-----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, BS7D0YPpkgGt8tbjJc9w+IoSCEn0lFcFPW/m2X2dt94Qf3yliRAEmJRd6EpXlhbT mPj8z37oGqzhRchcoV07SA== 0000912057-97-010987.txt : 19970401 0000912057-97-010987.hdr.sgml : 19970401 ACCESSION NUMBER: 0000912057-97-010987 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: LARSCOM INC CENTRAL INDEX KEY: 0001024047 STANDARD INDUSTRIAL CLASSIFICATION: COMMUNICATIONS EQUIPMENT, NEC [3669] IRS NUMBER: 942362692 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-12491 FILM NUMBER: 97568641 BUSINESS ADDRESS: STREET 1: 4600 PATRICK HENRY DRIVE CITY: SANTA CLARA STATE: CA ZIP: 95054 BUSINESS PHONE: 4089886600 10-K 1 10-K - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER: 1-12491 ------------------------ LARSCOM INCORPORATED (Exact name of registrant as specified in its charter) DELAWARE 94-2362692 (State or other jurisdiction of (I.R.S Employer incorporation or organization) Identification No.) 4600 PATRICK HENRY DRIVE 95054 SANTA CLARA, CALIFORNIA (ZIP Code) (Address of principal executive offices)
(408) 988-6600 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: CLASS A COMMON STOCK, $.01 PAR VALUE (TITLE OF CLASS) ------------------------ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. / / The aggregate market value of the voting stock held by non-affiliates of the registrant as of February 28, 1997, was approximately $56,416,000. The number of the registrant's shares outstanding as of February 28, 1997, was 8,050,000 of Class A Common Stock and 10,000,000 of Class B Common Stock. DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Proxy Statement for the Registrant's 1997 Annual Meeting of Stockholders (the "Proxy Statement") are incorporated by reference in Part III of this Annual Report on Form 10-K. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TABLE OF CONTENTS PART I................................................................................. 3 ITEM 1. BUSINESS.................................................................. 3 ITEM 2. PROPERTIES................................................................ 13 ITEM 3. LEGAL PROCEEDINGS......................................................... 13 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS....................... 13 PART II................................................................................ 14 ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS..... 14 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA...................................... 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............................................................. 15 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............................... 23 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.............................................................. 40 PART III............................................................................... 41 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........................ 41 ITEM 11. EXECUTIVE COMPENSATION.................................................... 41 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............ 41 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................ 41 PART IV................................................................................ 42 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.......... 42
2 PART I ITEM 1. BUSINESS Except for the historical statements contained herein, this Annual Report on Form 10-K contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The actual results that the Company achieves may differ materially from those indicated in any forward looking statements due to the risks and uncertainties set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations", "Certain Risk Factors" and elsewhere in this Form 10-K. The Company undertakes no obligation to revise any forward looking statements in order to reflect events or circumstances that may arise after the date of this report. Readers are urged to carefully review and consider the various disclosures made by the Company in this report and in the Company's reports filed with the Securities and Exchange Commission that attempt to advise interested parties on the risks and factors that may affect the Company's business. OVERVIEW Larscom Incorporated (the "Company" or "Larscom") develops, manufactures and markets a broad range of high speed global internetworking solutions for network service providers ("NSPs") and corporate users. Larscom's products provide access to fractional T1 ("FT1"), E1, T1/E1, frame relay, fractional T3/E3, channelized T3 services and Clear Channel ATM ("CCA") inverse multiplexing, with clear channel T3, Integrated Services Digital Network ("ISDN"), Inverse Multiplexing for ATM ("IMA") and Asynchronous Transfer Mode ("ATM") under development. Larscom's newest families of products, the Orion 200 and Orion 4000, were designed with modular hardware and downloadable software to provide the Company's customers with the flexibility to increase network capacity and add services in a rapid and cost effective manner. Prior to the Company's initial public offering ("IPO") in December 1996, the Company was a wholly owned subsidiary of Axel Johnson Inc. ("Axel Johnson"). Upon consummation of the IPO Axel Johnson owned 55% of the Class A & B Common Stock of the Company and controlled 83% of the voting interest. INDUSTRY OVERVIEW The proliferation of personal computers and the continuing need of users to disseminate and share information, often across an enterprise and from remote locations, have created increased demand for both local area networks ("LANs") which connect computing resources within an enterprise and wide area networks ("WANs") which permit interconnection across wide geographic areas. As networks extend beyond the enterprise and reach around the world, demand for WAN capacity and higher speed WAN access has grown dramatically. More recently, this demand has been further fueled by the growth in Internet usage among both individuals and businesses, as well as the emergence of more bandwidth intensive applications such as video and imaging. The increased demand for WAN speed and capacity has been accompanied by increased complexity in available network services. In addition to dedicated 56/64 kbps and T1/FT1 services, both private and public frame relay, ISDN basic rate and primary rate and ATM are available. This large variety of services has also been coupled with an escalation in the variety and complexity of LAN technology (10 Mbps Ethernet, 100 Mbps Ethernet, Fiber Distributed Data Interface ("FDDI"), switched Ethernet and Gigabit Ethernet). ATM, in particular, adds complexity to network demands. As an alternative to current circuit based (or Time-Division Multiplexing ("TDM")) services, ATM is a new cell based service which allows corporate users and NSPs to combine all types of traffic--data, voice, video and image--across the same network. ATM is expected to become more widely available as standards evolve. Since it utilizes cell based technology rather than traditional circuit based TDM technology, ATM poses significant network hardware and software challenges. To date, ATM has been deployed in local area and campus network environments, as some corporations have elected to base their next generation network architecture on ATM. Although Network Service Providers ("NSPs") have yet to use the technology widely to transport ATM traffic, they have used ATM as a backbone technology to offer other services such as frame relay. 3 As a result of both the increased demand for WAN capacity and the complexity and continuing evolution of service offerings, businesses have been transitioning from the use of private WANs dedicated to individual businesses to greater use of public WANs maintained by NSPs. As this transition occurs, NSPs are being asked to provide an increasing variety of transmission services and network management services. In addition, corporate users in many cases are requiring NSPs to assume full responsibility for operation and monitoring of the network and to guarantee certain levels of service. NSPs and corporate users require equipment that supports higher bandwidth than provided by common T1 and E1 services. In addition, NSPs and corporate users increasingly are seeking a solution that bridges the technology gap by providing connectivity to both the currently ubiquitous TDM network environment and the emerging ATM environment without requiring that one technology be dropped in favor of the other. Moreover, many businesses need to operate on a global basis with networks that cross international boundaries. Furthermore, NSPs and corporate users require the ability to add more services and high speed applications in a rapid and affordable manner. Accordingly, NSPs and corporate users require telecommunications equipment that supports a broad range of services and that will operate reliably, flexibly and consistently in all the required countries. The complexity and variety of services and products have prompted both NSPs and corporate users alike to consolidate their purchasing activity by using fewer vendors who offer reliable and affordable equipment throughout the world. THE LARSCOM SOLUTION The Company's broad range of product offerings provides access to both ATM and TDM services across a variety of international standards at speeds ranging from 56 kbps to 155 Mbps. The Company's products have modular architectures that simplify the provisioning of new services by NSPs and lower the cost for large corporate users of obtaining additional bandwidth. BRIDGING THE TECHNOLOGY GAP. To address the gap between emerging and existing technologies, in particular between ATM and TDM, the Company has developed a broad range of network communications products that provide its corporate customers with reliable and flexible network access. The Company offers its NSP customers easily deployable, well managed solutions to provision new network services quickly. In the broadband market, for example, the Orion 4000 is unique in its ability to accommodate both ATM and TDM network connectivity within the same multiplexing architecture. The Orion 4000 can also accommodate bandwidth needs that range from a single T1 or E1 circuit to 155 Mbps. BRIDGING THE BANDWIDTH GAP. Through its Mega-T and Orion 4000 products, Larscom pioneered the use of multiple T1 and E1 inverse multiplexing, which enables users to achieve higher bandwidth capacity than offered by a single T1 line, thereby bridging the bandwidth gap between T1 and T3. Fractional T3 service, provided in this manner, allows the NSP to leverage the existing T1 based infrastructure and provides the corporate user with ready access to affordable and ubiquitous high speed bandwidth. SCALEABILITY AND MODULARITY. The Company has incorporated flexibility and modularity into its products as network complexity and bandwidth increase, as industry standards evolve and as NSPs and corporate users seek to meet multiple needs. The Company's upgradeable software and plug in modules enable NSPs to add services rapidly and cost effectively as demand changes and industry standards evolve. RELIABILITY AND QUALITY. The Company has earned a strong reputation for the quality of its products, as well as its responsive service. The Company's products are manufactured to meet the highest standards of reliability and quality, including intensive system level testing in development and manufacturing. Larscom has responded to its customers' needs by providing telecommunications equipment that operates reliably and consistently across the globe. Orion 200 and Orion 4000 platforms are designed, tested and certified for use in major international markets. CUSTOMER SERVICE AND SUPPORT. The Company offers real-time service and support through various stages of the customer relationship. The Company's service and support function begins by working closely with customers at the product definition and design stage. To meet its customers' unpredictable purchasing patterns, the Company's sales and operations departments are organized to respond quickly to short lead- 4 time orders. Finally, Larscom provides post-sale service and support of its