred stock, as applicable, equal to the quotient obtained by dividing the value of the Warrant on the date of exercise, which value is determined by subtracting (i) the aggregate exercise price of the Warrant from (ii) the aggregate fair market value of the Warrant shares on the date of exercise, by the fair market value of one share of the Company's Common Stock or Series E Preferred Stock, as applicable, on the date of exercise, as determined by the Company's Board of Directors. At December 31, 1997, these Series E Warrants are exercisable but no warrants had been exercised. At the date of issuance, the fair market value of these Warrants was deemed to be immaterial. F-13 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 1988 Stock Option Plan During 1988, the Company adopted the 1988 Stock Option Plan (the "1988 Plan") for key employees, officers and directors. The Company has reserved 8,900,000 shares under the 1988 Plan. Incentive stock options to purchase shares of common stock may be granted at not less than 100% of the fair market value, as determined by the Board of Directors, and generally have a term of five years from the date of grant, not to exceed ten years. The 1988 Plan also provides for holders of non-qualified stock options to purchase shares at not less than 85% of the fair market value, as determined by the Board of Directors. Options generally vest ratably over four years. The 1988 Plan also allows for the issuance of options which are immediately exercisable through execution of a restricted stock purchase agreement. Shares purchased pursuant to a stock purchase agreement generally vest over four years. In the event of termination of employment, the Company, at its discretion, may repurchase unvested shares at a price equal to the original issue price. Options granted under the 1988 Plan will remain outstanding in accordance with their original terms. However, effective April 1997, the Board of Directors determined that no further options will be granted under the 1988 Plan. 1997 Stock Plan During 1997, the Company adopted the 1997 Stock Plan (the "1997 Plan") for key employees, officers and directors. The Company has reserved 5,000,000 shares under the 1997 Plan. In February 1998, the Board of Directors authorized an increase in the number of shares reserved for issuance under the 1997 Plan to 6,200,000 shares. Incentive stock options to purchase shares of common stock may be granted at not less than 100% of the fair market value, as determined by the Board of Directors, and generally have a term of five years from the date of grant, not to exceed ten years. The 1997 Plan also provides for holders of non-qualified stock options to purchase shares at not less than 85% of the fair market value, as determined by the Board of Directors. Options generally vest ratably over four years. The 1997 Plan also allows for the issuance of options which are immediately exercisable through execution of a restricted stock purchase agreement. Shares purchased pursuant to a stock purchase agreement generally vest annually over four years. In the event of termination of employment, the Company, at its discretion, may repurchase unvested shares at a price equal to the original issuance price. As of December 31, 1997, no shares of common stock were issued and outstanding under these restricted stock purchase agreements. F-14 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Stock option activity under the 1988 and 1997 Plans is summarized below:
WEIGHTED NUMBER AVERAGE OF OPTIONS EXERCISE PRICE ---------- -------------- Options outstanding, December 31, 1994....... 2,227,000 $0.57 Grants.................. 943,800 1.11 Cancellations........... (104,551) 0.80 Exercises............... (1,072,373) 0.53 ---------- ----- Options outstanding, December 31, 1995....... 1,993,876 0.84 Grants.................. 1,618,700 1.38 Cancellations........... (130,938) 1.07 Exercises............... (630,124) 0.83 ---------- ----- Options outstanding, December 31, 1996....... 2,851,514 1.14 Grants.................. 2,185,700 1.40 Cancellations........... (366,626) 1.29 Exercises............... (354,156) 0.83 ---------- ----- Options outstanding, December 31, 1997....... 4,316,432 1.28 Grants.................. 215,250 2.00 Cancellations........... (43,938) 1.24 Exercises............... (405,049) 1.16 ---------- ----- Options outstanding, March 31, 1998 (unaudited)............. 4,082,695 $1.33 ========== ===== Exercisable at December 31, 1996................ 2,851,514 $1.14 ========== ===== Exercisable at December 31, 1997................ 4,316,432 $1.28 ========== ===== Exercisable at March 31, 1998 (unaudited)........ 3,932,695 $1.31 ========== =====
The following table summarizes the stock options outstanding as of December 31, 1997:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE --------------------------------------------------------------------- WEIGHTED NUMBER AVERAGE WEIGHTED NUMBER WEIGHTED OUTSTANDING AT REMAINING AVERAGE EXERCISABLE AVERAGE EXERCISE DECEMBER 31, LIFE (IN EXERCISE DECEMBER 31, EXERCISE PRICE RANGE 1997 YEARS) PRICE 1997 PRICE ----------- -------------- --------- -------- ------------ -------- $0.15 25,500 1.7 $0.15 25,500 $0.15 0.60-0.77 431,189 1.2 0.72 431,189 0.72 0.97-1.40 3,859,743 3.8 1.35 3,859,743 1.35 --------- --- ----- --------- ----- 0.15-1.40 4,316,432 3.5 $1.28 4,316,432 $1.28 ========= === ===== ========= =====
Certain options issued under the 1988 and 1997 Plans may be exercised any time prior to their expiration. In addition, the Company has the right, upon termination of an optionholder's employment or service with the Company, at its discretion, to repurchase any unvested shares issued under the 1988 and 1997 Plans at the original purchase price. As of December 31, 1997 and March 31, 1998, 220,938 and 479,938 shares, respectively, were subject to repurchase by the Company at prices ranging from $0.77 to $1.40 per share and a weighted average repurchase price of $1.12 and $1.27, respectively. Of the 4,316,432 options exercisable at December 31, 1997, 871,290 were vested, and of the 3,932,695 options exercisable at March 31, 1998, 764,915 were vested. F-15 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In connection with the issuance of stock options to employees during the three months ended March 31, 1998, the Company has recorded deferred compensation in the aggregate amount of approximately $530,000, representing the difference between the deemed fair value of the Company's common stock and the exercise price of the stock options at the date of grant. The Company is amortizing the deferred compensation expense over the shorter of the period in which the employee provides services or the applicable vesting period, which is typically 48 months. For the three-month period ended March 31, 1998, amortization expense was approximately $11,000. Deferred compensation is decreased in the period of forfeiture arising from the early termination of an option holder's services. No compensation expense related to any other periods presented has been recorded. The Company accounts for the Plans under APB Opinion No. 25, "Accounting for Stock Issued to Employees." Had compensation expense for the Plans been determined consistent with SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net loss and basic net loss per share would have been increased to the following pro forma amounts (in thousands, except per share amounts):
YEARS ENDED DECEMBER 31, -------------------------- 1995 1996 1997 ------- -------- ------- Net loss: As reported.................................... $(8,713) $(10,716) $(8,214) Pro forma...................................... (8,789) (10,992) (8,626) Basic net loss per share: As reported.................................... $ (0.56) $ (0.62) $ (0.44) Pro forma...................................... (0.56) (0.63) (0.46)
The weighted-average grant date fair value of options granted during 1995, 1996 and 1997 was $0.08, $0.17 and $0.19, respectively. The fair value of each option grant is estimated on the date of grant using the minimum value method and the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1995, 1996 and 1997: risk-free interest rates of 5.95%, 6.10% and 5.60%, respectively; expected dividend yields of zero percent; expected lives of 4 years. Because the Company has been a non-public entity, it has omitted expected volatility in determining a value for its options. Shares Reserved At December 31, 1997, the Company has reserved shares of its common stock as follows: Conversion of convertible preferred stock......................... 7,887,381 Exercise and future issuance of stock options..................... 7,265,382 Warrants.......................................................... 430,000 Series D purchase right-Motorola.................................. 49,000 ---------- 15,631,763 ==========
7. INCOME TAXES: The Company accounts for income taxes using SFAS No. 109, "Accounting for Income Taxes". SFAS No. 109 provides for an asset and liability approach under which deferred income taxes are based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. Income taxes for the years ended December 31, 1995, 1996 and 1997 primarily consist of taxes related to foreign subsidiaries. F-16 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The components of the net deferred income tax asset as of December 31, 1996 and 1997 are as follows (in thousands):
1996 1997 -------- -------- Net operating loss carryforwards......................... $ 23,986 $ 26,315 Deferred revenue......................................... 1,084 940 Tax credit carryforwards................................. 3,051 3,537 Capitalized research and development costs............... 1,469 1,852 Reserves and other cumulative temporary differences...... 1,104 906 -------- -------- 30,694 33,550 Valuation allowance...................................... (30,694) (33,550) -------- -------- Net deferred income tax asset............................ $ -- $ -- ======== ========
As of December 31, 1997, the Company had net operating loss carryforwards for Federal and state income tax reporting purposes of approximately $76.0 million and $5.0 million, respectively, which expire at various dates through 2012. In addition, as of December 31, 1997, the Company had tax credit carryforwards of approximately $3.5 million, which expire at various dates through 2012. The Internal Revenue Code of 1986, as amended, contains provisions that may limit the net operating loss and credit carryforwards available for use in any given period upon the occurrence of certain events, including a significant change in ownership interests. A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance due to the history of losses and the variability of operating results. As of December 31, 1996 and 1997, the Company had no significant deferred tax liabilities. 8. SUBSEQUENT EVENTS (UNAUDITED): Pro Forma Stockholders' Equity In April 1998, the Board of Directors authorized the filing of a registration statement with the Securities and Exchange Commission permitting the Company to sell shares of its common stock in connection with the proposed initial public offering ("IPO"). In addition, the Board of Directors authorized the Company to amend its articles of incorporation, whereby the Company will be authorized to issue 100,000,000 shares of common stock and 5,000,000 shares of preferred stock. If the offering is consummated under the terms presently anticipated, all of the currently outstanding preferred stock will automatically convert into 7,887,381 shares of common stock upon the closing of the IPO. The effect of the above has been reflected in the accompanying unaudited pro forma stockholders' equity as of March 31, 1998. 1998 Directors Option Plan Non-employee directors are entitled to participate in the 1998 Director Option Plan (the "Director Plan"). The Director Plan was adopted by the Board of Directors in May 1998, is subject to stockholder approval and will not become effective until the date of this offering. The Director Plan has a term of ten years, unless terminated sooner by the Board. A total of 300,000 shares of Common Stock have been reserved for issuance under the Director Plan, plus an increase each year equal to 100,000 shares or such lesser amount as the Board may determine. The Director Plan provides for the automatic grant of 25,000 shares of common stock (the "First Option") to each non-employee director on the date he or she first becomes a director (provided that such person joins the Board after May 29, 1998). Each non-employee director shall also automatically be granted an option to purchase 10,000 shares (a "Subsequent Option") on both the effective date of this offering and on the date of the F-17 ECHELON CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Company's Annual Stockholder Meeting provided that he or she is re-elected to the Board or otherwise remains on the Board, if on such date he or shall have served on the Board for at least the preceding six months. Each First Option and each Subsequent Option shall have a term of five years and the shares subject to the option shall vest as to 25% of the shares subject to option on each anniversary of the date of grant. The exercise price of each First Option and Subsequent Option shall be 100% of the fair market value per share of the common stock, generally determined with reference to the closing price of the common stock as reported on the Nasdaq National Market on the date of grant. On the effective date of this offering options to purchase an aggregate of 60,000 shares will be granted under the Director Plan, with an exercise price equal to the initial public offering price per share. In the event of a merger of the Company with or into another corporation or the sale of substantially all of the assets of the Company, each option shall be assumed or an equivalent option may be substituted by the successor corporation. Following such assumption or substitution, if the optionee's status as a director of the successor corporation terminates other than upon a voluntary resignation by the optionee, the option shall become fully exercisable, including as to shares as to which it would not otherwise be exercisable. If the outstanding options are not assumed or substituted, the options shall become fully vested and exercisable. Options granted under the Director Plan must be exercised within three months of the end of the optionee's tenure as a director of the Company, or within twelve months after such director's termination by death or disability, but in no event later than the expiration of the option's five year term; provided, however, that shares subject to an option granted to a director who has served as a director with the Company for at least five years shall become fully vested and exercisable for the remainder of the option's five year term upon such director's termination. No option granted under the Director Plan is transferable by the optionee other than by will or the laws of descent and distribution, and each option is exercisable, during the lifetime of the optionee, only by such optionee. Bank Revolving Line of Credit Agreement In May 1998, the Company entered into a revolving line of credit agreement with a bank, whereby the Company may borrow up to 85% of eligible accounts receivable, not to exceed $5.0 million. If the credit agreement had been in place as of April 30, 1998, the amount available to be borrowed would have been $2.6 million. Advances under the credit agreement bear interest at the bank's reference rate or, at the option of the Company, at a fixed rate of interest equal to the London interbank offered rate plus 150 basis points. As of May 31, 1998, there was approximately $65,000 outstanding under this line of credit in the form of a letter of credit. The credit agreement, which expires in May 1999, contains certain negative covenants restricting the Company's ability to pay dividends or enter into certain financial transactions. The credit agreement also contains a minimum tangible net worth requirement, determined on a quarterly basis. F-18 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- No dealer, sales representative, or any other person has been authorized to give any information or to make any representations in connection with this of- fering other than those contained in this Prospectus, and, if given or made, such information or representations must not be relied upon as having been au- thorized by the Company or any of the Underwriters. This Prospectus does not constitute an offer to sell or a solicitation of an offer to buy any securities other than the Common Stock to which it relates or an offer to, or a solicita- tion of, any person in any jurisdiction where such an offer or solicitation would be unlawful. Neither the delivery of this Prospectus nor any sale made hereunder shall, under any circumstances, create any implication that there has been no change in the affairs of the Company since the date hereof or that the information contained herein is correct as of any time subsequent to the date hereof. -------------------------- TABLE OF CONTENTS --------------------------
Page ---- Prospectus Summary....................................................... 3 Risk Factors............................................................. 5 Use of Proceeds.......................................................... 16 Dividend Policy.......................................................... 16 Capitalization........................................................... 17 Dilution................................................................. 18 Selected Consolidated Financial Data..................................... 19 Management's Discussion and Analysis of Financial Condition and Results of Operations........................................................... 20 Business................................................................. 29 Management............................................................... 40 Certain Transactions..................................................... 49 Principal Stockholders................................................... 51 Description of Capital Stock............................................. 54 Shares Eligible for Future Sale.......................................... 57 Underwriting............................................................. 59 Legal Matters............................................................ 61 Experts.................................................................. 61 Additional Information................................................... 61 Index to Consolidated Financial Statements............................... F-1
Until , 1998 (25 days after the date of this Prospectus), all dealers ef- fecting transactions in the Common Stock offered hereby, whether or not partic- ipating in this distribution, may be required to deliver a Prospectus. This is in addition to the obligation of dealers to deliver a Prospectus when acting as Underwriters and with respect to their unsold allotments or subscriptions. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 5,000,000 SHARES [LOGO OF ECHELON(R)] COMMON STOCK --------------- PROSPECTUS --------------- NationsBanc Montgomery Securities LLC BancAmerica Robertson Stephens Volpe Brown Whelan & Company , 1998 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION The following table sets forth the costs and expenses, other than the underwriting discount, payable by the Registrant in connection with the sale of Common Stock being registered. All amounts are estimates except the SEC registration fee and the NASD filing fee.