products through technical consulting, installation assistance and maintenance. PRODUCTS The Company's principal products consist of broadband access solutions such as the Orion 4000 family of products and digital access solutions such as the Orion 200 and Access-T families of products. Broadband products address transmission speeds greater than 2 Mbps and digital access products address speeds less than 2 Mbps. The Company's principal product platforms feature modular software and hardware which can be adapted to changing industry standards and customer needs. The products can be upgraded in the field, for new features or standards, by downloading new software. In addition, several of the products are designed to permit ready addition of modules to provide new functions or interfaces. This provides an NSP or corporate user with the components necessary to design an entire system to interconnect multiple locations in a cost effective and manageable network. BROADBAND PRODUCTS Larscom entered the broadband market in 1991 with the acquisition of T3 Technologies, Inc. Larscom's broadband product line consists of a range of products that include the Orion 4000 broadband access multiplexer, a family of inverse multiplexers and a single function T3 Digital Service Unit ("DSU"). ORION 4000. The Orion 4000 is a highly versatile broadband access multiplexer with a unique WAN access architecture that handles both ATM and TDM traffic on a dual, redundant, 155 Mbps bus structure. Prices for the Orion 4000 start at $20,500 for a basic system equipped with a single inverse multiplexing module. The Orion 4000 accommodates data applications operating at speeds from 1.54 Mbps up to 50 Mbps, as well as network connections that range from T1 or E1 to 155 Mbps. The Orion 4000 is designed to enable different functionality to be added in a modular and cost effective fashion. It is available in both 5 slot and 12 slot shelf configurations, both of which have met the requirements of CE (European Union certification) for international markets. The Orion 4000 is distinctive in the role that it can play in hybrid networks (TDM networks with ATM applications) and in providing an economic migration path from TDM to ATM, thereby ensuring legacy equipment investment protection. In a TDM environment, the Orion 4000 is able to support full and fractional T3 networks. Its T1 and E1 inverse multiplexing modules, introduced in 1994 and 1995, respectively, provide transparent channels for applications such as LAN interconnection or video transmission. The T3mux and Tmux modules, introduced in 1995, provide greater flexibility in transporting T1 circuits across the network. They can be used to consolidate several fractional T3 applications onto a single T3 circuit and combine T1 traffic from a digital PBX or a T1 multiplexer with inverse multiplexed data. ORION 4000 MODULES UNDER DEVELOPMENT. The next step in the evolution of the Orion 4000's TDM capability is the development of a clear channel T3 module, which will increase the bandwidth available for applications to 44 Mbps. This will be a single slot module that, in addition to a clear channel T3 interface, will offer four Data Terminal Equipment ("DTE") ports supporting High-Speed Data ("HSD") and High-Speed Serial Interface ("HSSI") connections and a combination of eight T1 ports and four multiplexer channels. The Company's CCA inverse multiplexer began volume shipments in early 1997. The first in a series of modules, it provides a 45 Mbps UNI (User to Network Interface) connection to up to eight T1 circuits. CCA allows NSPs and corporate users to pass ATM traffic between local and campus environments using inverse multiplexing of regular T1 or E1 circuits. The CCA modules provide buffering and rate adaptation to match application speeds to network facilities. The Company is also developing ATM modules (network and data interfaces) for the Orion 4000, which will be able to connect LAN data traffic to public or private ATM networks. OTHER BROADBAND PRODUCTS. The Mega T, introduced in 1993, is the first inverse multiplexer to bridge the bandwidth gap between T1 and T3. Priced from $7,500 it provides affordable access to greater than T1 5 bandwidth for high speed applications, deriving a data channel of up to 6 Mbps from four T1 circuits. Larscom's patented inverse multiplexing algorithm, used for both the Mega-T and Orion 4000, handles alignment of the individual T1s and allows for differential delay between individual T1s. This algorithm also allows the data transmission rate to be lowered should individual T1 circuits fail and to be raised when the circuits are restored. The Mega-T shares with the Orion 4000 the unique ability to identify individual T1 circuits, thereby simplifying trouble shooting. The Mega-T is primarily used for high speed LAN internetworking, as well as frame relay network access above T1 speed and broadcast quality digital video. The Access T45, introduced in 1992, is a dual port, 45 Mbps DSU that provides a clear channel T3 network interface. Priced at $7,500 it is used for very high speed LAN internetworking, for Internet access and backbones and for channel extension. The Access T45 allocates bandwidth in increments of 3 Mbps, a functionality which has been used by some ISPs to control bandwidth assignment for their customers. In addition, it is capable of scrambling LAN data in a manner which ensures the successful receipt of transmitted data. EtherSpan, introduced in 1996, is an advanced Ethernet bridge that can handle a sustained data rate of 10 Mbps. It offers cost effective, high speed WAN connectivity for Ethernet LANs, with one 10Base-T Ethernet LAN port and a single WAN port that utilizes either HSD or HSSI standards. DIGITAL ACCESS PRODUCTS Larscom entered the digital access market in 1986 with emphasis on performance monitoring of T1 lines. Larscom's pioneering efforts to deliver an advanced network diagnostic system within a Channel Service Unit ("CSU") resulted in its TNDS (T1 Network Diagnostic System) product line. The advanced performance monitoring capabilities, which were featured in the first TNDS and enhanced and complemented in subsequent CSU and CSU/DSU products, continue to be a hallmark of Larscom throughout its product lines. ORION 200 FAMILY. The Orion 200 family, introduced in 1994, is an advanced T1 and E1 access multiplexer that can accommodate from two to eight data ports and two network ports. Priced from $4,995 its primary application is for LAN interconnection, often coupled with digital Private Branch Exchange ("PBX") traffic, as well as video conferencing. The Orion 200 family can operate in both T1 and E1 networks, and can also perform conversion between T1 and E1 standards. OTHER DIGITAL ACCESS PRODUCTS. The Access-T family, introduced in 1991, is a series of T1/FT1 CSU/ DSUs. Pricing starts at $1,595 for a single port DSU. The primary use of the Access-T family is for LAN interconnection, often coupled with the multiplexing of digital PBX traffic onto a single T1/FT1 circuit. The Access-T 1500, a shelf based version introduced in 1992, utilizes a hub and spoke architecture that allows centralized network nodes to serve units at dispersed sites and to concentrate traffic in a single location where network hubs are constrained for space. In 1996, the Access-T100S, a low cost, smaller version of a single port Access T, was introduced, allowing the Company to respond to downward price pressure in the digital access market. The Split-T, introduced in 1990, is a stand alone T1/FT1 CSU/DSU, with prices starting at $3,195. It has a front panel that incorporates an LCD user interface for local configuration and is primarily used for LAN interconnection and digital PBX traffic. In addition, Larscom offers a family of T1 CSU products, introduced in 1986, centered on the TNDS family of fully featured T1 CSUs. These products offer a T1 network interface with advanced performance monitoring and diagnostic capabilities. CUSTOMERS The Company's customers principally consist of NSPs, including Internet Service Providers, Fortune 500 corporations, systems integrators, value added resellers ("VARs") and federal, state and local government agencies. 6 The Company believes that its relationships with large customers, particularly the NSPs and telecommunications companies, will be critical to its future success. These customers prefer to purchase the majority of their network access solutions from a single vendor which may benefit the Company as it broadens and enhances its product line. In 1996, 1995 and 1994, NSPs represented 62%, 48% and 41%, respectively, of total revenues and the Company's top five customers accounted for 52%, 48%, and 41% of revenues in 1996, 1995 and 1994, respectively. The following table summarizes the percentage of total revenues for customers accounting for more than 10% of the Company's revenues:
YEARS ENDED DECEMBER 31, ------------------------------------- 1996 1995 1994 ----- ----- ----------- MCI................................................................. 21% 18% 15% IBM/Advantis........................................................ 13% 14% *10%
None of the Company's customers are contractually obliged to purchase any quantity of products in any particular period, and product sales to major customers have varied widely from quarter to quarter and year to year. There can be no assurance that the Company's current customers will continue to place orders with the Company, that orders from existing customers will continue at the levels of previous periods or that the Company will be able to obtain orders from new customers. Loss of, or a material reduction in orders by, one or more of the Company's major customers could have a material adverse effect on the Company's business and operating results. BACKLOG The Company's backlog at any point in time is typically limited. Accordingly, sales in any quarter are largely dependent on orders received during that quarter. Furthermore, the Company's agreements with its customers typically provide that they may change delivery schedules and cancel orders within specified timeframes, typically up to 30 days prior to the scheduled shipment date, without penalty. The Company's customers have in the past built, and may in the future build, significant inventory in order to facilitate more rapid deployment of anticipated major projects or for other reasons. Decisions by such customers to reduce their inventory levels could lead to reductions in purchases from the Company. Therefore, customer decisions to delay delivery, cancel orders or reduce purchases could have a material adverse effect on the Company's business and operating results. MARKETING AND SALES The Company sells its products in the U.S. primarily through its direct sales organization, with products also being sold through OEMs, VARs and systems integrators. The Company seeks to continue the expansion of its customer base through both direct and alternate distribution channels. Developments in broadband and digital access platforms will continue to be handled by a direct sales organization experienced in systems level sales. Additionally, the Company seeks to extend its market reach to the Fortune 2000 corporations in the U.S. through the development of alternate distribution channels and supporting services, with the intent to have such channels in operation beginning in 1998. The Company markets its products internationally through non-exclusive distribution agreements with VARs and systems integrators. In international markets, the Company is seeking to develop partnerships with international NSPs and to develop its own sales and support organization, beginning in 1998, to complement existing distributor relationships. NSPs require that products undergo extensive lab testing and field trials prior to their deployment in the network. Accordingly, the Company is continually submitting successive generations of its current products as well as new products to its customers for evaluation and approval. Additionally, international NSPs require products to meet country specific certification standards for safety, emissions and network connectivity. The length of the various approval processes is affected by a number of factors, including the complexity of the product involved, the priorities of the customer, budgets and regulatory issues. 