AMOUNT TO BE PAID -------- SEC registration fee............................................... $ 15,266 NASD filing fee.................................................... 5,675 Printing and engraving expenses.................................... 125,000 Legal fees and expenses............................................ 300,000 Accounting fees and expenses....................................... 150,000 Blue Sky qualification fees and expenses........................... 10,000 Transfer agent and registrar fees.................................. 10,000 Miscellaneous fees................................................. 84,059 -------- Total............................................................ $700,000 ========
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS As permitted by Section 145 of the Delaware General Corporation Law, the Registrant's Certificate of Incorporation includes a provision that eliminates the personal liability of its directors for monetary damages for breach or alleged breach of their duty of care. In addition, as permitted by Section 145 of the Delaware General Corporation Law, the Bylaws of the Registrant provide that: (i) the Registrant is required to indemnify its directors and executive officers and persons serving in such capacities in other business enterprises (including, for example, subsidiaries of the Registrant) at the Registrant's request, to the fullest extent permitted by Delaware law, including in those circumstances in which indemnification would otherwise be discretionary; (ii) the Registrant may, in its discretion, indemnify employees and agents in those circumstances where indemnification is not required by law; (iii) the Registrant is required to advance expenses, as incurred, to its directors and executive officers in connection with defending a proceeding (except that it is not required to advance expenses to a person against whom the Registrant brings a claim for breach of the duty of loyalty, failure to act in good faith, intentional misconduct, knowing violation of law or deriving an improper personal benefit; (iv) the rights conferred in the Bylaws are not exclusive, and the Registrant is authorized to enter into indemnification agreements with its directors, executive officers and employees; and (v) the Registrant may not retroactively amend the Bylaw provisions in a way that is adverse to such directors, executive officers and employees. The Registrant's policy is to enter into indemnification agreements with each of its directors and executive officers that provide the maximum indemnity allowed to directors and executive officers by Section 145 of the Delaware General Corporation Law and Bylaws, as well as certain additional procedural protections. In addition, such indemnity agreements provide that directors and executive officers will be indemnified to the fullest possible extent not prohibited by law against all expenses (including attorney's fees) and settlement amounts paid or incurred by them in any action or proceeding, including any derivative action by or in the right of the Registrant, on account of their services as directors or executive officers of the Registrant or as directors or officers of any other Company or enterprise when they are serving in such capacities at the request of the Registrant. The Company will not be obligated pursuant to the indemnity agreements to indemnify or advance expenses to an indemnified party with respect to proceedings or claims initiated by the indemnified party and not by way of defense, except with respect to proceedings specifically authorized by the Board of Directors or brought to enforce a right to indemnification under the indemnity agreement, the Company's Bylaws or any statute or law. Under the agreements, the Company is not obligated to indemnify the indemnified party (i) for any expenses II-1 incurred by the indemnified party with respect to any proceeding instituted by the indemnified party to enforce or interpret the agreement, if a court of competent jurisdiction determines that each of the material assertions made by the indemnified party in such proceeding was not made in good faith or was frivolous; (ii) for any amounts paid in settlement of a proceeding unless the Company consents to such settlement; (iii) with respect to any proceeding brought by the Company against the indemnified party for willful misconduct, unless a court determines that each of such claims was not made in good faith or was frivolous; (iv) on account of any suit in which judgment is rendered against the indemnified party for an accounting of profits made from the purchase or sale by the indemnified party of securities of the Company pursuant to the provisions of (S)16(b) of the Exchange Act and related laws; (v) on account of the indemnified party's conduct which is finally adjudged to have been knowingly fraudulent or deliberately dishonest, or to constitute willful misconduct or a knowing violation of the law; (vi) an account of any conduct from which the indemnified party derived an improper personal benefit; (vii) on account of conduct the indemnified party believed to be contrary to the best interests of the Company or its stockholders; (viii) on account of conduct that constituted a breach of the indemnified party's duty of loyalty to the Company or its stockholders; or (ix) if a final decision by a court having jurisdiction in the matter shall determine that such indemnification is not lawful. The indemnification provision in the Bylaws and the indemnification agreements entered into between the Registrant and its directors and executive officers, may be sufficiently broad to permit indemnification of the Registrant's officers and directors for liabilities arising under the Securities Act. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES (a) During the period from June 1, 1995, to June 30, 1998, the Company sold an aggregate of 1,826,570 shares of unregistered Common Stock to 134 individuals who were officers, employees or former employees of the Company, for an aggregate offering price of $1,405,045. These shares were sold pursuant to the exercise of options issued under the Company's 1988 Stock Option Plan. As to each employee, officer and director of the Company who was issued such securities, the Company relied upon Rule 701 of the Securities Act. Each such person purchased securities of the Company pursuant to a written contract between such person and the Company; in addition, the Company met the conditions imposed under Rule 701(b). (b) During the period from June 1, 1995 to June 30, 1998, the Company sold an aggregate of 1,984,000 shares of unregistered Common Stock to eight individuals who were officers or employees of the Company or an entity affiliated with a member of the Company's Board of Directors, for an aggregate offering price of $2,672,750. These shares were sold pursuant to stock purchase agreements between the Company and such individuals and entities. As to each person who was issued such securities, the Company relied upon Section 4(2) of the Securities Act. (c) In May 1997 the Company sold an aggregate of 2,000,000 shares of unregistered Series E Preferred Stock to certain investors, each of which was an existing stockholder of the Company, for an aggregate offering price of $10,000,000. In connection therewith, the Company issued Warrants to seven investors to purchase an aggregate of 400,000 shares of Series E Preferred Stock. As to each investor constituting a "U.S. person" (within the meaning of Regulation S) who was issued such shares of Series E Preferred Stock, the Company relied upon Section 4(2) of the 1933 Act and Regulation D, Rule 506, thereunder. The sale of Series E Preferred Stock and the issuance of Warrants were made in compliance with all of the terms of Rules 501 and 502 of Regulation D, there were no more than 35 investors (as calculated pursuant to Rule 501(e) of Regulation D), and each investor who was not an accredited investor represented to the Company that he or she had such knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the investment. Appropriate legends were affixed to the share certificates issued in the transactions described above. All recipients had adequate access, through their relationships with the Company, to information about the Company. II-2 (d) In January 1998, the Company registered with the Commission pursuant to a Regulation A Offering Statement options granted under the Company's 1997 Stock Plan to purchase up to 3,571,428 of the Company's Common Stock and the Common Stock issuable upon the exercise of such options. As of June 30, 1998, an aggregate of 347,750 shares of unregistered Common Stock have been sold upon exercise of stock options to 27 individuals who were officers, employers or former employees of the Company for an aggregate offering price of $516,850. ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (A) EXHIBITS
EXHIBIT NO. DESCRIPTION OF DOCUMENT ------- ----------------------- 1.1* Form of Underwriting Agreement. 3.1* Amended and Restated Certificate of Incorporation of Registrant. 3.2 Amended and Restated Certificate of Incorporation of Registrant (to be effective upon closing of Offering). 3.3* Amended and Restated Bylaws of Registrant. 4.1 Form of Registrant's Common Stock Certificate. 4.2* Second Amended and Restated Modification Agreement dated May 15, 1997. 5.1 Opinion of Wilson Sonsini Goodrich & Rosati P.C., regarding the legality of the securities being issued. 10.1* Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers. 10.2 1997 Stock Plan and forms of related agreements. 10.3* 1988 Stock Option Plan and forms of related agreements. 10.4* Second Amended and Restated Modification Agreement dated May 15, 1997 (included in Exhibit 4.2). 10.5* Form of International Distributor Agreement. 10.6* Form of OEM License Agreement. 10.7* Form of Software License Agreement. 10.8* International Distributor Agreement between the Company and EBV Elektronik GmbH as of December 1, 1997. 10.9* 1998 Director Option Plan. 21.1 Subsidiaries of the Registrant. 23.1 Consent of Wilson Sonsini Goodrich & Rosati P.C. (included in Exhibit 5.1). 23.2 Consent of Arthur Andersen LLP (see page II-6). 24.1* Power of Attorney. 27.1* Financial Data Schedule (available in EDGAR format only).
- -------- *Previously filed.
(B) FINANCIAL STATEMENT SCHEDULE Report of Independent Public Accountants on Schedule S-1 Schedule II--Valuation and Qualifying Accounts S-2
Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the financial statements or notes thereto. II-3 ITEM 17. UNDERTAKINGS The undersigned Registrant hereby undertakes to provide to the Underwriters at the closing specified in the Underwriting Agreement, certificates in such denominations and registered in such names as required by the Underwriters to permit prompt delivery to each purchaser. Insofar as indemnification for liabilities arising under the Securities Act, may be permitted to directors, officers and controlling persons of the Registrant pursuant to the California Corporation Law, the Registrant's Amended and Restated Certificate of Incorporation, the Registrant's Amended and Restated Bylaws, the Registrant's indemnification agreements or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act, and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered hereunder, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. The undersigned Registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act, the information omitted from the form of Prospectus filed as part of this Registration Statement in reliance upon Rule 430A and contained in a form of Prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this Registration Statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of Prospectus shall be deemed to be a new Registration Statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Amendment to the Registration Statement on Form S-1 to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of Palo Alto, State of California, on this 9th day of July, 1998. By: /s/ M. Kenneth Oshman ---------------------------------- M. Kenneth Oshman Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Act of 1933, this Amendment to the Registration Statement has been signed by the following persons in the capacities and on the dates indicated:
SIGNATURES TITLE DATE ---------- ----- ---- /s/ M. Kenneth Oshman Chairman of the July 9, 1998 - ------------------------------------- Board, President M. KENNETH OSHMAN and Chief Executive Officer (Principal Executive Officer) * Vice President of July 9, 1998 - ------------------------------------- Finance and Chief OLIVER R. STANFIELD Financial Officer (Principal Financial Officer and Principal Accounting Officer) * Vice Chairman July 9, 1998 - ------------------------------------- ARMAS CLIFFORD MARKKULA, JR. * Director July 9, 1998 - ------------------------------------- BERTRAND CAMBOU * Director July 9, 1998 - ------------------------------------- ROBERT R. MAXFIELD * Director July 9, 1998 - ------------------------------------- RICHARD M. MOLEY * Director July 9, 1998 - ------------------------------------- ARTHUR ROCK * Director July 9, 1998 - ------------------------------------- LARRY W. SONSINI *By: /s/ M. Kenneth Oshman --------------------------------- M. KENNETH OSHMAN Attorney-in-fact
II-5 EXHIBIT 23.2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the use of our reports and to all references to our Firm included in or made a part of this Registration Statement. ARTHUR ANDERSEN LLP San Jose, California July 9, 1998 II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE To Echelon Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of Echelon Corporation and subsidiaries included in this Registration Statement and have issued our report thereon dated February 17, 1998. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index above is the responsibility of the Company's management and is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP San Jose, California February 17, 1998 S-1 ECHELON CORPORATION SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E - ----------------------------------- ---------- ---------- ---------- --------- BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND AT END DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS OF PERIOD - ----------------------------------- ---------- ---------- ---------- --------- Year ended December 31, 1995: Allowance for returns and doubtful accounts.......................... $174 $304 $-- $478 Year ended December 31, 1996: Allowance for returns and doubtful accounts.......................... 478 341 -- 819 Year ended December 31, 1997: Allowance for returns and doubtful accounts.......................... 819 -- 257 562
S-2 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION OF DOCUMENT ------- ----------------------- 1.1* Form of Underwriting Agreement. 3.1* Amended and Restated Certificate of Incorporation of Registrant. 3.2 Amended and Restated Certificate of Incorporation of Registrant (to be effective upon closing of Offering). 3.3* Amended and Restated Bylaws of Registrant. 4.1 Form of Registrant's Common Stock Certificate. 4.2* Second Amended and Restated Modification Agreement dated May 15, 1997. 5.1 Opinion of Wilson Sonsini Goodrich & Rosati P.C., regarding the legality of the securities being issued. 10.1* Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers. 10.2 1997 Stock Plan and forms of related agreements. 10.3* 1988 Stock Option Plan and forms of related agreements. 10.4* Second Amended and Restated Modification Agreement dated May 15, 1997 (included in Exhibit 4.2). 10.5* Form of International Distributor Agreement. 10.6* Form of OEM License Agreement. 10.7* Form of Software License Agreement. 10.8* International Distributor Agreement between the Company and EBV Elektronik GmbH as of December 1, 1997. 10.9* 1998 Director Option Plan. 21.1 Subsidiaries of the Registrant. 23.1 Consent of Wilson Sonsini Goodrich & Rosati P.C. (included in Exhibit 5.1). 23.2 Consent of Arthur Andersen LLP (see page II-6). 24.1* Power of Attorney. 27.1* Financial Data Schedule (available in EDGAR format only).