7 CUSTOMER SERVICE AND SUPPORT The Company's products are required to meet rigorous standards imposed by both customers and internal product quality assurance testing procedures. The Company has service contracts with most of its major customers, and provides on site service via arrangements with a number of service partners worldwide such as Racal Datacom and Netcom Solutions in the U.S. and ND Networks in Europe. These contracts typically establish response time and level of service commitments, with penalties for non-performance. Larscom maintains a 24 hours, 7 days a week technical assistance support center, and provides on site support with contracted response times, plus a wide range of repair programs. The Company also provides technical applications assistance, as well as customer and distributor product maintenance and installation training. Prior to January 1997 all of the Company's products carried a two year warranty, which generally covered defects in materials and workmanship. In January 1997 the Company changed the warranty period for most of its products to three years. In the past the Company's warranty expenses have been relatively insignificant and the Company does not expect this to change as a result of the extension of the warranty period. RESEARCH AND DEVELOPMENT Larscom believes that its future success depends on its ability to maintain technological leadership through timely enhancements of existing products and development of new products that meet customer needs. During 1996, 1995 and 1994, total research and development expenses were $8.1 million, $7.1 million and $6.7 million, respectively. The Company believes that a continued commitment to research and development, particularly related to broadband products and emerging technologies in response to customer demands will be required to remain competitive. Accordingly, the Company is increasing its engineering staff and anticipates that its research and development expenses will increase in future periods. The Company's research and development programs are focused on its modular platforms (the Orion 4000 family, the Orion 200 family and the Access-T family), which allow new technologies to be incorporated and new services supported through incremental modules. In the short term, the Company will develop new modules for the Orion 4000 that integrate ATM with inverse multiplexing. In the future, the Company intends to extend the international capabilities of its products and to address additional broadband technology such as Synchronous Optical Network ("SONET") and Synchronous Digital Hierarchy ("SDH"). The Orion 200 and Orion 4000 product families were designed specifically to meet the demands of its major customers. These relationships provide the Company with advanced insight into the evolving needs of customers and allow the Company to anticipate new technology requirements. Enhancements to these product families are being developed by including major customers in the product definition and review process. Timely customer feedback is important to the Company in making modifications to existing products and designing new products. The rapid development of new technologies increases the risk that current or new competitors could develop products that would reduce the competitiveness of the Company's products. The Company's success will depend to a substantial degree upon its ability to respond to changes in technology and customer requirements. This will require the timely selection, development and marketing of new products and enhancements on a cost effective basis. The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation. For the network access market, expertise is required in the general areas of telephony, data networking, network management, as well as specific technologies such as ISDN, ATM and SONET. Further, the telecommunications industry is characterized by the need to design products which meet industry standards for safety, immunity, emissions and network connection. Such industry standards are often changing or incomplete as new and emerging technologies and service offerings are introduced by NSPs. As a result, there is a potential for product development delay due to the need for compliance with new or modified standards. The introduction of 8 new and enhanced products also requires that the Company manages transitions from older products in order to minimize disruptions in customer orders, avoid excess inventory of old products and ensure that adequate supplies of new products can be delivered to meet customer orders. There can be no assurance that the Company will be successful in developing, introducing or managing the transition to new or enhanced products or that any such products will be responsive to technological changes or will gain acceptance in the market. The Company's business and operating results could be materially adversely affected if the Company were to be unsuccessful, or to incur significant delays, in developing and introducing such new products or enhancements. MANUFACTURING AND QUALITY ASSURANCE The Company's manufacturing operations consist of materials procurement, third party assembly of final product based on printed circuit boards, product testing and inspection and system configuration for shipment. The Company has maintained a long term relationship with its third party printed circuit board assembler, Top Line Electronics Corporation, which has allowed the Company to implement total quality control in the entire manufacturing process, including statistically monitored process control programs. The Company utilizes traditional procurement methods with its suppliers, using standard purchase orders for all scheduling and commitments. No contract relationships exist. Most purchase order payment terms are standard with payment due in 30 days, with some orders negotiated to net 45 days payment. The Company uses automated functional product testing to remain flexible to customers' needs while maintaining control of the quality of the manufacturing process. During 1996, the Company has increased its emphasis on aggressively monitoring software quality in its products by implementing automated system test programs that verify product performance concurrent with product development and prior to product release. On time delivery of the Company's products is dependent upon the availability of quality components used in its products. The Company purchases parts and components for assembly from a variety of pre-approved suppliers through a worldwide procurement sourcing program. The Company attempts to manage risks through developing alternate sources and by maintaining quality relationships with its suppliers. To date, the Company has been able to obtain adequate supplies of required components in a timely manner from existing sources or, when necessary, from alternate sources. The Company does acquire certain components from sole sources, either to achieve economies of scale or because of proprietary technical features designed into the Company's products. Sole sourced components come from suppliers such as Waferscale, Vicor and PMC Sierra. A substantial portion of the Company's shipments in any fiscal period relates to orders for certain products received in that period. To meet this demand, the Company maintains a supply of finished goods inventories at its manufacturing facility, including safety stocks of critical components. In addition, a significant percentage of the Company's orders are shipped within three business days. However, there can be no assurance that interrupted or delayed supplies of key components will not occur which could have a material adverse effect on the Company's business and operating results. The Company maintains a comprehensive quality control program. However, complex products such as those offered by the Company may contain undetected errors or failures when first introduced or as new versions are released. Despite testing by the Company and its customers, there can be no assurance that existing or future products based upon the Orion 4000 architecture or other technologies will not contain undetected errors or failures when first introduced or as new versions are released. While the Company believes that its reserves for estimated future warranty costs are adequate there are inherent risks associated with these estimates particularly for those estimates related to products which have been recently introduced such as the Orion 4000. Warranty claims in excess of those expected by the Company could have a material adverse effect on the Company's business and operating results. 9 COMPETITION The markets for the Company's products are intensely competitive and the Company expects competition to increase in the future. In the broadband market, the Company competes primarily with Digital Link, ADC Kentrox, RAD Data Communications and 3Com's Broadband Division (previously OnStream Networks). In the digital access market, the Company competes against traditional CSU/DSU vendors, such as ADC Kentrox, Verilink and Digital Link, and relatively newer entrants to the market such as ADTRAN and TxPort. The Company competes to a lesser extent with other telecommunications equipment companies. The Company believes that its ability to compete successfully depends upon a number of factors, including timely development of new products and features, product quality and performance, price, announcements by competitors, experienced sales, marketing and service organizations and evolving industry standards. The Company believes that it generally competes favorably in these areas. However, certain competitors have more broadly developed distribution channels and are further along in certain emerging technologies, such as ATM and SONET. In addition, the Company's digital access products could be adversely affected by the integration of WAN functionality into switches and routers, by the entry of LAN equipment vendors into the Company's markets, or by the requirement for alternate methods of performance monitoring for services such as frame relay. There can be no assurance that the Company will be able to continue to compete successfully with existing or new competitors. The key competitive factors in the Company's market include timely development of new products and features, product quality and performance, price, experienced sales, marketing and service organizations and evolving industry standards. In the broadband market, the Company believes that it competes favorably due to the wide functionality of its products and its superior customer service and support. In particular, the Orion 4000 platform has a unique WAN access architecture that accommodates both ATM and TDM technology, providing flexibility for hybrid networks. Also, the Orion 4000, in conjunction with the Mega-T and Access T45, provides cost effective and competitively distinctive hub and spoke concentration. However, sales of the Company's broadband products could be adversely affected by a significant increase in availability of public ATM services since some competitors could be better positioned at this time to support public ATM service. Some of the Company's competitors have developed partnerships with third parties for joint marketing or development efforts that could place the Company at a relative disadvantage. In the digital access market, the Company believes that it competes favorably due to its commitment to reliability, service and support. Since price is increasingly important, the Company will provide competitively priced products such as the recently announced Access-T100S. However, some of the Company's competitors are more advanced in developing indirect sales channels and this may be a disadvantage to the Company's sales of digital access products. The Company's digital access products could also be materially adversely affected by the integration of CSU/DSU functionality into switches and routers, by the entry of LAN equipment vendors into the Company's markets, or by the requirement for alternative methods of performance monitoring for services such as frame relay. There is also a risk to the digital access