- -------- *Previously filed. EX-3.2 2 AMENDED & RESTATED CERTIFICATE OF ECHELON EXHIBIT 3.2 AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF ECHELON CORPORATION Echelon Corporation, a corporation organized and existing under the laws of the State of Delaware (the "Corporation"), certifies that: A. The name of the Corporation is Echelon Corporation. Echelon Corporation was originally incorporated under the name Echelon Systems, Inc., and the original Certificate of Incorporation was filed with the Secretary of State of the State of Delaware on December 7, 1988. B. Pursuant to Sections 242 and 245 of the General Corporation Law of the State of Delaware, this Amended and Restated Certificate restates, integrates and further amends the provisions of the Corporation's Certificate of Incorporation. C. The text of the Amended and Restated Certificate of Incorporation as previously amended or supplemented is restated and further amended to read as follows: ONE. The name of this Corporation is Echelon Corporation. --- TWO. The address of the Corporation's registered office in the State --- of Delaware is The Corporation Trust Company, 1209 Orange Street, in the City of Wilmington, County of New Castle. The name of its registered agent at such office is The Corporation Trust Company. THREE. The nature of the business or purposes to be conducted by this ----- Corporation is to engage in any lawful act or activity for which a corporation may be organized under the General Corporation Law of Delaware. FOUR. This Corporation is authorized to issue two classes of shares ---- to be designated respectively Common Stock and Preferred Stock. The total number of shares of Common Stock this Corporation shall have authority to issue is 100,000,000, with par value of $0.01 per share, and the total number of shares of Preferred Stock this Corporation shall have authority to issue is 13,430,000, with par value of $0.01 per share. Of the Preferred Stock, 1,250,000 shares shall be designated Series B Preferred Stock ("Series B Stock"), 1,608,000 shares shall be designated Series C Preferred Stock ("Series C Stock"), 3,172,000 shares shall be designated Series D Preferred Stock ("Series D Stock") and 2,400,000 shares shall be designated Series E Preferred Stock ("Series E Stock"). The undesignated 5,000,000 shares of Preferred Stock may be issued from time to time in one or more series. The Board of Directors is authorized to determine the number of shares of any such series. The Board of Directors is also authorized to determine or alter the powers, designations, preferences, rights and restrictions to be imposed upon any wholly unissued series of Preferred Stock and, within the limits and restrictions stated in any resolution or resolutions of the Board of Directors originally fixing the number of shares constituting any series, to increase (but not above the total number of authorized shares of the class) or decrease (but not below the number of shares of such series then outstanding) the number of shares of any series subsequent to the issue of shares of that series. The Corporation shall from time to time in accordance with the laws of the State of Delaware increase the authorized amount of its Common Stock if at any time the number of shares of Common Stock remaining unissued and available for issuance shall not be sufficient to permit conversion of the Preferred Stock. The rights, preferences, privileges and restrictions granted to or imposed on the Common Stock and Preferred Stock are as follows: 1. Dividends. The holders of the Preferred Stock shall be entitled to --------- receive when and as declared by the Board of Directors out of any funds legally available therefor, dividends at the rate of (i) $0.48 per share per annum, on each outstanding share of Series B Stock, (ii) $0.622 per share per annum, on each outstanding share of Series C Stock, (iii) $0.80 per share per annum, on each outstanding share of Series D Stock and (iv) $0.40 per share per annum, on each outstanding share of Series E Stock, adjusted for any combinations, consolidations, or stock distributions or dividends with respect to such shares. No dividends (other than those payable solely in Common Stock) shall be paid with respect to the Common Stock during any fiscal year of the Corporation until dividends in the total amount of $0.48 per share on the Series B Stock, $0.622 per share on the Series C Stock, $0.80 per share on the Series D Stock and $0.40 per share on the Series E Stock (adjusted for any combinations, consolidations, or stock distributions or dividends with respect to such shares) shall have been paid or declared and set apart during that fiscal year. Dividends on the Series B Stock, Series C Stock, Series D Stock and Series E Stock shall not be cumulative and no rights shall accrue to the holders of Series B Stock, Series C Stock, Series D Stock and Series E Stock in the event that the Corporation shall fail to declare or pay dividends on the Series B Stock in the amount of $0.48 per share, the Series C Stock in the amount of $0.622 per share, the Series D Stock in the amount of $0.80 per share or the Series E Stock in the amount of $0.40 per share (adjusted for any combina tions, consolidations, or stock distributions or dividends with respect to such shares) or in any amount in any previous fiscal year of the Corporation, whether or not the earnings of the Corporation in that previous fiscal year were sufficient to pay such dividends in whole or in part. After dividends in the amount of $0.48 per share on the Series B Stock, dividends in the amount of $0.622 per share on the Series C Stock, dividends in the amount of $0.80 per share on the Series D Stock and dividends in the amount of $0.40 per share on the Series E Stock (adjusted for any combinations, consolidations, or stock distributions or dividends with respect to such shares) have been paid or declared and set apart in any one fiscal year of the Corporation, if the Board shall elect to declare -2- additional dividends out of funds legally available therefor in that fiscal year, such additional dividends shall be declared solely on the Common Stock. 2. Liquidation Preference. ---------------------- (a) In the event of any liquidation, dissolution or winding up of the Corporation, either voluntary or involuntary, the holders of Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Common Stock by reason of their ownership of such stock, the amount of (i) $6.00 per share for each share of Series B Stock then held by them, (ii) $7.7736 per share for each share of Series C Stock then held by them, (iii) $10.00 per share for each share of Series D Stock then held by them and (iv) $5.00 per share for each share of Series E Stock then held by them (adjusted for any combinations, consolidations, or stock distributions or dividends with respect to such shares), and, in addition, the amount of any declared but unpaid dividends on each share of Preferred Stock then held by them. (b) If upon the occurrence of such event, the assets and funds thus distributed among the holders of the Preferred Stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amount, then the entire assets and funds of the Corporation legally available for distribution shall be distributed among the holders of the Preferred Stock in proportion to the aggregate preferential amount of all shares of Preferred Stock then held by them bears to the aggregate preferential amount of all shares of Preferred Stock outstanding as of the date of the distribution upon the occurrence of such event. (c) In the event of any liquidation, dissolution or winding up of the Corporation, whether voluntary or involuntary, after payment has been made to the holders of Preferred Stock of the full amounts to which they shall be entitled as aforesaid, the holders of Common Stock shall be entitled to share ratably in the remaining assets, based on the number of shares of Common Stock held. (d) For purposes of this Section 2, a consolidation or merger of the Corporation with and into any other corporation or corporations, or a sale of all or substantially all of the assets of the Corporation, or a reorganization of the Corporation in which more than fifty percent (50%) of the outstanding stock of the Corporation is exchanged, shall be treated as a liquidation, dissolution or winding up within the meaning of this paragraph. 3. Voting Rights. The holders of shares of Preferred Stock shall have ------------- the following voting rights: (a) Subject to the provision for adjustment hereinafter set forth, the holder of each share of Preferred Stock shall be entitled to the number of votes equal to the number of shares of Common Stock into which such share of Preferred Stock could be converted at the record date for the determination of the stockholders entitled to vote on such matters, or, if no such record date is established, at the date such vote is taken or any written consent of the stockholders is solicited. Holders of Preferred Stock shall be entitled to notice of any stockholders' meeting in accordance with -3- the Bylaws of the Corporation. Fractional votes by the holders of Preferred Stock shall not, however, be permitted and any fractional voting rights shall (after aggregating all shares into which shares of Preferred Stock held by each holder could be converted) be rounded to the nearest whole number. (b) Except as otherwise provided herein or by law, the holders of shares of Preferred Stock and the holders of shares of Common Stock shall vote together as one class on all matters submitted to a vote of stockholders of the Corporation, and except as required by law, holders of Preferred Stock shall have no special voting rights. 4. Conversion. The holders of Preferred Stock shall have conversion ---------- rights as follows (the "Conversion Rights"): (a) Right to Convert. Subject to the adjustment provisions of this ---------------- Section 4, each share of Preferred Stock shall be convertible, at the option of the holder and without payment of additional consideration, at any time after the date of issuance of such share at the office of the Corporation or any transfer agent for such stock, into such number of fully paid and nonassessable shares of Common Stock, as is determined (i) in the case of Series B Stock, by dividing $6.00 by the Series B Conversion Price, (ii) in the case of the Series C Stock, by dividing $7.7736 by the Series C Conversion Price, (iii) in the case of the Series D Stock, by dividing $10.00 by the Series D Conversion Price and (iv) in the case of the Series E Stock, by dividing $5.00 by the Series E Conversion Price, determined as hereinafter provided, in effect at the time of the conversion. The respective prices at which shares of Common Stock shall be deliverable upon conversion of shares of each series of Preferred Stock shall initially be $6.00 with respect to shares of Series B Stock (the "Series B Conversion Price"), $7.7736 with respect to shares of Series C Stock (the "Series C Conversion Price"), $10.00 with respect to shares of Series D Stock (the "Series D Conversion Price") and $5.00 with respect to shares of Series E Stock (the "Series E Conversion Price"). The term "Conversion Price" as used herein shall refer to the Series B Conversion Price, the Series C Conversion Price and the Series D Conversion Price and the Series E Conversion Price, as applicable. The initial Conversion Price shall be subject to adjustment as provided below. (b) Automatic Conversion. Each share of Preferred Stock shall -------------------- automatically be converted into shares of Common Stock at the then effective Conversion Price: (i) upon the affirmative vote of the holders of a majority of the outstanding Preferred Stock voting together as a single class to cause all outstanding shares of Preferred Stock to be converted. (ii) upon the closing of a firm commitment underwritten public offering pursuant to an effective registration statement under the Securities Act of 1933, as amended, covering the offer and sale of equity securities for the account of the Corporation to the public at an aggregate price (prior to underwriter's commissions and offering expenses) of not less than $15,000,000 (a "Qualified Public Offering"). In the event of the automatic conversion of the Preferred Stock upon a Qualified Public Offering as aforesaid, the person(s) entitled to receive the -4- Common Stock issuable upon such conversion of the Preferred Stock shall not be deemed to have converted such Preferred Stock until immediately prior to the closing of such sale of securities. (c) Mechanics of Conversion. No fractional shares of Common Stock ----------------------- shall be issued upon conversion of the Preferred Stock. In lieu of any fractional shares to which the holder would otherwise be entitled, the Corporation shall pay cash equal to such fraction multiplied by the then effective Conversion Price. Before any holder of Preferred Stock shall be entitled to convert the same into full shares of Common Stock and to receive certificates therefor, he shall surrender the certificate or certificates therefor, duly endorsed, at the office of the Corporation or of any transfer agent for the Preferred Stock, and shall give written notice to the Corporation at such office that he elects to convert the same; provided, however, that in the event of an automatic conversion pursuant to Section 4(b), the outstanding shares of Preferred Stock shall be converted automatically without any further action by the holders of such shares and whether or not the certificates representing such shares are surrendered to the Corporation or its transfer agent, and provided further that the Corporation shall not be obligated to issue certificates evidencing the shares of Common Stock issuable upon such automatic conversion unless the certificates evidencing such shares of Preferred Stock are either delivered to the Corporation or its transfer agent as provided above, or the holder notifies the Corporation or its transfer agent that such certificates have been lost, stolen or destroyed and executes an agreement satisfactory to the Corporation to indemnify the Corporation from any loss incurred by it in connection with such certificates. The Corporation shall, as soon as practicable after such delivery, or such agreement and indemnification in the case of a lost certificate, issue and deliver at such office to such holder of Preferred Stock, a certificate or certificates for the number of shares of Common Stock to which he shall be entitled as aforesaid and a check payable to the holder in the amount of any cash amounts payable as the result of a conversion into fractional shares of Common Stock. Such conversion shall be deemed to have been immediately prior to the close of business on the date of such surrender of the shares of Preferred Stock to be converted, or in the case of automatic conversion on the date of closing of the offering, and the person or persons entitled to receive the shares of Common Stock issuable upon such conversion shall be treated for all purposes as the record holder or holders of such shares of Common Stock on such date. (d) Adjustments to Conversion Price for Diluting Issues. --------------------------------------------------- (i) Adjustments for Subdivisions, Combinations or Consolidation of -------------------------------------------------------------- Common Stock. In the event the outstanding shares of Common Stock shall be - ------------ subdivided (by stock split, stock dividends or otherwise), into a greater number of shares of Common Stock, the Conversion Price then in effect shall, concurrently with the effectiveness of such subdivision, be proportionately decreased. In the event the outstanding shares of Common Stock shall be combined or consolidated, by reclassification or otherwise, into a lesser number of shares of Common Stock, the Conversion Price then in effect shall, concurrently with the effectiveness of such combination or consolidation, be proportionately increased. (ii) Adjustments for Stock Dividends and Other Distributions. In ------------------------------------------------------- the event the Corporation at any time or from time to time makes, or fixes a record date for the determination of holders of Common Stock entitled to receive any distribution (excluding any -5- repurchases of securities by the Corporation not made on a pro-rata basis from all holders of any class of the Corporation's securities) payable in property or in securities of the Corporation other than shares of Common Stock, and other than as otherwise adjusted in this Section 4 or as provided in Section 1, then and in each such event the holders of Preferred Stock shall receive at the time of such distribution, the amount of property or the number of securities of the Corporation that they would have received had their Preferred Stock been converted into Common stock on the date of such event. (iii) Adjustments for Reclassification, Exchange and Substitution. ----------------------------------------------------------- Except as provided in Section 2 upon any liquidation, dissolution or winding up of the Corporation, if the Common Stock issuable upon conversion of the Preferred Stock shall be changed into the same or a different number of shares of any other class or classes of stock, whether by capital reorganization, reclassification or otherwise (other than a subdivision or combination of shares provided for above), the Conversion Price then in effect shall, concurrently with the effectiveness of such reorganization or reclassification, be proportionately adjusted such that the Preferred Stock shall be convertible into, in lieu of the number of shares of Common Stock which the holders would otherwise have been entitled to receive, a number of shares of such other class or classes of stock equivalent to the number of shares of Common Stock that would have been subject to receipt by the holders upon conversion of the Preferred Stock immediately before that exchange. (e) No Impairment. The Corporation will not, by amendment of its Amended ------------- and Restated Certificate of Incorporation or through any reorganization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities, or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed under this certificate by the Corporation, but will at all times in good faith assist in the carrying out of all the provisions of Section 4 and in the taking of all such action as may be necessary or appropriate in order to protect the Conversion Rights of the holders of the Preferred Stock against impairment. (f) Certificate as to Adjustments. Upon the occurrence of each adjustment ----------------------------- or readjustment of the Conversion Price pursuant to Section 4, the Corporation at its expense shall promptly compute such adjustment or readjustment in accordance with the terms of this certificate and cause independent public accountants selected by the Corporation to verify such computation and prepare and furnish to each holder of Preferred Stock a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based. The Corporation shall, upon the written request at any time of any holder of Preferred Stock, furnish or cause to be furnished to such holder a like certificate setting forth (i) such adjustments and readjustments, (ii) the Conversion Price at the time in effect, and (iii) the number of shares of Common Stock and the amount, if any, of other property that at the time would be received upon the conversion of the Preferred Stock. (g) Notices of Record Date. In the event of any taking by the Corporation ---------------------- of a record of the holders of any class of securities for the purpose of determining the holders of such securities who are entitled to receive any dividend or other distribution whether in cash, property, stock or other securities, or any right to subscribe for, purchase, or otherwise acquire any shares of -6- stock of any class or any other securities or property, or to receive any other right, the Corporation shall mail to each holder of Preferred Stock at least twenty (20) days prior to the date specified in such notice, a notice specifying the date on which any such record is to be taken for the purpose of such dividend, distribution, or rights, and the amount and character of such dividend, distribution, or right. (h) Reservation of Stock Issuable Upon Conversion. The Corporation shall --------------------------------------------- at all times reserve and keep available out of its authorized but unissued shares of Common Stock solely for the purpose of effecting the conversion of the shares of the Preferred Stock such number of its shares of Common Stock as shall from time to time be sufficient to effect the conversion of all outstanding shares of the Preferred Stock. If at any time the number of authorized but unissued shares of Common Stock shall not be sufficient to effect the conversion of all then outstanding shares of the Preferred Stock, the Corporation will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of Common Stock to such number of shares as shall be sufficient for such purpose. (i) Notices. Any notice required by the provisions of Section 4 to be ------- given to the holders of shares of Preferred Stock shall be deemed given if deposited in the United States mail, postage prepaid, and addressed to each holder of record at his address appearing on the books of the Corporation. (j) Status of Converted Shares. In the event any shares of Preferred Stock -------------------------- shall be converted pursuant to Section 4, the shares so converted shall be cancelled and shall not be reissuable by the Corporation. 5. Amendment. The Amended and Restated Certificate of Incorporation of the --------- Corporation shall not be further amended without the affirmative vote of the holders of a majority of the outstanding shares of Preferred Stock, voting separately as a class, if the amendment would (i) increase or decrease the aggregate number of authorized shares of Preferred Stock, (ii) increase or decrease the par value of the shares of Preferred Stock, or (iii) alter or change the powers, preferences or special rights of the shares of Preferred Stock so as to affect them adversely. FIVE. The Corporation is to have perpetual existence. ---- SIX. In furtherance and not in limitation of the powers conferred by --- statute, the Board of Directors is expressly authorized to make, alter, amend or repeal the Bylaws of the Corporation. SEVEN. The exact number of directors shall be as set forth in the Bylaws ----- of the Corporation. Prior to the closing of a Qualified Public Offering, the number of directors of the Corporation shall be not less than five (5) nor more than seven (7). Effective upon the closing of a Qualified Public Offering, the preceding sentence shall have no further force or effect. -7- EIGHT. Vacancies existing in the Board of Directors for any reason, and ----- any directorships resulting from any increase in the authorized number of directors, may be filled between annual meetings of stockholders only by the Board of Directors acting according to the procedures for the filling of vacancies set forth in the Bylaws of the Corporation. NINE. This Article shall become effective immediately upon the ---- Corporation's no longer being subject to Section 2115 of the California Corporations Code. Upon the effectiveness of this Article, the Board of Directors shall be divided into three classes consisting of as nearly equal numbers of directors as possible, and designated Class A, Class B, and Class C. The term of office of Class A shall expire at the first annual meeting of stockholders following the effectiveness of this Article, and each third annual meeting of stockholders thereafter; the term of office of Class B shall expire at the second annual meeting of stockholders following the effectiveness of this Article, and each third annual meeting of stockholders thereafter; and the term of office of Class C shall expire at the third annual meeting of stockholders following the effectiveness of this Article, and each third annual meeting of stockholders thereafter. If Section 2115 of the California Corporations Code becomes inapplicable to the Corporation upon the occurrence of an annual stockholders meeting, then the election of directors at such meeting shall be in accordance with the terms set forth in this Article NINE. If Section 2115 of the California Corporations Code becomes inapplicable to the Corporation between annual meetings of stockholders, then as soon as practicable following the effectiveness of this Article, the directors then in office shall by resolution of the Board of Directors select which of such directors shall be Class A directors, Class B directors and Class C directors. Directors added to the board of directors between annual meetings of stockholders by reason of an increase in the authorized number of directors shall belong to the class designated by the Board of Directors; provided however that the number of board seats designated to belong to Class A, Class B and Class C must be as nearly equal in number as possible. Following the effectiveness of this Article, stockholders may effect the removal of a director only for cause. This provision shall supersede any provision to the contrary in the Corporation's Bylaws. TEN. At all elections of directors of the Corporation, if any holder of --- stock of this Corporation entitled to vote at an election of directors shall have given the Corporation notice in accordance with the manner therefor set forth in the Corporation's Bylaws of such holder's intention to cumulate his or her votes for the election of directors, then each holder of stock or of any class or classes or of a series or series thereof shall be entitled to as many votes as shall equal the number of votes which (except for this provision as to cumulative voting) such holder would be entitled to cast for the election of directors with respect to his or her shares of stock multiplied by the number of directors to be elected, and the holder may cast all of such votes for a single director or may distribute them among the number of directors to be voted for, or for any two or more of them as such holder may see fit. ELEVEN. Article TEN of this Amended and Restated Certificate of ------ Incorporation, providing for cumulative voting, shall cease to be effective immediately upon the Corporation's no longer being subject to Section 2115 of the California Corporations Code, and any provision to the contrary in the Bylaws of the Corporation shall then be null and void. -8- TWELVE. Anything in this Amended and Restated Certificate of Incorporation ------ to the contrary notwithstanding, neither the provisions of this Article nor the provisions of Article ELEVEN (elimination of cumulative voting), Article NINE (classification of the Board of Directors), or Article SEVEN (authorized number of directors) of this Amended and Restated Certificate of Incorporation nor the provisions of Section 2.3 (special meeting), Section 2.15 (advance notice of stockholder nominees), Section 2.16 (advance notice of stockholder business), or Section 9.2 (super majority vote) of the Bylaws shall be repealed or amended, nor shall any provision inconsistent with the aforementioned provisions be adopted and added to this Amended and Restated Certificate of Incorporation or the Bylaws except upon the affirmative vote of not less than two-thirds of the shares of the Corporation issued and outstanding. THIRTEEN. Meetings of stockholders may be held within or without the State -------- of Delaware, as the Bylaws may provide. Effective upon the closing of a Qualified Public Offering, no action that is required or permitted to be taken by the stockholders of the Corporation at any annual or special meeting of stockholders may be effected by written consent of stockholders in lieu of a meeting of stockholders. The books of the Corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the Bylaws of the Corporation. FOURTEEN. To the fullest extent permitted by the Delaware General -------- Corporation Law, a director of the Corporation shall not be personally liable to the Corporation or its stock holders for monetary damages for breach of fiduciary duty as a director, except to the extent such exception from liability or limitation thereof is not permitted under the Delaware Corporation Law as the same exists or may hereafter be amended. Neither any amendment nor repeal of this Article FOURTEEN, nor the adoption of any provision of this Amended and Restated Certificate of Incorporation inconsistent with this Article FOURTEEN, shall eliminate or reduce the effect of this Article FOURTEEN in respect of any matter occurring, or any cause of action, suit or claim that, but for this Article FOURTEEN, would accrue or arise, prior to such amendment, repeal or adoption of an inconsistent provision. FIFTEEN. Advance notice of new business and stockholder nominations for ------- the election of directors shall be given in the manner and to the extent provided in the Bylaws of the Corporation. Election of directors need not be by written ballot unless the Bylaws of the Corporation shall so provide. SIXTEEN. The Corporation reserves the right to amend, alter, change or ------- repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now or hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. -9- IN WITNESS WHEREOF, Echelon Corporation has caused this Amended and Restated Certificate of Incorporation to be signed by M. Kenneth Oshman, its President, this _____ day of _______________, 1998. ECHELON CORPORATION ---------------------------------------- M. Kenneth Oshman, President -10- EX-4.1 3 FORM OF REGISTRANT'S COMMON STOCK CERTIFICATE EXHIBIT 4.1 ECHELON NUMBER SHARES ECH THIS CERTIFICATE IS TRANSFERABLE SEE REVERSE FOR CERTAIN DEFINITIONS IN NEW YORK, N.Y. AND RIDGEFIELD AND A STATEMENT AS TO RIGHTS, PARK, N.J. PREFERENCES, PRIVILEGES AND RESTRICTIONS, IF ANY INCORPORATED UNDER THE LAWS OF THE STATE OF DELAWARE CUSIP 27874N 10 5 THIS CERTIFIES THAT ________________________________________________________________________________ IS THE RECORD HOLDER OF FULLY PAID AND NONASSESSABLE SHARES OF COMMON STOCK, $0.01 PAR VALUE PER SHARE, OF ECHELON CORPORATION transferable only on the books of the Corporation by the holder hereof in person or by duly authorized Attorney upon surrender of this certificate properly endorsed. This certificate is not valid until countersigned by the Transfer Agent and registered by the Registrar. WITNESS the facsimile seal of the Corporation and the facsimile signatures of its duly authorized officers. Dated /s/ /s/ VICE PRESIDENT AND CHIEF CHAIRMAN OF THE BOARD, PRESIDENT FINANCIAL OFFICER AND CHIEF EXECUTIVE OFFICER [ECHELON CORPORATION DELAWARE CORPORATE SEAL DECEMBER 7, 1988] COUNTERSIGNED AND REGISTERED: CHASEMELLON SHAREHOLDER SERVICES, L.L.C. TRANSFER AGENT AND REGISTRAR BY__________________________________________________ AUTHORIZED SIGNATURE A statement of the powers, designations, preferences and relative, participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights as established, from time to time, by the Certificate of Incorporation of the Corporation and by any certificate of determination, the number of shares constituting each class and series, and the designations thereof, may be obtained by the holder hereof upon request and without charge from the Secretary of the Corporation at the principal office of the Corporation. The following abbreviations, when used in the inscription on the face of the certificate, shall be construed as though they were written out in full according to applicable laws or regulations: TEN COM -- as tenants in common TEN ENT -- as tenants by the entireties JT TEN -- as joint tenants with right of survivorship and not as tenants in common COM PROP -- as community property UNIF GIFT MIN ACT -- _________________________Custodian_________________________ (Cust) (Minor) under Uniform Gifts to Minors Act__________________________ (State) UNIF TRF MIN ACT -- ________________________________Custodian (until age______) (Cust) ____________________________________under Uniform Transfers (Minor) to Minor Act_______________________________________________ (State) Additional abbreviations may also be used though not in the above list. FOR VALUE RECEIVED,______________________________________________ hereby sell, assign and transfer unto PLEASE INSERT SOCIAL SECURITY OR OTHER IDENTIFICATION NUMBER OF ASSIGNEE ______________________________________ ________________________________________________________________________________ (PLEASE PRINT OR TYPEWRITE NAME AND ADDRESS, INCLUDING ZIP CODE, OF ASSIGNEE) ________________________________________________________________________________ ________________________________________________________________________________ __________________________________________________________________________Shares of the common stock represented by the within Certificate, and do hereby irrevocably constitute and appoint ________________________________________________________________________Attorney to transfer the said stock on the books of the within named Corporation with full power of substitution in the premises. Dated______________________________ X _____________________________________ X _____________________________________ NOTICE: THE SIGNATURE(S) TO THE ASSIGNMENT MUST CORRESPOND WITH THE NAMES AS WRITTEN UPON THE FACE OF THE CERTIFICATE IN EVERY PARTICULAR, WITHOUT ALTERATION OR ENLARGEMENT OR ANY CHANGE WHATEVER. Signature(s) Guaranteed By______________________________________________________________________________ THE SIGNATURE(S) MUST BE GUARANTEED BY AN ELIGIBLE GUARANTOR INSTITUTION (BANKS, STOCKBROKERS, SAVINGS AND LOAN ASSOCIATIONS