market generally from new technologies that could displace some parts of the T1/E1 CSU/ DSU product line. For example, Asymmetric Digital Subscriber Line ("ADSL") and High-Speed Digital Subscriber Line ("HDSL") are subscriber loop technologies that can enable service providers to deploy T1/FT1 services. These new technologies may ultimately enlarge the total addressable market for digital access products and services. PROPRIETARY RIGHTS The telecommunications equipment industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. The Company has not conducted a formal patent search relating to the technology used in its products, due in part to the high cost and limited benefits of a formal search. In addition, since patent applications in the U.S. are not publicly disclosed until the patent is issued, 10 applications may have been filed by competitors of the Company which could relate to the Company's products. Software comprises a substantial portion of the technology in the Company's products. The scope of protection accorded to patents covering software related inventions is evolving and is subject to a degree of uncertainty which may increase the risk and cost to the Company if the Company discovers third party patents related to its software products or if such patents are asserted against the Company in the future. The Company may receive communications from third parties in the future asserting that the Company's products infringe or may infringe on the proprietary rights of such third parties. In its distribution agreements, the Company typically agrees to indemnify its customers for any expenses or liabilities, resulting from claimed infringements of patents, trademarks or copyrights of third parties. In the event of litigation to determine the validity of any third party claims, such litigation, whether or not determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel. In the event of an adverse ruling in such litigation, the Company might be required to discontinue the use and sale of infringing products, expend significant resources to develop non infringing technology or obtain licenses from third parties. There can be no assurance that licenses from third parties would be available on acceptable terms, if at all. A successful claim against the Company and the failure of the Company to develop or license a substitute technology could have a material adverse effect on the Company's business and operating results. In addition, the laws of certain foreign countries in which the Company's products are or may be developed, manufactured or sold may not protect the Company's products or intellectual property rights to the same extent as do the laws of the U.S. and thus make the possibility of misappropriation of the Company's technology and products more likely. EMPLOYEES As of December 31, 1996, the Company had 242 full time employees of whom 71 were primarily engaged in research and development, 55 in manufacturing and quality control, 62 in marketing and sales, 23 in customer service and 31 in administration and finance. The Company also employed a total of 9 temporary and contract personnel. None of the Company's employees is represented by a collective bargaining unit nor has the Company ever experienced any work stoppage. The Company believes its relationship with its employees is good. MANAGEMENT The executive officers and directors of the Company are as follows:
NAME AGE POSITION - ------------------------------ --- ------------------------------------------------------- Deborah M. Soon 44 President, Chief Executive Officer and Director Bruce D. Horn 45 Vice President, Finance and Chief Financial Officer Jeffrey W. Reedy 38 Vice President, Engineering Paul A. Strudwick 44 Vice President, Marketing George M. Donohoe 59 Vice President, Sales William H. Cory 43 Vice President, Operations Paul E. Graf 52 Chairman of the Board (2) Donald G. Heitt 61 Director (2) Kevin N. Kalkhoven 51 Director (1) Harvey L. Poppel 58 Director (1)(2) Joseph F. Smorada 49 Director (1)
- ------------------------ (1) Member of Audit Committee. (2) Member of Compensation Committee. 11 Deborah M. Soon has served as President and Chief Executive Officer of the Company since July 1994. Previously, she served as Vice President of Marketing and Sales from June 1993 to June 1994, as Vice President of Marketing from from January 1991 to May 1993, and as Director of Marketing from May 1990 to December 1990. Prior to joining the Company, Ms. Soon held management positions in engineering, marketing and sales with AT&T, Prime Computers, BBN Communications Corporation and Data Architects Systems Inc. Ms. Soon earned a B.A. in Mathematics from the University of California, San Diego and an M.B.A. from the Harvard Graduate School of Business. She has also completed special undergraduate studies at Cambridge University in England. Bruce D. Horn has served as Vice President of Finance and Chief Financial Officer of the Company since January 1993. Previously, he served as Director of Finance and Chief Financial Officer from March 1991 to December 1992. Prior to joining the Company, Mr. Horn was Director of Finance at Insystems, Inc. and Corporate Controller at Anicon, Inc. Mr. Horn earned an M.B.A. in Finance from California State University, Hayward and a B.A. in Accounting from the University of Northern Iowa. Jeffrey W. Reedy has served as Vice President of Engineering of the Company since August 1994. Previously, he served as Vice President/Division Manager from January 1993 to August 1994, and Director of Engineering from November 1991 to January 1993. Prior to November 1991, Mr. Reedy was the Co-founder and Vice President of Engineering at T3 Technologies, Inc. (which was acquired by the Company in 1991). Mr. Reedy earned a B.S.E. in Electrical Engineering and Computer Science from Duke University and an M.S.E.E. from Stanford University. Paul A. Strudwick has served as Vice President of Marketing of the Company since August 1994. Previously, he served as Director of Product Management from March 1992 to August 1994. Prior to joining the Company, he was Product Management/Marketing Consultant for PolyCom, Inc. from October 1991 to February 1992. Prior to October 1991, he was Director of Product Line Management with Northern Telecom, Inc. and held a number of positions with Bell Northern Research in Canada. Mr. Strudwick earned a B.Sc. from the University of Sussex in England. George M. Donohoe has served as Vice President of Sales of the Company since August 1994. Previously, he served as Director of Telco Sales from April 1994 to August 1994 and Western Region Sales Manager from November 1993 to March 1994. Prior to joining the Company, Mr. Donohoe was Director of LAN Product Sales at Teleglobe from February 1993 to October 1993, and Vice President of Sales at Halley Systems from December 1989 to January 1993. Other professional affiliations include Luxcom, Infinet, Honeywell Information Systems and IBM. Mr. Donohoe earned a B.S. in Industrial Engineering and Management Sciences from the University of South Dakota. William H. Cory has served as Vice President of Operations of the Company since February 1990. Prior to joining the Company, Mr. Cory was Director of Quality Assurance for Verilink, Vice President for Wyken Technology, Director of Quality Assurance for Compression Labs, Inc. and Manager of Quality Assurance for Drivetec Inc. Mr. Cory earned a B.S. in Industrial Engineering and Management Science from Northwestern University. Donald G. Heitt has been the Chairman of the Board of Voysys Corporation since December 1995. From April 1990 to January 1996, Mr. Heitt was the President and Chief Executive Officer of Voysys Corporation. Prior to 1990, Mr. Heitt served as Senior Vice President of Telebit Corporation, Vice President of Sales and Marketing and President of the computer division of General Automation, Inc., and Vice President of Honeywell Information Systems, Inc. Mr. Heitt earned a B.B.A. from the University of Iowa. Kevin N. Kalkhoven has been the President and Chief Executive Officer of Uniphase since 1992. Mr. Kalkhoven joined Uniphase in January 1992 and has been a member of its board of directors since February 1992. Prior to joining Uniphase, Mr. Kalkhoven held executive positions at a variety of software companies. He served as President and Chief Executive Officer of Demax Software and as President and Chief Executive Officer of AIDA Corporation. Previously, he was Vice President of Marketing for the European division of Comshare Corporation and Group Vice President for its U.S. subsidiary. 12 Paul E. Graf has served as Chairman of the Board of Directors of the Company since June 1990. Mr. Graf has served as President and Chief Executive Officer for Axel Johnson since 1989. Prior to joining Axel Johnson, Mr. Graf held various senior executive positions with Schroders, a venture capital company, Conrac Corporation and Texas Instruments. Mr. Graf earned a B.S. in Electrical Engineering from Rensselear Polytechnic Institute and an M.B.A. from Boston University. Harvey L. Poppel has served as Managing Director at Broadview Associates L.L.C. since January 1985, and President of Poptech, Inc. since 1984. Previously, he was Senior Vice President, Board Member and Managing Officer of the Information Industry Practice at Booz, Allen & Hamilton and managed communications software development at both Western Union and Westinghouse Electric. Mr. Poppel holds an M.S. and a B.S. from Rensselear Polytechnic Institute. Joseph F. Smorada has served as a Director of the Company since June 1992. Mr. Smorada has served as Senior Vice President and Chief Financial Officer of Axel Johnson since April 1992. Prior to joining Axel Johnson, Mr. Smorada was Senior Vice President and Chief Financial Officer for Lone Star Industries from September 1988 to April 1992. Prior to 1988, Mr. Smorada also held senior executive positions with Conrac Corporation and Continental Group, Inc. Mr. Smorada earned a B.A. in Economics from California University of Pennsylvania. ITEM 2. PROPERTIES The Company leases approximately 50,000 square feet in Santa Clara, California and 16,000 square feet in Research Triangle Park, North Carolina. All manufacturing, sales and marketing and some research and development is performed at the Company's Santa Clara facility. The Research Triangle Park facility is primarily used for research and development. The Company has a 33.3% ownership interest in the Santa Clara facility. The lease for the Santa Clara facility expires in January 1998 and the lease for the Research Triangle Park facility expires in June 2001. The Company has an option to extend the Research Triangle Park lease for an additional three years. In March 1997 the Company signed a lease for an additional 119,000 square feet near its current facility. The Company intends to sublease a portion of the additional space as it will not be necessary in the immediate future. ITEM 3. LEGAL PROCEEDINGS America Online, Inc. ("AOL") has opposed Larscom's application for federal trademark registration of its logo, alleging that Larscom's design mark is similar to an AOL mark and that Larscom is attempting to register its mark for goods and services related to certain AOL goods and services. The Company does not believe the resolution of this opposition will have a material adverse effect on the Company's business and operating results. The Company is not involved in any other proceeding the outcome of which could have a material adverse effect on its business and operating results. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the Company subsequent to the Company's initial public offering. 13 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The Company made its initial public offering of Class A Common Stock on December 18, 1996, at $12.00 per share, and the Class A Common Stock of the Company began trading in the over-the-counter market on the Nasdaq National Market on December 19, 1996, under the symbol "LARS." The following table sets forth the high and low closing prices for the Company's Class A Common Stock as reported on the Nasdaq National Market from December 19, 1996 through December 31, 1996. These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.
HIGH LOW ----- ---------- Period from December 19 to December 31, 1996................................... $ 12 $ 111/8
As of February 28, 1997, there were 18 holders of record of the Company's Class A Common Stock and 1 holder of record of the Company's Class B Common Stock. In August 1996, the Company declared a dividend of $25,000,000, as evidenced by a note payable to Axel Johnson, bearing interest at a rate of 7.5% per annum. The principal was paid out of the proceeds of the Company's initial public offering on December 24, 1996. The Company currently intends to retain any future earnings for use in its business and does not anticipate paying any cash dividends in the foreseeable future. 14 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEARS ENDED DECEMBER 31, ----------------------------------------------------- 1996 1995 1994 1993 1992 --------- --------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) CONSOLIDATED STATEMENT OF OPERATIONS DATA: Revenues................................................... $ 66,444 $ 48,663 $ 36,550 $ 39,035 $ 33,502 Cost of revenues........................................... 29,949 21,147 15,037 14,989 13,654 --------- --------- --------- --------- --------- Gross profit........................................... 36,495 27,516 21,513 24,046 19,848 --------- --------- --------- --------- --------- Operating expenses: Research and development................................. 8,123 7,143 6,703 6,269 5,458 Selling, general and administrative...................... 19,408 15,762 13,385 13,629 11,752 --------- --------- --------- --------- --------- Total operating expenses............................... 27,531 22,905 20,088 19,898 17,210 --------- --------- --------- --------- --------- Operating income........................................... 8,964 4,611 1,425 4,148 2,638 Non-operating income (expense), net........................ (597) 3 9 -- 2 --------- --------- --------- --------- --------- Income before income taxes................................. 8,367 4,614 1,434 4,148 2,640 Provision for income taxes................................. 3,437 2,085 773 1,853 1,260 --------- --------- --------- --------- --------- Net income................................................. $ 4,930 $ 2,529 $ 661 $ 2,295 $ 1,380 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Supplemental net income per share(1)....................... $ 0.37 $ 0.18 $ -- $ -- $ -- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Shares used to compute supplemental net income per share(1)................................................. 14,317 14,193 -- -- -- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Cash dividends per share................................... $ 2.10 $ -- $ -- $ -- $ -- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Shares used to compute cash dividends per share............ 11,900 -- -- -- -- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- DECEMBER 31, ----------------------------------------------------- 1996 1995 1994 1993 1992 --------- --------- --------- --------- --------- (IN THOUSANDS) CONSOLIDATED BALANCE SHEET DATA: Working capital............................................ $ 55,944 $ 8,605 $ 7,520 $ 7,620 $ 6,426 Total assets............................................... 73,043 25,739 21,772 19,526 18,670 Total stockholders' equity................................. 61,445 18,236 15,707 15,046 12,757
- ------------------------ (1) See Note 1 of Notes to the Consolidated Financial Statements for an explanation of the determination of net income and of shares used to compute supplemental net income per share. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Over the past several years, Larscom has transitioned its business from supplying single purpose T1 and FT1 wide area network customer premises equipment ("CPE") to Fortune 500 corporations, to providing high speed network access platform solutions predominantly to NSPs. From 1986 through 1991, Larscom engaged primarily in the development, marketing and support of T1 CSU/DSUs and T1 diagnostic equipment. In October 1991, the Company acquired T3 Technologies Inc. ("T3T"), a broadband products company. The first broadband products developed by Larscom after the acquisition of T3T were the Access T45, one of the first T3 DSUs, and the Mega T, the first multiple T1 inverse multiplexer. Since then, the Company has invested significant resources in developing a suite of broadband capabilities for the Orion 4000 platform. Sales related to the Company's broadband products--Access T45, EtherSpan, Mega-T and Orion 4000 represented 31% and 12% of total revenues in 1996 and 1995, respectively. 15 A small number of customers, consisting of NSPs and resellers, have accounted for a majority of the Company's revenues in each of the past several years. Sales to the Company's top five customers accounted for 52%, 48%, and 41% of revenues in 1996, 1995 and 1994, respectively. Sales to NSPs represented 62%, 48% and 41% in 1996, 1995 and 1994, respectively. Sales to NSPs and resellers are often difficult to forecast due to the relatively long sales cycle and acceleration or delays in the timing of specific equipment deployment projects for which the NSP or reseller is acquiring equipment. The Company has experienced fluctuations in both annual and quarterly revenues due to the timing of receipt of customer orders as well as decisions from time to time by major customers to cease marketing, purchasing and reselling the Company's products. Since the Company continues to have significant sales to a small number of customers, similar sales fluctuations may occur in the future. In 1995, the Company experienced a shift in the purchasing behavior of its customers which resulted in higher second and third quarter sales relative to fourth quarter sales. These purchasing patterns and resulting cyclicality could continue in the future. Since most of the Company's sales are in the form of large orders with short delivery times to a limited number of customers, the Company's ability to predict revenues is limited. In addition, announcements by the Company or its competitors of new products and technologies could cause customers to defer purchases of the Company's existing products. In the event that anticipated orders from major customers fail to materialize, or delivery schedules are deferred or canceled as a result of the above factors or other unanticipated factors, the Company's business and operating results could be materially adversely affected. The Company establishes its expenditure levels for product development and other operating expenses based on projected sales levels and margins, however, expenses are relatively fixed in the short term. Accordingly, if sales are below expectations in any given period, the adverse impact of the revenue shortfall on the Company's operating results may be greater due to the Company's inability to adjust spending in the short term to compensate for the shortfall. As a result, the Company believes that period-to-period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indicative of future performance. The Company sells its products primarily through a direct sales force and to a lesser extent through a variety of resellers, including OEMs, VARs, systems integrators and distributors. Sales outside the U.S. have not been significant to date. 16 RESULTS OF OPERATIONS The following table sets forth the percentage of revenues represented by certain items in the Company's consolidated statement of operations for the periods indicated:
YEARS ENDED DECEMBER 31, ------------------------------------- 1996 1995 1994 ----------- ----------- ----------- Revenues........................................................... 100% 100% 100% Cost of revenues................................................... 45 43 41 --- --- --- Gross profit................................................... 55 57 59 --- --- --- Operating expenses: Research and development......................................... 12 15 18 Selling, general and administrative.............................. 29 33 37 --- --- --- Total operating expenses....................................... 41 48 55 --- --- --- Operating income................................................... 14 9 4 Nonoperating income (expense), net................................. (1) -- -- --- --- --- Income before income taxes......................................... 13 9 4 Provision for income taxes......................................... 6 4 2 --- --- --- Net income......................................................... 7% 5% 2% --- --- --- --- --- ---
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 REVENUES. Revenues increased 37% to $66,444,000 in 1996 from $48,663,000 in 1995. The growth in revenues reflected increased sales across the Company's product lines, particularly sales of broadband products such as the Access T45 and Orion 4000 to NSPs. GROSS PROFIT. As a percentage of revenues, gross profit declined to 55% in 1996 from 57% in 1995. This decrease was primarily the result of lower average unit selling prices of digital access products, partially offset by increased sales of higher margin broadband products. The Company is continuing to seek to increase broadband product sales and to reduce costs of its broadband products as well as its digital access products. There can be no assurance that such efforts will be sufficient to offset the expected continued decline in the average selling prices of digital access products. RESEARCH AND DEVELOPMENT. Research and development expenses increased 14% to $8,123,000 in 1996 from $7,143,000 in 1995. As a percentage of revenues, research and development expenses declined to 12% in 1996 from 15% in 1995 due to increased revenues which was offset by an increase in research and development expenses. The increase in research and development expenses in 1996 was due primarily to a 45% increase in headcount during 1996, as well as increased costs associated with product safety and country specific product certification. The Company believes that a continued commitment to research and development, particularly related to broadband products and emerging technologies in response to customer demands, will be required to remain competitive. Accordingly, the Company is increasing its engineering staff and anticipates that its research and development expenses will increase in future periods in absolute dollars. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses increased 23% to $19,408,000 in 1996 from $15,762,000 in 1995. As a percentage of revenues, selling, general and administrative expenses declined to 29% in 1996 from 33% in 1995. The increase in absolute dollars was due to additional personnel costs associated with expansion of the Company's sales and marketing resources, as well as higher selling expenses associated with higher revenues. Selling, general and administrative expenses included the amortization of goodwill of approximately $356,000 and $988,000 during 1996 and 1995, respectively, related to the acquisition of Larscom by Axel Johnson in 1987 and the acquisition of 17 T3T by Larscom in 1991. Goodwill relating to these acquisitions has been fully amortized as of December 31, 1996. Selling, general and administrative expenses also include a charge from Axel Johnson for legal, accounting, tax, treasury and administrative services. For 1996 and 1995, these charges were approximately $527,000 and $549,000, respectively. The Company anticipates that selling, general and administrative expenses will increase in absolute dollars in the future as a result of the Company's continued investment in the expansion of its sales, service and support organizations, the development of its distribution channels (particularly outside the United States) as well as the legal, accounting, human resources and administrative expenses associated with being a public company. NON-OPERATING INCOME (EXPENSE), NET. Net non-operating expense during 1996 of $597,000 primarily represents interest charged on the $25,000,000 note payable to Axel Johnson, which was paid with the proceeds of the initial public offering. PROVISION FOR INCOME TAXES. The effective tax rates of 41% and 45% for 1996 and 1995, respectively, differed from the federal statutory rates as a result of non deductible goodwill amortization and state taxes, offset in part by research and development tax credits in 1995. The effective tax rate decreased in 1996 as the non-deductible items constituted a relatively lower percentage of pre-tax income during that period. YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994 REVENUES. Revenues increased 33% to $48,663,000 in 1995 from $36,550,000 in 1994. This growth was primarily due to an increase in digital access product unit sales. Broadband product unit sales increased to a lesser extent. GROSS PROFIT. As a percentage of revenues, gross profit declined to 57% in 1995 from 59% in 1994. This decrease was due primarily to price pressures in the digital access market, partially offset by the increase in sales of higher gross profit broadband products. RESEARCH AND DEVELOPMENT. Research and development expenses increased to $7,143,000 in 1995 from $6,703,000 in 1994. The increase was primarily due to higher costs associated with continued development in 1995 of the broadband product line and related technologies. As a percentage of revenues, research and development expenses decreased to 15% in 1995 from 18% in 1994 due to increased revenues. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses increased 18% to $15,762,000 in 1995 from $13,385,000 in 1994. As a percentage of revenues, selling, general and administrative expenses declined to 33% in 1995 from 37% in 1994. The increase in absolute dollars was due to the additional personnel and increased incentive compensation costs required to generate additional sales and support an increased sales force. Selling, general and administrative expenses during both 1995 and 1994 also included the amortization of goodwill, related to the acquisition of Larscom by Axel Johnson in 1987 and the acquisition of T3T by Larscom in 1991, of $988,000. Selling, general and administrative expenses also included charges by Axel Johnson of $549,000 and $526,000 in 1995 and 1994, respectively. PROVISION FOR INCOME TAXES. The effective tax rates of 45% in 1995 and 54% in 1994 differed from the federal statutory rates as a result of non-deductible goodwill amortization and state taxes, offset in part by research and development tax credits. The effective tax rate decreased in 1995 as the non-deductible items constituted a relatively lower percentage of pre-tax income during that period. LIQUIDITY AND CAPITAL RESOURCES Since its acquisition by Axel Johnson in 1987 and until its initial public offering in December 1996, the Company met its operating and capital requirements primarily from cash flow from operations and advances from Axel Johnson. The Company's operating activities generated $4,710,000 in cash in 1996, primarily as a result of net income and increases in accrued expenses and other liabilities which were offset by increases in accounts 18 receivable and inventories. Operating activities generated $4,034,000 in cash in 1995, primarily as a result of net income and an increase in accrued expenses and accounts payable partially offset by increases in accounts receivable and inventories. On December 18, 1996, the Company sold 5,800,000 shares of Class A Common Stock at a price per share of $12 in its initial public offering. During 1996, net proceeds of the offering were $63,279,000 after issuance costs of $1,449,000 and the underwriting discount. In January 1997, the underwriters exercised their option to sell an additional 350,000 shares and the Company received net proceeds of $3,906,000. In December 1996, the Company entered into a credit agreement with Axel Johnson ("the Credit Agreement") under which the Company has available a revolving line of credit of $15,000,000. The Credit Agreement contains various representations, covenants and events of default typical for financing a business of a similar size and nature. The events of default under the Credit Agreement include any failure to pay punctually any principal or interest due under the Credit Agreement, any act of insolvency of Larscom and any sale by Larscom of all or substantially all of its assets. Upon an event of default any borrowings under the line of credit shall become payable in full. In addition to such Credit Agreement, the Company and Axel Johnson entered into an administrative services agreement and a tax sharing agreement for the purposes of defining the on-going relationship between them. See Footnote 1 and 3 of the Notes to the Consolidated Financial Statements for more details. Capital expenditures in 1996 of $3,131,000, were principally for the purchase of computers, software and test equipment. The Company expects capital expenditures during 1997 to be approximately $4,000,000. On March 20, 1997, the Company entered into an operating lease under which the Company agreed to pay approximately $155,000 per month for 119,000 square feet of space located close to the Company's current facilities in Santa Clara, California. The lease commences in August 1997 and lasts for seven years. The Company has an option to extend the lease for a period of five years subject to certain conditions. These facilities are intended to replace the Company's current facilities. The Company believes that working capital together with the Company's line of credit and funds generated from operations, will provide adequate liquidity to meet the Company's operating and capital requirements at least through 1997. However, there can be no assurance that future events, such as the potential use of cash to fund acquisitions, will not require the Company to seek additional capital at an earlier date or, if so required, that adequate capital will be available on terms acceptable to the Company, or at all. The effects of inflation on the Company's revenues and operating income have not been material. CERTAIN RISK FACTORS CUSTOMER CONCENTRATION. The Company believes that its relationships with large customers, particularly the NSPs and telecommunications companies, will be critical to its future success. A small number of customers have accounted for a majority of the Company's revenues in each of the past several years. In 1996, 1995 and 1994, NSPs represented 62%, 48% and 41%, respectively, of total revenues and the Company's top five customers accounted for 52%, 48%, and 41% of revenues in 1996, 1995 and 1994, respectively. None of the Company's customers are contractually obliged to purchase any quantity of products in any particular period, and product sales to major customers have varied widely from quarter to quarter and year to year. There can be no assurance that the Company's current customers will continue to place orders with the Company, that orders from existing customers will continue at the levels of previous periods or that the Company will be able to obtain orders from new customers. Loss of, or a material reduction in orders by, one or more of the Company's major customers could have a material adverse effect on the Company's business and operating results. DEPENDENCE ON RECENTLY INTRODUCED PRODUCTS AND PRODUCTS UNDER DEVELOPMENT. The Company's future operating results are highly dependent on continuing market acceptance of the Company's newest products, particularly in the broadband area. There can be no assurance that these products or any future 19 products will continue to achieve widespread market acceptance. In addition, the Company has in the past experienced delays in the development of new products and the enhancement of existing products, and such delays may occur in the future. The Company's potential inability to develop and introduce new products or versions in a timely manner, due to resource constraints or technological or other reasons, or to achieve timely and widespread market acceptance of its new products or releases could have a material adverse effect on the Company's business and operating results. RAPID TECHNOLOGICAL CHANGE. The telecommunications equipment industry is characterized by rapidly changing technologies and frequent new product introductions. The rapid development of new technologies increases the risk that current or new competitors could develop products that would reduce the competitiveness of the Company's products. The Company's success will depend to a substantial degree upon its ability to respond to changes in technology and customer requirements. This will require the timely selection, development and marketing of new products and enhancements on a cost effective basis. There can be no assurance that the Company will be successful in developing, introducing or managing the transition to new or enhanced products or that any such products will be responsive to technological changes or will gain market acceptance. If the Company were to be unsuccessful or to incur significant delays in developing and introducing such new products or enhancements, the Company's business and operating results could be materially adversely affected. NO RECENT INDEPENDENT OPERATING HISTORY. The Company has been a wholly owned subsidiary of Axel Johnson since 1987 until the date of the Company's IPO and, accordingly, has had no recent independent operating history. The Company will be required to further develop financial, management, administrative and other resources previously provided by Axel Johnson which are necessary to operate successfully as an independent public company. Although the Company and Axel Johnson have entered into several agreements that are intended to ease the Company's transition to an independent public company, there can be no assurance that the Company will be able to manage this transition or to develop these independent resources successfully. Although the Company will have access, subject to certain conditions, to a $15.0 million credit facility provided by Axel Johnson, there can be no assurance that alternative sources of financing will be available upon the expiration or termination of such facility or that additional sources of funding will be available on terms favorable to the Company if the Company's borrowing requirements exceed the amount of the facility. FLUCTUATIONS IN QUARTERLY OPERATING RESULTS; ABSENCE OF SIGNIFICANT BACKLOG. The Company's operating results have fluctuated significantly in the past and may fluctuate in the future on a quarterly and annual basis as a result of a number of factors, many of which are beyond the Company's control. In 1995, the Company experienced a shift in the purchasing behavior of its customers which resulted in higher second and third quarter sales relative to fourth quarter sales. These purchasing patterns and resulting cyclicality could continue in the future. Moreover, the Company's sales historically have been concentrated in a small number of customers. Therefore, sales for a given quarter may depend to a significant degree upon product shipments to a limited number of customers. Sales to individual large customers are often related to the customer's specific equipment deployment projects, the timing of which are subject to change on limited notice. The Company has experienced both acceleration and slowdown in orders related to such projects, causing changes in the sales level of a given quarter relative to both the preceding and subsequent quarters. For example, since 1994 sales to MCI, IBM/Advantis, AT&T and other current customers have occasionally varied by $1.0 million or more from quarter to quarter. Since most of the Company's sales are in the form of large orders with short delivery times to a limited number of customers, the Company's ability to predict revenues is limited. In addition, announcements by the Company or its competitors of new products and technologies could cause customers to defer purchases of the Company's existing products. In the event that anticipated orders from major customers fail to materialize, or delivery schedules are deferred or canceled as a result of the above factors or other unanticipated factors, the Company's business and operating results could be materially adversely affected. As a result, the Company believes that period to period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indicative of future performance. 20 The Company's gross margin is affected by a number of factors, including product mix, product pricing, cost of components and manufacturing costs. For example, a price reduction of a particular product in response to competitive pressure which is not offset by a reduction in production costs or by sales of other products with higher gross margins would decrease the Company's overall gross margin and could have a material adverse effect on the Company's business and operating results. The Company's anticipated increase in overall spending in future periods in order to pursue new market opportunities may also affect operating margins. The Company establishes its expenditure levels for product development and other operating expenses based on projected sales levels and margins, however, expenses are relatively fixed in the short term. Accordingly, if sales are below expectations in any given period, the adverse impact of the revenue shortfall on the Company's operating results may be greater due to the Company's inability to adjust spending in the short term to compensate for the shortfall. Results in any period could also be affected by changes in market demand, competitive market conditions, market acceptance of new or existing products, the cost and availability of components, the mix of the Company's customer base and sales channels, the mix of products sold, sales promotion activities by the Company, the Company's ability to expand its sales and marketing organization effectively, the Company's ability to attract and retain key technical and managerial employees and general economic conditions. Due to all of the foregoing factors, the Company's operating results in one or more future periods may be subject to significant fluctuations. In the event this results in the Company's financial performance being below the expectations of public market analysts and investors, the price of the Company's Class A Common Stock could be materially adversely affected. CONTROL BY AXEL JOHNSON. Holders of Class A Common Stock are entitled to one vote per share and holders of Class B Common Stock are entitled to four votes per share, subject to adjustment, to preserve the initial voting ratio. As a result, Axel Johnson has sufficient voting power to control the direction and policies of the Company, including mergers, consolidations, the sale of all or substantially all of the assets of the Company and the election of the Board of Directors of the Company, and to prevent or cause a change in control of the Company. In addition, the authorized but unissued capital stock of the Company includes 5,000,000 shares of preferred stock (the "Preferred Stock"). The Board of Directors is authorized to provide for the issuance of Preferred Stock in one or more series and to fix the designations, preferences, powers