AND CREDIT UNIONS WITH MEMBERSHIP IN AN APPROVED SIGNATURE GUARANTEE MEDALLION PROGRAM, PURSUANT TO S.E.C. RULE 17Ad- 15. EX-5.1 4 OPINION OF WILSON SONSINI GOODRICH & ROSATI EXHIBIT 5.1 [LETTERHEAD OF WILSON SONSINI GOODRICH & ROSATI] Echelon Corporation 4015 Miranda Avenue Palo Alto, CA 94304 RE: REGISTRATION STATEMENT ON FORM S-1 Ladies and Gentlemen: We have examined the Registration Statement on Form S-1 filed by you with the Securities and Exchange Commission on June 1, 1998 (Registration No. 333-55719) (the "Registration Statement"), in connection with the registration under the Securities Act of 1933, as amended, of up to 5,750,000 shares of your Common Stock, par value $0.01 per share (the "Shares"). The Shares include an over-allotment option granted to the underwriters of the offering to purchase 750,000 shares. We understand that the Shares are to be sold to the underwriters of the offering for resale to the public as described in the Registration Statement. As your legal counsel, we have examined the proceedings taken, and are familiar with the proceedings proposed to be taken, by you in connection with the sale and issuance of the Shares. It is our opinion that, upon completion of the proceedings being taken or contemplated by us, as your counsel, to be taken prior to the issuance of the Shares, including the proceedings being taken in order to permit such transaction to be carried out in accordance with applicable state securities laws, the Shares, when issued and sold in the manner described in the Registration Statement and in accordance with the resolutions adopted by the Board of Directors of the Company, will be legally and validly issued, fully paid and nonassessable. We consent to the use of this opinion as an exhibit to the Registration Statement and further consent to the use of our name wherever appearing in the Registration Statement, including the prospectus constituting a part thereof, and any amendments thereto. Very truly yours, WILSON SONSINI GOODRICH & ROSATI Professional Corporation /s/ Wilson Sonsini Goodrich & Rosati EX-10.2 5 1997 STOCK PLAN AND FORMS OF RELATED AGREEMENTS EXHIBIT 10.2 ECHELON CORPORATION 1997 STOCK PLAN (AS AMENDED AND RESTATED MAY 29, 1998) 1. Purposes of the Plan. The purposes of this 1997 Stock Plan are: -------------------- . to attract and retain the best available personnel for positions of substantial responsibility, . to provide additional incentive to Employees, Directors and Consultants, and . to promote the success of the Company's business. Options granted under the Plan may be Incentive Stock Options or Nonstatutory Stock Options, as determined by the Administrator at the time of grant. Stock Purchase Rights may also be granted under the Plan. 2. Definitions. As used herein, the following definitions shall apply: ----------- (a) "Administrator" means the Board or any of its Committees as shall be ------------- administering the Plan, in accordance with Section 4 of the Plan. (b) "Applicable Laws" means the requirements relating to the --------------- administration of stock option plans under U. S. state corporate laws, U.S. federal and state securities laws, the Code, any stock exchange or quotation system on which the Common Stock is listed or quoted and the applicable laws of any foreign country or jurisdiction where Options or Stock Purchase Rights are, or will be, granted under the Plan. (c) "Board" means the Board of Directors of the Company. ----- (d) "Code" means the Internal Revenue Code of 1986, as amended. ---- (e) "Committee" means a committee of Directors appointed by the Board --------- in accordance with Section 4 of the Plan. (f) "Common Stock" means the common stock of the Company. ------------ (g) "Company" means Echelon Corporation, a Delaware corporation. ------- (h) "Consultant" means any person, including an advisor, engaged by the ---------- Company or a Parent or Subsidiary to render services to such entity. (i) "Director" means a member of the Board. -------- (j) "Disability" means total and permanent disability as defined in ---------- Section 22(e)(3) of the Code. (k) "Employee" means any person, including Officers and Directors, -------- employed by the Company or any Parent or Subsidiary of the Company. A Service Provider shall not cease to be an Employee in the case of (i) any leave of absence approved by the Company or (ii) transfers between locations of the Company or between the Company, its Parent, any Subsidiary, or any successor. For purposes of Incentive Stock Options, no such leave may exceed ninety days, unless reemployment upon expiration of such leave is guaranteed by statute or contract. If reemployment upon expiration of a leave of absence approved by the Company is not so guaranteed, on the 181st day of such leave any Incentive Stock Option held by the Optionee shall cease to be treated as an Incentive Stock Option and shall be treated for tax purposes as a Nonstatutory Stock Option. Neither service as a Director nor payment of a director's fee by the Company shall be sufficient to constitute "employment" by the Company. (l) "Exchange Act" means the Securities Exchange Act of 1934, as ------------ amended. (m) "Fair Market Value" means, as of any date, the value of Common Stock ----------------- determined as follows: (i) If the Common Stock is listed on any established stock exchange or a national market system, including without limitation the Nasdaq National Market or The Nasdaq SmallCap Market of The Nasdaq Stock Market, its Fair Market Value shall be the closing sales price for such stock (or the closing bid, if no sales were reported) as quoted on such exchange or system for the last market trading day prior to the time of determination, as reported in The Wall Street --------------- Journal or such other source as the Administrator deems reliable; - ------- (ii) If the Common Stock is regularly quoted by a recognized securities dealer but selling prices are not reported, the Fair Market Value of a Share of Common Stock shall be the mean between the high bid and low asked prices for the Common Stock on the last market trading day prior to the day of determination, as reported in The Wall Street Journal or such other source as ----------------------- the Administrator deems reliable; or (iii) In the absence of an established market for the Common Stock, the Fair Market Value shall be determined in good faith by the Administrator. (n) "Incentive Stock Option" means an Option intended to qualify as an ---------------------- incentive stock option within the meaning of Section 422 of the Code and the regulations promulgated thereunder. -2- (o) "Nonstatutory Stock Option" means an Option not intended to qualify ------------------------- as an Incentive Stock Option. (p) "Notice of Grant" means a written or electronic notice evidencing --------------- certain terms and conditions of an individual Option or Stock Purchase Right grant. The Notice of Grant is part of the Option Agreement. (q) "Officer" means a person who is an officer of the Company within the ------- meaning of Section 16 of the Exchange Act and the rules and regulations promulgated thereunder. (r) "Option" means a stock option granted pursuant to the Plan. ------ (s) "Option Agreement" means an agreement between the Company and an ---------------- Optionee evidencing the terms and conditions of an individual Option grant. The Option Agreement is subject to the terms and conditions of the Plan. (t) "Option Exchange Program" means a program whereby outstanding ----------------------- Options are surrendered in exchange for Options with a lower exercise price. (u) "Optioned Stock" means the Common Stock subject to an Option or -------------- Stock Purchase Right. (v) "Optionee" means the holder of an outstanding Option or Stock -------- Purchase Right granted under the Plan. (w) "Parent" means a "parent corporation," whether now or hereafter ------ existing, as defined in Section 424(e) of the Code. (x) "Plan" means this 1997 Stock Plan. ---- (y) "Restricted Stock" means shares of Common Stock acquired pursuant to ---------------- a grant of Stock Purchase Rights under Section 11 of the Plan. (z) "Restricted Stock Purchase Agreement" means a written agreement ----------------------------------- between the Company and the Optionee evidencing the terms and restrictions applying to stock purchased under a Stock Purchase Right. The Restricted Stock Purchase Agreement is subject to the terms and conditions of the Plan and the Notice of Grant. (aa) "Rule 16b-3" means Rule 16b-3 of the Exchange Act or any successor ---------- to Rule 16b-3, as in effect when discretion is being exercised with respect to the Plan. (bb) "Section 16(b)" means Section 16(b) of the Exchange Act. ------------- -3- (cc) "Service Provider" means an Employee, Director or Consultant. ---------------- (dd) "Share" means a share of the Common Stock, as adjusted in ----- accordance with Section 13 of the Plan. (ee) "Stock Purchase Right" means the right to purchase Common Stock -------------------- pursuant to Section 11 of the Plan, as evidenced by a Notice of Grant. (ff) "Subsidiary" means a "subsidiary corporation", whether now or ---------- hereafter existing, as defined in Section 424(f) of the Code. 3. Stock Subject to the Plan. Subject to the provisions of Section 13 of ------------------------- the Plan, the maximum aggregate number of Shares which may be optioned and sold under the Plan is 6,200,000 Shares, plus an annual increase to be added on the first day of the Company's fiscal year (beginning in 1999) equal to the lesser of (i) 5,000,000 Shares, (ii) 5% of the outstanding shares on such date or (iii) a lesser amount determined by the Board. The Shares may be authorized, but unissued, or reacquired Common Stock. If an Option or Stock Purchase Right expires or becomes unexercisable without having been exercised in full, or is surrendered pursuant to an Option Exchange Program, the unpurchased Shares which were subject thereto shall become available for future grant or sale under the Plan (unless the Plan has terminated); provided, however, that Shares that have actually been issued under -------- the Plan, whether upon exercise of an Option or Right, shall not be returned to the Plan and shall not become available for future distribution under the Plan, except that if Shares of Restricted Stock are repurchased by the Company at their original purchase price, such Shares shall become available for future grant under the Plan. 4. Administration of the Plan. -------------------------- (a) Procedure. --------- (i) Multiple Administrative Bodies. The Plan may be administered by ------------------------------ different Committees with respect to different groups of Service Providers. (ii) Section 162(m). To the extent that the Administrator determines -------------- it to be desirable to qualify Options granted hereunder as "performance-based compensation" within the meaning of Section 162(m) of the Code, the Plan shall be administered by a Committee of two or more "outside directors" within the meaning of Section 162(m) of the Code. (iii) Rule 16b-3. To the extent desirable to qualify transactions ---------- hereunder as exempt under Rule 16b-3, the transactions contemplated hereunder shall be structured to satisfy the requirements for exemption under Rule 16b-3. -4- (iv) Other Administration. Other than as provided above, the Plan -------------------- shall be administered by (A) the Board or (B) a Committee, which committee shall be constituted to satisfy Applicable Laws. (b) Powers of the Administrator. Subject to the provisions of the Plan, --------------------------- and in the case of a Committee, subject to the specific duties delegated by the Board to such Committee, the Administrator shall have the authority, in its discretion: (i) to determine the Fair Market Value; (ii) to select the Service Providers to whom Options and Stock Purchase Rights may be granted hereunder; (iii) to determine the number of shares of Common Stock to be covered by each Option and Stock Purchase Right granted hereunder; (iv) to approve forms of agreement for use under the Plan; (v) to determine the terms and conditions, not inconsistent with the terms of the Plan, of any Option or Stock Purchase Right granted hereunder. Such terms and conditions include, but are not limited to, the exercise price, the time or times when Options or Stock Purchase Rights may be exercised (which may be based on performance criteria), any vesting acceleration or waiver of forfeiture restrictions, and any restriction or limitation regarding any Option or Stock Purchase Right or the shares of Common Stock relating thereto, based in each case on such factors as the Administrator, in its sole discretion, shall determine; (vi) to reduce the exercise price of any Option or Stock Purchase Right to the then current Fair Market Value if the Fair Market Value of the Common Stock covered by such Option or Stock Purchase Right shall have declined since the date the Option or Stock Purchase Right was granted; (vii) to institute an Option Exchange Program; (viii) to construe and interpret the terms of the Plan and awards granted pursuant to the Plan; (ix) to prescribe, amend and rescind rules and regulations relating to the Plan, including rules and regulations relating to sub-plans established for the purpose of qualifying for preferred tax treatment under foreign tax laws; (x) to modify or amend each Option or Stock Purchase Right (subject to Section 15(c) of the Plan), including the discretionary authority to extend the post-termination exercisability period of Options longer than is otherwise provided for in the Plan; -5- (xi) to allow Optionees to satisfy withholding tax obligations by electing to have the Company withhold from the Shares to be issued upon exercise of an Option or Stock Purchase Right that number of Shares having a Fair Market Value equal to the amount required to be withheld. The Fair Market Value of the Shares to be withheld shall be determined on the date that the amount of tax to be withheld is to be determined. All elections by an Optionee to have Shares withheld for this purpose shall be made in such form and under such conditions as the Administrator may deem necessary or advisable; (xii) to authorize any person to execute on behalf of the Company any instrument required to effect the grant of an Option or Stock Purchase Right previously granted by the Administrator; (xiii) to make all other determinations deemed necessary or advisable for administering the Plan. (c) Effect of Administrator's Decision. The Administrator's decisions, ---------------------------------- determinations and interpretations shall be final and binding on all Optionees and any other holders of Options or Stock Purchase Rights. 5. Eligibility. Nonstatutory Stock Options and Stock Purchase Rights may ----------- be granted to Service Providers. Incentive Stock Options may be granted only to Employees. 6. Limitations. ----------- (a) Each Option shall be designated in the Option Agreement as either an Incentive Stock Option or a Nonstatutory Stock Option. However, notwithstanding such designation, to the extent that the aggregate Fair Market Value of the Shares with respect to which Incentive Stock Options are exercisable for the first time by the Optionee during any calendar year (under all plans of the Company and any Parent or Subsidiary) exceeds $100,000, such Options shall be treated as Nonstatutory Stock Options. For purposes of this Section 6(a), Incentive Stock Options shall be taken into account in the order in which they were granted. The Fair Market Value of the Shares shall be determined as of the time the Option with respect to such Shares is granted. (b) Neither the Plan nor any Option or Stock Purchase Right shall confer upon an Optionee any right with respect to continuing the Optionee's relationship as a Service Provider with the Company, nor shall they interfere in any way with the Optionee's right or the Company's right to terminate such relationship at any time, with or without cause. (c) The following limitations shall apply to grants of Options: (i) No Service Provider shall be granted, in any fiscal year of the Company, Options to purchase more than 1,860,000 Shares. -6- (ii) In connection with his or her initial service, a Service Provider may be granted Options to purchase up to an additional 1,860,000 Shares which shall not count against the limit set forth in subsection (i) above. (iii) The foregoing limitations shall be adjusted proportionately in connection with any change in the Company's capitalization as described in Section 13. (iv) If an Option is cancelled in the same fiscal year of the Company in which it was granted (other than in connection with a transaction described in Section 13), the cancelled Option will be counted against the limits set forth in subsections (i) and (ii) above. For this purpose, if the exercise price of an Option is reduced, the transaction will be treated as a cancellation of the Option and the grant of a new Option. 