and relative, participating, optional or other rights and restrictions thereof. Accordingly, the Company may issue a series of Preferred Stock in the future that will have preference over both classes of the Company's Common Stock with respect to the payment of dividends and upon liquidation, dissolution or winding up or which could otherwise adversely affect holders of the Common Stock or discourage or make difficult any attempt to obtain control of the Company. Such control may have the effect of discouraging certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of Class A Common Stock might otherwise receive a premium for their shares over the then current market price. RISKS ASSOCIATED WITH ENTRY INTO INTERNATIONAL MARKETS. The Company has had minimal sales to international customers to date, and has had little experience in international markets. The conduct of business outside the U.S. is subject to certain risks, including unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, longer payment cycles, greater difficulty in accounts receivable collection, currency fluctuations, expropriation and potentially adverse tax consequences. In addition, in order to sell its products internationally, the Company must meet standards established by telecommunications authorities in various countries, as well as recommendations of the International Telecommunications Union. A delay in obtaining, or the failure to obtain, certification of its products in countries outside the U.S. could deny or preclude the Company's marketing and sales efforts in such countries, which could have a material adverse effect on the Company's business and operating results. MANAGEMENT OF EXPANDING OPERATIONS. The growth in the Company's business has placed a significant strain on the Company's personnel, management and other resources, and is expected to continue to do so. In order to manage any future expansion effectively, the Company must attract, train, motivate and 21 manage new employees successfully, integrate new management and employees into its overall operations and continue to improve its operational, financial and management systems, particularly as the Company transitions from services provided to date by Axel Johnson. Availability of qualified sales and technical personnel is limited, and competition for experienced sales and technical personnel in the telecommunications equipment industry is intense. Moreover, the Company expects to increase significantly the size of its domestic and international sales support staff and expand the scope of its sales and marketing activities. The Company's failure to manage any expansion effectively, including the above factors, could have a material adverse effect on the Company's business and operating results. COMPLIANCE WITH REGULATIONS AND EVOLVING INDUSTRY STANDARDS. The market for the Company's products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. In the U.S., the Company's products must comply with various regulations defined by the Federal Communications Commission and standards established by Underwriters Laboratories, as well as industry standards established by various organizations. As standards for new services such as ATM evolve, the Company may be required to modify its existing products or develop and support new versions of its products. The failure of the Company's products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of the Company's products, which in turn could have a material adverse effect on the Company's business and operating results. RISKS ASSOCIATED WITH POTENTIAL ACQUISITIONS. An important element of the Company's strategy is to review acquisition prospects that would complement its existing product offerings, augment its market coverage, enhance its technological capabilities or offer growth opportunities. The Company has no current agreements or negotiations underway with respect to any such acquisitions. Future acquisitions by the Company could result in potentially dilutive issuances of equity securities and/or the incurrence of debt and the assumption of contingent liabilities, any of which could have a material adverse effect on the Company's business and operating results and/or the price of the Company's Class A Common Stock. In this regard, as a result of the ownership interest of Axel Johnson in the Company, the Company will not be able to use pooling of interests accounting for any future acquisition. Accordingly, such acquisitions could result in amortization of goodwill and other charges (including the immediate write-off of purchased research and development in process) typically associated with purchase accounting. Acquisitions entail numerous risks, including difficulties in the assimilation of acquired operations, technologies and products, diversion of management's attention to other business concerns, risks of entering markets in which the Company has limited or no prior experience and potential loss of key employees of acquired organizations. The Company's management has limited prior experience in assimilating acquired organizations. No assurance can be given as to the ability of the Company to successfully integrate any businesses, products, technologies or personnel that might be acquired in the future, and the failure of the Company to do so could have a material adverse effect on the Company's business and operating results. LIMITED PROTECTION OF INTELLECTUAL PROPERTY; PROPRIETARY INFORMATION. The Company relies upon a combination of trade secrets, contractual restrictions, copyrights, trademark laws and patents to establish and protect proprietary rights in its products and technologies. Although the Company has been issued only one U.S. patent to date, it believes that the success of its business depends primarily on its proprietary technology, information and processes and know-how, rather than patents. Much of the Company's proprietary information and technology is not patented and may not be patentable. There can be no assurance that the Company will be able to protect its technology or that competitors will not be able to develop similar technology independently. The Company has entered into confidentiality and invention assignment agreements with all of its employees, and enters into non-disclosure agreements with its suppliers, distributors and appropriate customers so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of the Company's technologies or discourage independent third-party development of similar technologies. In the event such arrangements are insufficient, the Company's business and operating results could be materially adversely affected. 22 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Larscom Incorporated In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of stockholders' equity present fairly, in all material respects, the financial position of Larscom Incorporated and its subsidiary at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ Price Waterhouse LLP PRICE WATERHOUSE LLP San Jose, California January 17, 1997, except for Note 9 which is as of March 24, 1997. 23 LARSCOM INCORPORATED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA) ASSETS
DECEMBER 31, -------------------- 1996 1995 --------- --------- Current assets: Cash and cash equivalents................................................................. $ 46,403 $ 30 Accounts receivable, net.................................................................. 9,478 6,424 Inventories............................................................................... 8,654 7,250 Deferred income taxes..................................................................... 2,026 1,415 Prepaid expenses and other current assets................................................. 722 412 --------- --------- Total current assets.................................................................... 67,283 15,531 Property and equipment, net................................................................. 5,530 4,358 Due from Axel Johnson....................................................................... -- 5,186 Intangible assets, net...................................................................... 92 526 Other assets................................................................................ 138 138 --------- --------- Total assets............................................................................ $ 73,043 $ 25,739 --------- --------- --------- --------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable.......................................................................... $ 2,569 $ 2,416 Accrued expenses and other current liabilities............................................ 7,441 4,510 Due to Axel Johnson....................................................................... 1,329 -- --------- --------- Total current liabilities............................................................... 11,339 6,926 --------- --------- Deferred income taxes....................................................................... 259 577 --------- --------- Commitments and contingencies (Notes 7, 8 and 9)............................................ Stockholders' equity: Preferred Stock, $0.01 par value; 5,000 shares authorized; no shares issued or outstanding............................................................................. -- -- Class A Common Stock, $0.01 par value; 100,000 shares authorized; 7,000 and 0 shares issued and outstanding, respectively.................................................... 70 -- Class B Common Stock, $0.01 par value; 11,900 shares authorized; 10,700 and 11,900 issued and outstanding, respectively........................................................... 107 119 Additional paid-in capital................................................................ 76,392 13,171 Retained earnings (accumulated deficit)................................................... (15,124) 4,946 --------- --------- Total stockholders' equity.............................................................. 61,445 18,236 --------- --------- Total liabilities and stockholders' equity.............................................. $ 73,043 $ 25,739 --------- --------- --------- ---------
The accompanying notes are an integral part of these financial statements. 24 LARSCOM INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- Revenues......................................................................... $ 66,444 $ 48,663 $ 36,550 Cost of revenues................................................................. 29,949 21,147 15,037 --------- --------- --------- Gross profit................................................................. 36,495 27,516 21,513 --------- --------- --------- Operating expenses: Research and development....................................................... 8,123 7,143 6,703 Selling, general and administrative............................................ 19,408 15,762 13,385 --------- --------- --------- Total operating expenses..................................................... 27,531 22,905 20,088 --------- --------- --------- Income from operations........................................................... 8,964 4,611 1,425 Interest expense charged by Axel Johnson......................................... (630) -- -- Interest income.................................................................. 33 3 9 --------- --------- --------- Income before income taxes....................................................... 8,367 4,614 1,434 Provision for income taxes....................................................... 3,437 2,085 773 --------- --------- --------- Net income....................................................................... $ 4,930 $ 2,529 $ 661 --------- --------- --------- --------- --------- --------- Supplemental net income per share(1)............................................. $ 0.37 $ 0.18 Shares used to compute supplemental net income per share(1)...................... 14,317 14,193
- ------------------------ (1) See Note 1 of Notes to the Consolidated Financial Statements for an explanation of the determination of net income and of shares used to compute supplemental net income per share. The accompanying notes are an integral part of these financial statements. 25 LARSCOM INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- Cash flows from operating activities: Net income...................................................................... $ 4,930 $ 2,529 $ 661 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation.................................................................. 1,959 1,535 1,516 Amortization.................................................................. 434 1,109 1,109 Deferred income taxes......................................................... (929) (132) (126) Changes in assets and liabilities: Accounts receivable......................................................... (3,054) (1,449) 386 Inventories................................................................. (1,404) (1,063) (1,078) Prepaid expenses and other current assets................................... (310) 77 82 Accounts payable............................................................ 153 233 983 Accrued expenses and other current liabilities.............................. 2,931 1,195 (594) --------- --------- --------- Net cash provided by operating activities......................................... 4,710 4,034 2,939 --------- --------- --------- Cash flows from investing activities: Purchase of property and equipment.............................................. (3,131) (2,087) (1,407) --------- --------- --------- Net cash used by investing activities............................................. (3,131) (2,087) (1,407) --------- --------- --------- Cash flows from financing activities: Net proceeds from Common Stock offering......................................... 63,279 -- -- Payment of dividend to Axel Johnson............................................. (25,000) -- -- Advances from (repayments to) Axel Johnson...................................... 6,515 (2,011) (1,721) --------- --------- --------- Net cash provided (used) by financing activities.................................. 44,794 (2,011) (1,721) --------- --------- --------- Increase (decrease) in cash and cash equivalents.................................. 46,373 (64) (189) Cash and cash equivalents at beginning of period.................................. 30 94 283 --------- --------- --------- Cash and cash equivalents at end of period........................................ $ 46,403 $ 30 $ 94 --------- --------- --------- --------- --------- --------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Interest paid..................................................................... $ 630 $ -- $ -- --------- --------- --------- Income taxes paid................................................................. $ 4,366 $ 2,217 $ 899 --------- --------- ---------