7. Term of Plan. Subject to Section 19 of the Plan, the Plan shall become ------------ effective upon its adoption by the Board. It shall continue in effect for a term of ten (10) years unless terminated earlier under Section 15 of the Plan. 8. Term of Option. The term of each Option shall be stated in the Option -------------- Agreement. In the case of an Incentive Stock Option, the term shall be ten (10) years from the date of grant or such shorter term as may be provided in the Option Agreement. Moreover, in the case of an Incentive Stock Option granted to an Optionee who, at the time the Incentive Stock Option is granted, owns stock representing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any Parent or Subsidiary, the term of the Incentive Stock Option shall be five (5) years from the date of grant or such shorter term as may be provided in the Option Agreement. 9. Option Exercise Price and Consideration. --------------------------------------- (a) Exercise Price. The per share exercise price for the Shares to be -------------- issued pursuant to exercise of an Option shall be determined by the Administrator, subject to the following: (i) In the case of an Incentive Stock Option (A) granted to an Employee who, at the time the Incentive Stock Option is granted, owns stock representing more than ten percent (10%) of the voting power of all classes of stock of the Company or any Parent or Subsidiary, the per Share exercise price shall be no less than 110% of the Fair Market Value per Share on the date of grant. (B) granted to any Employee other than an Employee described in paragraph (A) immediately above, the per Share exercise price shall be no less than 100% of the Fair Market Value per Share on the date of grant. -7- (ii) In the case of a Nonstatutory Stock Option, the per Share exercise price shall be determined by the Administrator. In the case of a Nonstatutory Stock Option intended to qualify as "performance-based compensation" within the meaning of Section 162(m) of the Code, the per Share exercise price shall be no less than 100% of the Fair Market Value per Share on the date of grant. Notwithstanding the foregoing, at no time shall the Shares underlying Nonstatutory Stock Options with exercise prices that are less than 100% of the Fair Market Value per Share on the date of grant constitute more than 10% of the aggregate number of Shares reserved for issuance under the Plan (including any Shares that have been issued or are issuable in connection with Options exercised or granted under the Plan). (iii) Notwithstanding the foregoing, Options may be granted with a per Share exercise price of less than 100% of the Fair Market Value per Share on the date of grant pursuant to a merger or other corporate transaction. (b) Waiting Period and Exercise Dates. At the time an Option is --------------------------------- granted, the Administrator shall fix the period within which the Option may be exercised and shall determine any conditions which must be satisfied before the Option may be exercised. (c) Form of Consideration. The Administrator shall determine the --------------------- acceptable form of consideration for exercising an Option, including the method of payment. In the case of an Incentive Stock Option, the Administrator shall determine the acceptable form of consideration at the time of grant. Such consideration may consist entirely of: (i) cash; (ii) check; (iii) promissory note; (iv) other Shares which (A) in the case of Shares acquired upon exercise of an option, have been owned by the Optionee for more than six months on the date of surrender, and (B) have a Fair Market Value on the date of surrender equal to the aggregate exercise price of the Shares as to which said Option shall be exercised; (v) consideration received by the Company under a cashless exercise program implemented by the Company in connection with the Plan; (vi) a reduction in the amount of any Company liability to the Optionee, including any liability attributable to the Optionee's participation in any Company-sponsored deferred compensation program or arrangement; (vii) any combination of the foregoing methods of payment; or -8- (viii) such other consideration and method of payment for the issuance of Shares to the extent permitted by Applicable Laws. 10. Exercise of Option. ------------------ (a) Procedure for Exercise; Rights as a Stockholder. Any Option granted ----------------------------------------------- hereunder shall be exercisable according to the terms of the Plan and at such times and under such conditions as determined by the Administrator and set forth in the Option Agreement. Unless the Administrator provides otherwise, vesting of Options granted hereunder shall be tolled during any unpaid leave of absence. An Option may not be exercised for a fraction of a Share. An Option shall be deemed exercised when the Company receives: (i) written or electronic notice of exercise (in accordance with the Option Agreement) from the person entitled to exercise the Option, and (ii) full payment for the Shares with respect to which the Option is exercised. Full payment may consist of any consideration and method of payment authorized by the Administrator and permitted by the Option Agreement and the Plan. Shares issued upon exercise of an Option shall be issued in the name of the Optionee or, if requested by the Optionee, in the name of the Optionee and his or her spouse. Until the Shares are issued (as evidenced by the appropriate entry on the books of the Company or of a duly authorized transfer agent of the Company), no right to vote or receive dividends or any other rights as a shareholder shall exist with respect to the Optioned Stock, notwithstanding the exercise of the Option. The Company shall issue (or cause to be issued) such Shares promptly after the Option is exercised. No adjustment will be made for a dividend or other right for which the record date is prior to the date the Shares are issued, except as provided in Section 13 of the Plan. Exercising an Option in any manner shall decrease the number of Shares thereafter available, both for purposes of the Plan and for sale under the Option, by the number of Shares as to which the Option is exercised. (b) Termination of Relationship as a Service Provider. If an Optionee ------------------------------------------------- ceases to be a Service Provider, other than upon the Optionee's death or Disability, the Optionee may exercise his or her Option within such period of time as is specified in the Option Agreement to the extent that the Option is vested on the date of termination (but in no event later than the expiration of the term of such Option as set forth in the Option Agreement). In the absence of a specified time in the Option Agreement, the Option shall remain exercisable for three (3) months following the Optionee's termination. If, on the date of termination, the Optionee is not vested as to his or her entire Option, the Shares covered by the unvested portion of the Option shall revert to the Plan. If, after termination, the Optionee does not exercise his or her Option within the time specified by the Administrator, the Option shall terminate, and the Shares covered by such Option shall revert to the Plan. (c) Disability of Optionee. If an Optionee ceases to be a Service ---------------------- Provider as a result of the Optionee's Disability, the Optionee may exercise his or her Option within such period of time -9- as is specified in the Option Agreement to the extent the Option is vested on the date of termination (but in no event later than the expiration of the term of such Option as set forth in the Option Agreement). In the absence of a specified time in the Option Agreement, the Option shall remain exercisable for twelve (12) months following the Optionee's termination. If, on the date of termination, the Optionee is not vested as to his or her entire Option, the Shares covered by the unvested portion of the Option shall revert to the Plan. If, after termination, the Optionee does not exercise his or her Option within the time specified herein, the Option shall terminate, and the Shares covered by such Option shall revert to the Plan. (d) Death of Optionee. If an Optionee dies while a Service Provider, ----------------- the Option may be exercised within such period of time as is specified in the Option Agreement (but in no event later than the expiration of the term of such Option as set forth in the Notice of Grant), by the Optionee's estate or by a person who acquires the right to exercise the Option by bequest or inheritance, but only to the extent that the Option is vested on the date of death. In the absence of a specified time in the Option Agreement, the Option shall remain exercisable for twelve (12) months following the Optionee's termination. If, at the time of death, the Optionee is not vested as to his or her entire Option, the Shares covered by the unvested portion of the Option shall immediately revert to the Plan. The Option may be exercised by the executor or administrator of the Optionee's estate or, if none, by the person(s) entitled to exercise the Option under the Optionee's will or the laws of descent or distribution. If the Option is not so exercised within the time specified herein, the Option shall terminate, and the Shares covered by such Option shall revert to the Plan. (e) Buyout Provisions. The Administrator may at any time offer to buy ----------------- out for a payment in cash or Shares an Option previously granted based on such terms and conditions as the Administrator shall establish and communicate to the Optionee at the time that such offer is made. 11. Stock Purchase Rights. --------------------- (a) Rights to Purchase. Stock Purchase Rights may be issued either ------------------ alone, in addition to, or in tandem with other awards granted under the Plan and/or cash awards made outside of the Plan. After the Administrator determines that it will offer Stock Purchase Rights under the Plan, it shall advise the offeree in writing or electronically, by means of a Notice of Grant, of the terms, conditions and restrictions related to the offer, including the number of Shares that the offeree shall be entitled to purchase, the price to be paid, and the time within which the offeree must accept such offer. The offer shall be accepted by execution of a Restricted Stock Purchase Agreement in the form determined by the Administrator. (b) Repurchase Option. Unless the Administrator determines otherwise, ----------------- the Restricted Stock Purchase Agreement shall grant the Company a repurchase option exercisable upon the voluntary or involuntary termination of the purchaser's service with the Company for any reason (including death or Disability). The purchase price for Shares repurchased pursuant to the Restricted Stock Purchase Agreement shall be the original price paid by -10- the purchaser and may be paid by cancellation of any indebtedness of the purchaser to the Company. The repurchase option shall lapse at a rate determined by the Administrator. (c) Other Provisions. The Restricted Stock Purchase Agreement shall ---------------- contain such other terms, provisions and conditions not inconsistent with the Plan as may be determined by the Administrator in its sole discretion. (d) Rights as a Stockholder. Once the Stock Purchase Right is ----------------------- exercised, the purchaser shall have the rights equivalent to those of a shareholder, and shall be a shareholder when his or her purchase is entered upon the records of the duly authorized transfer agent of the Company. No adjustment will be made for a dividend or other right for which the record date is prior to the date the Stock Purchase Right is exercised, except as provided in Section 13 of the Plan. 12. Non-Transferability of Options and Stock Purchase Rights. Unless -------------------------------------------------------- determined otherwise by the Administrator, an Option or Stock Purchase Right may not be sold, pledged, assigned, hypothecated, transferred, or disposed of in any manner other than by will or by the laws of descent or distribution and may be exercised, during the lifetime of the Optionee, only by the Optionee. If the Administrator makes an Option or Stock Purchase Right transferable, such Option or Stock Purchase Right shall contain such additional terms and conditions as the Administrator deems appropriate. 13. Adjustments Upon Changes in Capitalization, Dissolution, Merger or Asset ------------------------------------------------------------------------ Sale. ---- (a) Changes in Capitalization. Subject to any required action by the ------------------------- shareholders of the Company, the number of shares of Common Stock covered by each outstanding Option and Stock Purchase Right, and the number of shares of Common Stock which have been authorized for issuance under the Plan but as to which no Options or Stock Purchase Rights have yet been granted or which have been returned to the Plan upon cancellation or expiration of an Option or Stock Purchase Right, as well as the price per share of Common Stock covered by each such outstanding Option or Stock Purchase Right, and the Share numbers referred to in Sections 6(c)(i) and (ii) and Section 3(i) shall be proportionately adjusted for any increase or decrease in the number of issued shares of Common Stock resulting from a stock split, reverse stock split, stock dividend, combination or reclassification of the Common Stock, or any other increase or decrease in the number of issued shares of Common Stock effected without receipt of consideration by the Company; provided, however, that conversion of any convertible securities of the Company shall not be deemed to have been "effected without receipt of consideration." Such adjustment shall be made by the Board, whose determination in that respect shall be final, binding and conclusive. Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of shares of Common Stock subject to an Option or Stock Purchase Right. -11- (b) Dissolution or Liquidation. In the event of the proposed -------------------------- dissolution or liquidation of the Company, the Administrator shall notify each Optionee as soon as practicable prior to the effective date of such proposed transaction. The Administrator in its discretion may provide for an Optionee to have the right to exercise his or her Option until ten (10) days prior to such transaction as to all of the Optioned Stock covered thereby, including Shares as to which the Option would not otherwise be exercisable. In addition, the Administrator may provide that any Company repurchase option applicable to any Shares purchased upon exercise of an Option or Stock Purchase Right shall lapse as to all such Shares, provided the proposed dissolution or liquidation takes place at the time and in the manner contemplated. To the extent it has not been previously exercised, an Option or Stock Purchase Right will terminate immediately prior to the consummation of such proposed action. (c) Merger or Asset Sale. -------------------- (i) General. In the event of a merger of the Company with or into ------- another corporation, or the sale of substantially all of the assets of the Company (a "Merger"), each outstanding Option and Stock Purchase Right shall be assumed or an equivalent option or right substituted by the successor corporation or a Parent or Subsidiary of the successor corporation (the "Successor Corporation"). In the event that the Successor Corporation refuses to assume or substitute for the Option or Stock Purchase Right, the Optionee shall fully vest in and have the right to exercise the Option or Stock Purchase Right as to all of the Optioned Stock, including Shares as to which it would not otherwise be vested or exercisable. If an Option or Stock Purchase Right becomes fully vested and exercisable in lieu of assumption or substitution in the event of a Merger, the Administrator shall notify the Optionee in writing or electronically that the Option or Stock Purchase Right shall be fully vested and exercisable for a period of fifteen (15) days from the date of such notice, and the Option or Stock Purchase Right shall terminate upon the expiration of such period. For the purposes of this paragraph, the Option or Stock Purchase Right shall be considered assumed if, following the Merger, the option or right confers the right to purchase or receive, for each Share of Optioned Stock subject to the Option or Stock Purchase Right immediately prior to the Merger, the consideration (whether stock, cash, or other securities or property) received in the Merger by holders of Common Stock for each Share held on the effective date of the transaction (and if holders were offered a choice of consideration, the type of consideration chosen by the holders of a majority of the outstanding Shares); provided, however, that if such consideration received in the Merger is not solely common stock of the Successor Corporation or its Parent, the Administrator may, with the consent of the Successor Corporation, provide for the consideration to be received upon the exercise of the Option or Stock Purchase Right, for each Share of Optioned Stock subject to the Option or Stock Purchase Right, to be solely common stock of the Successor Corporation or its Parent equal in fair market value to the per share consideration received by holders of Common Stock in the Merger. (ii) Employee Options Following Assumption or Substitution. Following ----------------------------------------------------- an assumption or substitution in connection with a Merger as described in Section 13(c)(i) above, and in the event that upon the Merger the stockholders of the Company immediately prior to the Merger hold less than 50% of the outstanding voting equity securities of the Successor Corporation -12- following the Merger (a "Change of Control Merger"), if an Optionee's status as an Employee of the Successor Corporation is terminated by the Successor Corporation as a result of an Involuntary Termination (as defined below) within twelve months following the Change of Control Merger, the Optionee shall fully vest in and have the right to exercise Optionee's Option or Stock Purchase Right as to all of the Optioned Stock, including Shares as to which Optionee would not otherwise be vested or exercisable. Thereafter, the Option or Stock Purchase Right shall remain exercisable in accordance with Section 10. (A) For purposes of this section, any of the following events shall constitute an "Involuntary Termination": (i) without the Optionee's express written consent, a significant reduction of the Optionee's duties, authority or responsibilities, relative to the Optionee's duties, authority or responsibilities as in effect immediately prior to the Change of Control Merger; (ii) without the Optionee's express written consent, a substantial reduction, without good business reasons, of the facilities and perquisites (including office space and location) available to the Optionee immediately prior to the Change of Control Merger; (iii) a reduction in the base salary of the Optionee as in effect immediately prior to the Change of Control Merger; (iv) a material reduction in the kind or level of employee benefits, including bonuses, to which the Optionee was entitled immediately prior to the Change of Control Merger with the result that the Optionee's overall benefits package is significantly reduced; (v) the relocation of the Optionee to a facility or a location more than thirty (30) miles from the Optionee's then present location, without the Optionee's express written consent; (vi) any purported termination of the Optionee which is not effected for Disability or for Cause (as defined below), or any purported termination for which the grounds relied upon are not valid; (vii) or any act or set of facts or circumstances which would, under California case law or statute, constitute a constructive termination of the Optionee. (B) For purposes of this section, "Cause" shall mean (i) any act of personal dishonesty taken by the Optionee in connection with his responsibilities as a Service Provider and intended to result in substantial personal enrichment of the Optionee, (ii) Optionee's conviction of a felony, (iii) a willful act by the Optionee which constitutes gross misconduct and which is injurious to the Successor Corporation, and (iv) following delivery to the Optionee of a written demand for performance from the Successor Corporation which describes the basis for the Successor Corporation's belief that the Optionee has not substantially performed his duties, continued violations by the Optionee of the Optionee's obligations to the Successor Corporation which are demonstrably willful and deliberate on the Optionee's part. (iii) Director Options Following Assumption or Substitution. ----------------------------------------------------- Following an assumption or substitution in connection with a Change of Control Merger, if an Optionee's status as a director of the Successor Corporation terminates other than upon a voluntary resignation by the Optionee, the Optionee shall fully vest in and have the right to exercise Optionee's Option or Stock Purchase Right as to all of the Optioned Stock, including Shares as to which Optionee would not otherwise be vested or exercisable. Thereafter, the Option or Stock Purchase Right shall remain exercisable in accordance with Section 10. -13- 14. Date of Grant. The date of grant of an Option or Stock Purchase Right ------------- shall be, for all purposes, the date on which the Administrator makes the determination granting such Option or Stock Purchase Right, or such other later date as is determined by the Administrator. Notice of the determination shall be provided to each Optionee within a reasonable time after the date of such grant. 15. Amendment and Termination of the Plan. ------------------------------------- (a) Amendment and Termination. The Board may at any time amend, alter, ------------------------- suspend or terminate the Plan. (b) Stockholder Approval. The Company shall obtain shareholder approval -------------------- of any Plan amendment to the extent necessary and desirable to comply with Applicable Laws. (c) Effect of Amendment or Termination. No amendment, alteration, ---------------------------------- suspension or termination of the Plan shall impair the rights of any Optionee, unless mutually agreed otherwise between the Optionee and the Administrator, which agreement must be in writing and signed by the Optionee and the Company. Termination of the Plan shall not affect the Administrator's ability to exercise the powers granted to it hereunder with respect to Options granted under the Plan prior to the date of such termination. 16. Conditions Upon Issuance of Shares. ---------------------------------- (a) Legal Compliance. Shares shall not be issued pursuant to the ---------------- exercise of an Option or Stock Purchase Right unless the exercise of such Option or Stock Purchase Right and the issuance and delivery of such Shares shall comply with Applicable Laws and shall be further subject to the approval of counsel for the Company with respect to such compliance. (b) Investment Representations. As a condition to the exercise of an -------------------------- Option or Stock Purchase Right, the Company may require the person exercising such Option or Stock Purchase Right to represent and warrant at the time of any such exercise that the Shares are being purchased only for investment and without any present intention to sell or distribute such Shares if, in the opinion of counsel for the Company, such a representation is required. 17. Inability to Obtain Authority. The inability of the Company to obtain ----------------------------- authority from any regulatory body having jurisdiction, which authority is deemed by the Company's counsel to be necessary to the lawful issuance and sale of any Shares hereunder, shall relieve the Company of any liability in respect of the failure to issue or sell such Shares as to which such requisite authority shall not have been obtained. 18. Reservation of Shares. The Company, during the term of this Plan, will --------------------- at all times reserve and keep available such number of Shares as shall be sufficient to satisfy the requirements of the Plan. -14- 19. Stockholder Approval. The Plan shall be subject to approval by -------------------- the shareholders of the Company within twelve (12) months after the date the Plan is adopted. Such shareholder approval shall be obtained in the manner and to the degree required under Applicable Laws. -15- ECHELON CORPORATION STOCK OPTION AGREEMENT Unless otherwise defined herein, the terms defined in the Plan shall have the same defined meanings in this Option Agreement. I. NOTICE OF STOCK OPTION GRANT ---------------------------- [Optionee's Name and Address] You have been granted an option to purchase Common Stock of the Company, subject to the terms and conditions of the Plan and this Option Agreement, as follows: Grant Number _________________________ Date of Grant _________________________ Vesting Commencement Date _________________________ Exercise Price per Share $________________________ Total Number of Shares Granted _________________________ Total Exercise Price $________________________ Type of Option: ___ Incentive Stock Option ___ Nonstatutory Stock Option Term/Expiration Date: _________________________ Vesting Schedule: ---------------- This Option may be exercised, in whole or in part, in accordance with the following schedule: 25% of the Shares subject to the Option shall vest on each anniversary of the date of grant subject to the Optionee continuing to be a Service Provider on such dates. Termination Period: ------------------ This Option may be exercised for _____ after Optionee ceases to be a Service Provider. Upon the death or Disability of the Optionee, this Option may be exercised for __________ after Optionee ceases to be a Service Provider. In no event shall this Option be exercised later than the Term/Expiration Date as provided above. II. AGREEMENT --------- 1. Grant of Option. The Plan Administrator of the Company hereby grants to --------------- the Optionee named in the Notice of Grant attached as Part I of this Agreement (the "Optionee") an option (the "Option") to purchase the number of Shares, as set forth in the Notice of Grant, at the exercise price per share set forth in the Notice of Grant (the "Exercise Price"), subject to the terms and conditions of the Plan, which is incorporated herein by reference. Subject to Section 15(c) of the Plan, in the event of a conflict between the terms and conditions of the Plan and the terms and conditions of this Option Agreement, the terms and conditions of the Plan shall prevail. If designated in the Notice of Grant as an Incentive Stock Option ("ISO"), this Option is intended to qualify as an Incentive Stock Option under Section 422 of the Code. However, if this Option is intended to be an Incentive Stock Option, to the extent that it exceeds the $100,000 rule of Code Section 422(d) it shall be treated as a Nonstatutory Stock Option ("NSO"). 2. Exercise of Option. ------------------ (a) Right to Exercise. This Option is exercisable during its term in ----------------- accordance with the Vesting Schedule set out in the Notice of Grant and the applicable provisions of the Plan and this Option Agreement. (b) Method of Exercise. This Option is exercisable by delivery of an ------------------ exercise notice, in the form attached as Exhibit A (the "Exercise Notice"), which shall state the election to exercise the Option, the number of Shares in respect of which the Option is being exercised (the "Exercised Shares"), and such other representations and agreements as may be required by the Company pursuant to the provisions of the Plan. The Exercise Notice shall be completed by the Optionee and delivered to the Chief Financial Officer of the Company. The Exercise Notice shall be accompanied by payment of the aggregate Exercise Price as to all Exercised Shares. This Option shall be deemed to be exercised upon receipt by the Company of such fully executed Exercise Notice accompanied by such aggregate Exercise Price. No Shares shall be issued pursuant to the exercise of this Option unless such issuance and exercise complies with Applicable Laws. Assuming such compliance, for income tax purposes the Exercised Shares shall be considered transferred to the Optionee on the date the Option is exercised with respect to such Exercised Shares. -2- 3. Method of Payment. Payment of the aggregate Exercise Price shall be by ----------------- any of the following, or a combination thereof, at the election of the Optionee: (a) cash; or (b) check; or (c) consideration received by the Company under a cashless exercise program implemented by the Company in connection with the Plan; or (d) surrender of other Shares which (i) in the case of Shares acquired upon exercise of an option, have been owned by the Optionee for more than six (6) months on the date of surrender, and (ii) have a Fair Market Value on the date of surrender equal to the aggregate Exercise Price of the Exercised Shares; or (e) with the Administrator's consent, delivery of Optionee's promissory note (the "Note") in the form attached hereto as Exhibit C, in the amount of the aggregate Exercise Price of the Exercised Shares together with the execution and delivery by the Optionee of the Security Agreement attached hereto as Exhibit B. The Note shall bear interest at the "applicable federal rate" prescribed under the Code and its regulations at time of purchase, and shall be secured by a pledge of the Shares purchased by the Note pursuant to the Security Agreement. 4. Non-Transferability of Option. This Option may not be transferred in ----------------------------- any manner otherwise than by will or by the laws of descent or distribution and may be exercised during the lifetime of Optionee only by the Optionee. The terms of the Plan and this Option Agreement shall be binding upon the executors, administrators, heirs, successors and assigns of the Optionee. 5. Term of Option. This Option may be exercised only within the term set -------------- out in the Notice of Grant, and may be exercised during such term only in accordance with the Plan and the terms of this Option Agreement. 6. Tax Consequences. Some of the federal tax consequences relating to this ---------------- Option, as of the date of this Option, are set forth below. THIS SUMMARY IS NECESSARILY INCOMPLETE, AND THE TAX LAWS AND REGULATIONS ARE SUBJECT TO CHANGE. THE OPTIONEE SHOULD CONSULT A TAX ADVISER BEFORE EXERCISING THIS OPTION OR DISPOSING OF THE SHARES. (a) Exercising the Option. --------------------- (i) Nonstatutory Stock Option. The Optionee may incur regular ------------------------- federal income tax liability upon exercise of a NSO. The Optionee will be treated as having received compensation income (taxable at ordinary income tax rates) equal to the excess, if any, of the Fair Market Value of the Exercised Shares on the date of exercise over their aggregate Exercise Price. If -3- the Optionee is an Employee or a former Employee, the Company will be required to withhold from his or her compensation or collect from Optionee and pay to the applicable taxing authorities an amount in cash equal to a percentage of this compensation income at the time of exercise, and may refuse to honor the exercise and refuse to deliver Shares if such withholding amounts are not delivered at the time of exercise. (ii) Incentive Stock Option. If this Option qualifies as an ISO, ---------------------- the Optionee will have no regular federal income tax liability upon its exercise, although the excess, if any, of the Fair Market Value of the Exercised Shares on the date of exercise over their aggregate Exercise Price will be treated as an adjustment to alternative minimum taxable income for federal tax purposes and may subject the Optionee to alternative minimum tax in the year of exercise. In the event that the Optionee ceases to be an Employee but remains a Service Provider, any Incentive Stock Option of the Optionee that remains unexercised shall cease to qualify as an Incentive Stock Option and will be treated for tax purposes as a Nonstatutory Stock Option on the date three (3) months and one (1) day following such change of status. (b) Disposition of Shares. --------------------- (i) NSO. If the Optionee holds NSO Shares for at least one year, --- any gain realized on disposition of the Shares will be treated as long-term capital gain for federal income tax purposes. (ii) ISO. If the Optionee holds ISO Shares for at least one year --- after exercise and two years after the grant date, any gain realized on disposition of the Shares will be treated as long-term capital gain for federal income tax purposes. If the Optionee disposes of ISO Shares within one year after exercise or two years after the grant date, any gain realized on such disposition will be treated as compensation income (taxable at ordinary income rates) to the extent of the excess, if any, of the lesser of (A) the difference between the Fair Market Value of the Shares acquired on the date of exercise and the aggregate Exercise Price, or (B) the difference between the sale price of such Shares and the aggregate Exercise Price. Any additional gain will be taxed as capital gain, short-term or long-term depending on the period that the ISO Shares were held. (c) Notice of Disqualifying Disposition of ISO Shares. If the Optionee ------------------------------------------------- sells or otherwise disposes of any of the Shares acquired pursuant to an ISO on or before the later of (i) two years after the grant date, or (ii) one year after the exercise date, the Optionee shall immediately notify the Company in writing of such disposition. The Optionee agrees that he or she may be subject to income tax withholding by the Company on the compensation income recognized from such early disposition of ISO Shares by payment in cash or out of the current earnings paid to the Optionee. 7. Entire Agreement; Governing Law. The Plan is incorporated herein by ------------------------------- reference. The Plan and this Option Agreement constitute the entire agreement of the parties with respect to the subject matter hereof and supersede in their entirety all prior undertakings and agreements of the -4- Company and Optionee with respect to the subject matter hereof, and may not be modified adversely to the Optionee's interest except by means of a writing signed by the Company and Optionee. This agreement is governed by the internal substantive laws, but not the choice of law rules, of California. 8. NO GUARANTEE OF CONTINUED SERVICE. OPTIONEE ACKNOWLEDGES AND AGREES --------------------------------- THAT THE VESTING OF SHARES PURSUANT TO THE VESTING SCHEDULE HEREOF IS EARNED ONLY BY CONTINUING AS A SERVICE PROVIDER AT THE WILL OF THE COMPANY (AND NOT THROUGH THE ACT OF BEING HIRED, BEING GRANTED AN OPTION OR PURCHASING SHARES HEREUNDER). OPTIONEE FURTHER ACKNOWLEDGES AND AGREES THAT THIS AGREEMENT, THE TRANSACTIONS CONTEMPLATED HEREUNDER AND THE VESTING SCHEDULE SET FORTH HEREIN DO NOT CONSTITUTE AN EXPRESS OR IMPLIED PROMISE OF CONTINUED ENGAGEMENT AS A SERVICE PROVIDER FOR THE VESTING PERIOD, FOR ANY PERIOD, OR AT ALL, AND SHALL NOT INTERFERE WITH OPTIONEE'S RIGHT OR THE COMPANY'S RIGHT TO TERMINATE OPTIONEE'S RELATIONSHIP AS A SERVICE PROVIDER AT ANY TIME, WITH OR WITHOUT CAUSE. By your signature and the signature of the Company's representative below, you and the Company agree that this Option is granted under and governed by the terms and conditions of the Plan and this Option Agreement. Optionee has reviewed the Plan and this Option Agreement in their entirety, has had an opportunity to obtain the advice of counsel prior to executing this Option Agreement and fully understands all provisions of the Plan and Option Agreement. Optionee hereby agrees to accept as binding, conclusive and final all decisions or interpretations of the Administrator upon any questions relating to the Plan and Option Agreement. Optionee further agrees to notify the Company upon any change in the residence address indicated below. OPTIONEE: ECHELON CORPORATION ____________________________________ _________________________________ Signature By ____________________________________ _________________________________ Print Name Title ____________________________________ Residence Address ____________________________________ -5- CONSENT OF SPOUSE ----------------- The undersigned spouse of Optionee has read and hereby approves the terms and conditions of the Plan and this Option Agreement. In consideration of the Company's granting his or her spouse the right to purchase Shares as set forth in the Plan and this Option Agreement, the undersigned hereby agrees to be irrevocably bound by the terms and conditions of the Plan and this Option Agreement and further agrees that any community property interest shall be similarly bound. The undersigned hereby appoints the undersigned's spouse as attorney-in-fact for the undersigned with respect to any amendment or exercise of rights under the Plan or this Option Agreement. _______________________________________ Spouse of Optionee -6- EXHIBIT A --------- 1997 STOCK PLAN EXERCISE NOTICE Echelon Corporation 4015 Miranda Avenue Palo Alto, CA 94304 Attention: Chief Financial Officer 1. Exercise of Option. Effective as of today, ________________, 199__, the ------------------ undersigned ("Purchaser") hereby elects to purchase ______________ shares (the "Shares") of the Common Stock of Echelon Corporation (the "Company") under and pursuant to the 1997 Stock Plan (the "Plan") and the Stock Option Agreement dated _____________, 19___ (the "Option Agreement"). The purchase price for the Shares shall be $_____________, as required by the Option Agreement. 2. Delivery of Payment. Purchaser herewith delivers to the Company the ------------------- full purchase price for the Shares. 3. Representations of Purchaser. Purchaser acknowledges that Purchaser has ---------------------------- received, read and understood the Plan and the Option Agreement and agrees to abide by and be bound by their terms and conditions. 4. Rights as Stockholder. Until the issuance (as evidenced by the --------------------- appropriate entry on the books of the Company or of a duly authorized transfer agent of the Company) of the Shares, no right to vote or receive dividends or any other rights as a shareholder shall exist with respect to the Optioned Stock, notwithstanding the exercise of the Option. The Shares so acquired shall be issued to the Optionee as soon as practicable after exercise of the Option. No adjustment will be made for a dividend or other right for which the record date is prior to the date of issuance, except as provided in Section 13 of the Plan. 5. Tax Consultation. Purchaser understands that Purchaser may suffer ---------------- adverse tax consequences as a result of Purchaser's purchase or disposition of the Shares. Purchaser represents that Purchaser has consulted with any tax consultants Purchaser deems advisable in connection with the purchase or disposition of the Shares and that Purchaser is not relying on the Company for any tax advice. 6. Entire Agreement; Governing Law. The Plan and Option Agreement are ------------------------------- incorporated herein by reference. This Agreement, the Plan and the Option Agreement constitute the entire agreement of the parties with respect to the subject matter hereof and supersede in their entirety all prior undertakings and agreements of the Company and Purchaser with respect to the subject matter hereof, and may not be modified adversely to the Purchaser's interest except by means of a writing signed by the Company and Purchaser. This agreement is governed by the internal substantive laws, but not the choice of law rules, of California. Submitted by: Accepted by: PURCHASER: ECHELON CORPORATION _________________________________ ______________________________ Signature By _________________________________ ______________________________ Print Name Its Address: Address: - ------- ------- _________________________________ Echelon Corporation _________________________________ 4015 Miranda Avenue Palo Alto, CA 94304 ______________________________ Date Received -2- EXHIBIT B --------- SECURITY AGREEMENT This Security Agreement is made as of __________, 19___ between Echelon Corporation, a Delaware corporation ("Pledgee"), and _________________________ ("Pledgor"). Recitals -------- Pursuant to Pledgor's election to purchase Shares under the Option Agreement dated ________ (the "Option"), between Pledgor and Pledgee under Pledgee's 1997 Stock Plan, and Pledgor's election under the terms of the Option to pay for such shares with his promissory note (the "Note"), Pledgor has purchased _________ shares of Pledgee's Common Stock (the "Shares") at a price of $________ per share, for a total purchase price of $__________. The Note and the obligations thereunder are as set forth in Exhibit C to the Option. NOW, THEREFORE, it is agreed as follows: 1. Creation and Description of Security Interest. In consideration of the --------------------------------------------- transfer of the Shares to Pledgor under the Option Agreement, Pledgor, pursuant to the California Commercial Code, hereby pledges all of such Shares (herein sometimes referred to as the "Collateral") represented by certificate number ______, duly endorsed in blank or with executed stock powers, and herewith delivers said certificate to the Secretary of Pledgee ("Pledgeholder"), who shall hold said certificate subject to the terms and conditions of this Security Agreement. The pledged stock (together with an executed blank stock assignment for use in transferring all or a portion of the Shares to Pledgee if, as and when required pursuant to this Security Agreement) shall be held by the Pledgeholder as security for the repayment of the Note, and any extensions or renewals thereof, to be executed by Pledgor pursuant to the terms of the Option, and the Pledge holder shall not encumber or dispose of such Shares except in accordance with the provisions of this Security Agreement. 2. Pledgor's Representations and Covenants. To induce Pledgee to enter --------------------------------------- into this Security Agreement, Pledgor represents and covenants to Pledgee, its successors and assigns, as follows: a. Payment of Indebtedness. Pledgor will pay the principal sum of the ----------------------- Note secured hereby, together with interest thereon, at the time and in the manner provided in the Note. b. Encumbrances. The Shares are free of all other encumbrances, ------------ defenses and liens, and Pledgor will not further encumber the Shares without the prior written consent of Pledgee. c. Margin Regulations. In the event that Pledgee's Common Stock is now ------------------ or later becomes margin-listed by the Federal Reserve Board and Pledgee is classified as a "lender" within the meaning of the regulations under Part 207 of Title 12 of the Code of Federal Regulations ("Regulation G"), Pledgor agrees to cooperate with Pledgee in making any amendments to the Note or providing any additional collateral as may be necessary to comply with such regulations. 3. Voting Rights. During the term of this pledge and so long as all ------------- payments of principal and interest are made as they become due under the terms of the Note, Pledgor shall have the right to vote all of the Shares pledged hereunder. 4. Stock Adjustments. In the event that during the term of the pledge any ----------------- stock dividend, reclassification, readjustment or other changes are declared or made in the capital structure of Pledgee, all new, substituted and additional shares or other securities issued by reason of any such change shall be delivered to and held by the Pledgee under the terms of this Security Agreement in the same manner as the Shares originally pledged hereunder. In the event of substitution of such securities, Pledgor, Pledgee and Pledgeholder shall cooperate and execute such documents as are reasonable so as to provide for the substitution of such Collateral and, upon such substitution, references to "Shares" in this Security Agreement shall include the substituted shares of capital stock of Pledgor as a result thereof. 5. Options and Rights. In the event that, during the term of this pledge, ------------------ subscription Options or other rights or options shall be issued in connection with the pledged Shares, such rights, Options and options shall be the property of Pledgor and, if exercised by Pledgor, all new stock or other securities so acquired by Pledgor as it relates to the pledged Shares then held by Pledgeholder shall be immediately delivered to Pledgeholder, to be held under the terms of this Security Agreement in the same manner as the Shares pledged. 6. Default. Pledgor shall be deemed to be in default of the Note and of ------- this Security Agreement in the event: a. Payment of principal or interest on the Note shall be delinquent for a period of 10 days or more; or b. Pledgor fails to perform any of the covenants set forth in the Option or contained in this Security Agreement for a period of 10 days after written notice thereof from Pledgee. In the case of an event of Default, as set forth above, Pledgee shall have the right to accelerate payment of the Note upon notice to Pledgor, and Pledgee shall thereafter be entitled to pursue its remedies under the California Commercial Code. 7. Release of Collateral. Subject to any applicable contrary rules under --------------------- Regulation G, there shall be released from this pledge a portion of the pledged Shares held by Pledgeholder here under upon payments of the principal of the Note. The number of the pledged Shares which shall be released shall be that number of full Shares which bears the same proportion to the initial number of -2- Shares pledged hereunder as the payment of principal bears to the initial full principal amount of the Note. 8. Withdrawal or Substitution of Collateral. Pledgor shall not sell, ---------------------------------------- withdraw, pledge, substitute or otherwise dispose of all or any part of the Collateral without the prior written consent of Pledgee. 9. Term. The within pledge of Shares shall continue until the payment of ---- all indebtedness secured hereby, at which time the remaining pledged stock shall be promptly delivered to Pledgor, subject to the provisions for prior release of a portion of the Collateral as provided in paragraph 7 above. 10. Insolvency. Pledgor agrees that if a bankruptcy or insolvency ---------- proceeding is instituted by or against it, or if a receiver is appointed for the property of Pledgor, or if Pledgor makes an assignment for the benefit of creditors, the entire amount unpaid on the Note shall become immediately due and payable, and Pledgee may proceed as provided in the case of default. 11. Pledgeholder Liability. In the absence of willful or gross negligence, ---------------------- Pledgeholder shall not be liable to any party for any of his acts, or omissions to act, as Pledgeholder. 12. Invalidity of Particular Provisions. Pledgor and Pledgee agree that the ----------------------------------- enforceability or invalidity of any provision or provisions of this Security Agreement shall not render any other provision or provisions herein contained unenforceable or invalid. 13. Successors or Assigns. Pledgor and Pledgee agree that all of the terms --------------------- of this Security Agreement shall be binding on their respective successors and assigns, and that the term "Pledgor" and the term "Pledgee" as used herein shall be deemed to include, for all purposes, the respective designees, successors, assigns, heirs, executors and administrators. 14. Governing Law. This Security Agreement shall be interpreted and ------------- governed under the internal substantive laws, but not the choice of law rules, of California. -3- IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year first above written. "PLEDGOR" _________________________________ Signature _________________________________ Print Name Address: _________________________________ _________________________________ "PLEDGEE" Echelon Corporation, a Delaware corporation ________________________________ Signature ________________________________ Print Name ________________________________ Title "PLEDGEHOLDER" ________________________________ Secretary of Echelon Corporation -4- EXHIBIT C --------- NOTE $_______________ Palo Alto, California ______________, 19___ FOR VALUE RECEIVED, _______________ promises to pay to Echelon Corporation, a Delaware corporation (the "Company"), or order, the principal sum of _______________________ ($_____________), together with interest on the unpaid principal hereof from the date hereof at the rate of _______________ percent (____%) per annum, compounded semiannually. Principal and interest shall be due and payable on __________, 19___. Payment of principal and interest shall be made in lawful money of the United States of America. The undersigned may at any time prepay all or any portion of the principal or interest owing hereunder. This Note is subject to the terms of the Option, dated as of ________________. This Note is secured in part by a pledge of the Company's Common Stock under the terms of a Security Agreement of even date herewith and is subject to all the provisions thereof. The holder of this Note shall have full recourse against the undersigned, and shall not be required to proceed against the collateral securing this Note in the event of default. In the event the undersigned shall cease to be an employee, director or consultant of the Company for any reason, this Note shall, at the option of the Company, be accelerated, and the whole unpaid balance on this Note of principal and accrued interest shall be immediately due and payable. Should any action be instituted for the collection of this Note, the reasonable costs and attorneys' fees therein of the holder shall be paid by the undersigned. ____________________________________ ____________________________________ EX-21.1 6 SUBSIDIARIES OF THE REGISTRANT EXHIBIT 21.1 Subsidiaries of the Registrant Echelon Corporation Echelon Credit Corporation Echelon BV Echelon China Echelon Europe Ltd. Echelon France Echelon GmbH Echelon Asia-Pacific Echelon Japan K.K. -----END PRIVACY-ENHANCED MESSAGE-----