The accompanying notes are an integral part of these financial statements. 26 LARSCOM INCORPORATED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
CLASS A CLASS B RETAINED COMMON STOCK COMMON STOCK ADDITIONAL EARNINGS/ ------------------------ ---------------------- PAID-IN (ACCUMULATED SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT) ----------- ----------- --------- ----------- ----------- ------------ Balance at December 31, 1993.................. -- $ -- 11,900 $ 119 $ 13,171 $ 1,756 Net income.................................... -- -- -- -- -- 661 ----- ----- --------- ----- ----------- ------------ Balance at December 31, 1994.................. -- -- 11,900 119 13,171 2,417 Net income.................................... -- -- -- -- -- 2,529 ----- ----- --------- ----- ----------- ------------ Balance at December 31, 1995.................. -- -- 11,900 119 13,171 4,946 Conversion of Class B Common Stock to Class A Common Stock................................ 1,200 12 (1,200) (12) -- -- Sale of Class A Common Stock, net............. 5,800 58 -- -- 63,221 -- Dividend paid................................. (25,000) Net income.................................... -- -- -- -- -- 4,930 ----- ----- --------- ----- ----------- ------------ Balance at December 31, 1996.................. 7,000 $ 70 10,700 $ 107 $ 76,392 $ (15,124) ----- ----- --------- ----- ----------- ------------ ----- ----- --------- ----- ----------- ------------ TOTAL STOCKHOLDERS' EQUITY ------------- Balance at December 31, 1993.................. $ 15,046 Net income.................................... 661 ------------- Balance at December 31, 1994.................. 15,707 Net income.................................... 2,529 ------------- Balance at December 31, 1995.................. 18,236 Conversion of Class B Common Stock to Class A Common Stock................................ -- Sale of Class A Common Stock, net............. 63,279 Dividend paid................................. (25,000) Net income.................................... 4,930 ------------- Balance at December 31, 1996.................. $ 61,445 ------------- -------------
The accompanying notes are an integral part of these financial statements. 27 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1-- THE COMPANY AND A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Larscom Incorporated (the "Company") , a majority owned subsidiary of Axel Johnson, develops, manufactures and markets a broad range of high speed, global internetworking solutions for network service providers and corporate users. The Company operates in one industry segment. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary. All material intercompany transactions and balances have been eliminated in consolidation. The Company's investment in a less than 50% owned entity is accounted for using the equity method. CONCENTRATIONS OF CREDIT RISK Financial instruments which subject the Company to concentrations of credit risk consist primarily of accounts receivable. The Company's accounts receivable is derived from sales to customers primarily in the United States. The Company performs ongoing credit evaluations of its customers, and generally requires no collateral from its customers. The Company maintains reserves for potential credit losses, and to date has not experienced any material losses. At December 31, 1996 and 1995, receivables from two customers represented 18% and 11%, and 23% and 12%, respectively, of gross accounts receivable. MANAGEMENT ESTIMATES AND ASSUMPTIONS 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 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. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all cash and highly liquid investments with original maturities of three months or less. The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of those investments and the financial stability of the issuers. The Company participates in Axel Johnson's centralized cash management system. In general, the cash funding requirements of the Company have been met by, and substantially all cash generated by the Company has been transferred to, Axel Johnson. Average daily net balances owed to Axel Johnson will incur interest at the same rate as set forth in the Credit Agreement (See Note 3 for details). Average daily net balances due from Axel Johnson will earn interest at the average rate earned by Axel Johnson on its investments. INVENTORIES Inventories are stated at the lower of cost, determined using the first-in first-out method, or market. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Depreciation and amortization are computed using the straight line method based upon the estimated useful lives of the assets, which range from three to five years. Leasehold improvements are amortized using the straight line method over the shorter of the estimated useful lives or the lease term of the respective assets. 28 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1-- THE COMPANY AND A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) INTANGIBLE ASSETS Purchased identifiable intangible assets are amortized using the straight line method over their estimated useful lives of five to ten years. Goodwill, representing the excess of purchase price over the fair value of net assets acquired has been amortized over periods ranging from five to eight years on a straight line basis. At each balance sheet date, a review is performed by management to ascertain whether intangibles have been impaired based on several criteria, including, but not limited to, revenue trends, undiscounted operating cash flows and other operating factors. LONG-LIVED ASSETS On January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of." This statement established accounting standards for the impairment of long-lived assets, certain identifiable intangibles and goodwill. The adoption of this statement had no effect on the Company's financial position or results of operations. WARRANTY The Company provides a two year warranty for its products. Effective January 1, 1997, certain of the Company's products were sold with warranty periods of three years. A provision for the estimated cost of warranty, which includes material, labor and overhead, is recorded at the time revenue is recognized. While the Company believes that its reserves for estimated future warranty costs are adequate there are inherent risks associated with these estimates particularly for those estimates related to products which have been recently introduced. PENSIONS Axel Johnson has a noncontributory funded defined benefit pension plan and an unfunded retirement restoration plan covering substantially all the Company's employees. In general the cost of these plans has been allocated to the Company based on the compensation of the Company's employees. Amounts so allocated are not necessarily indicative of the pension cost that would have been incurred if the Company maintained its own benefit plans. See Note 6 for details. Pension cost allocated to the Company is recorded in the "Due from/(to) Axel Johnson" balance. The Company's exposure to retirement benefits is limited to the cost so allocated. REVENUE RECOGNITION Revenue from product sales is recognized upon shipment of the product. The Company, in general, does not grant a right of return to its customers. The following table summarizes the percentage of total revenues for customers accounting for more than 10% of the Company's revenues:
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- MCI........................................................................... 21% 18% 15% IBM/Advantis.................................................................. 13% 14% *10%
29 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1-- THE COMPANY AND A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) RESEARCH AND DEVELOPMENT All research and development costs, including the software development costs discussed below, are charged to expense as incurred. SOFTWARE DEVELOPMENT COSTS Software development costs incurred prior to establishment of technological feasibility are expensed as research and development costs. Costs incurred subsequent to the establishment of technological feasibility, and prior to the general release of the product to the public, were not significant for all periods presented and accordingly have been expensed. INCOME TAXES Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their financial statement reported amounts. Current tax expense has been determined as if the Company was a separate taxpayer. Income taxes currently payable are deemed to have been remitted by the Company to Axel Johnson in the period that the liability arose. Income taxes currently receivable are deemed to have been received by the Company from Axel Johnson in the period that a refund could have been recognized by the Company had the Company been a separate taxpayer. In December 1996, the Company entered into an income tax sharing agreement with Axel Johnson, pursuant to which the Company made a payment to Axel Johnson, of an amount in respect of income taxes attributable to the Company for the period from January 1, 1996 to December 18, 1996, the date of the Company's IPO, when the Company ceased to be a member of the Axel Johnson consolidated group. SUPPLEMENTAL NET INCOME PER SHARE Supplemental net income per share is computed using the weighted average number of shares of common stock outstanding during the period. The weighted average number of shares of common stock also includes a number of common shares, calculated using the net proceeds per share of common stock in the offering, which would be required to pay the $25,000,000 dividend to Axel Johnson. Net income for the year ended December 31, 1996, has been increased by interest expense, net of income taxes, of approximately $371,000 on the note payable to Axel Johnson. Net income per share for periods prior to 1995 has not been presented as such presentation is not meaningful. STOCK-BASED COMPENSATION As permitted under Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS 123), the Company is continuing to measure compensation cost for stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25 "Accounting for Stock Issued to Employees." SFAS 123 defines a "fair value" method of accounting for an employee stock option or similar equity instrument and encourages, but does not require, entities to adopt that method of accounting for their employee stock compensation plans. The pro forma disclosures of the difference between compensation cost included in net income and the related cost measured by the fair value method are presented in Note 6. 30 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1-- THE COMPANY AND A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) FAIR VALUE OF FINANCIAL INSTRUMENTS For all financial instruments, including accounts receivable, accounts payable, accrued expenses and other liabilities, the carrying value is considered to approximate fair value due to the relatively short maturities of the respective instruments. NOTE 2--BALANCE SHEET COMPONENTS
DECEMBER 31, -------------------- 1996 1995 --------- --------- (IN THOUSANDS) Accounts receivable: Gross accounts receivable................................................................. $ 9,603 $ 6,514 Less: Allowance for doubtful accounts..................................................... (125) (90) --------- --------- $ 9,478 $ 6,424 --------- --------- --------- --------- Inventories: Raw materials............................................................................. $ 1,508 $ 1,338 Work in process........................................................................... 1,823 3,834 Finished goods............................................................................ 5,323 2,078 --------- --------- $ 8,654 $ 7,250 --------- --------- --------- --------- Property and equipment: Machinery and equipment................................................................... $ 6,751 $ 5,848 Computers and software.................................................................... 5,136 3,486 Leasehold improvements.................................................................... 1,069 979 Furniture and fixtures.................................................................... 742 647 --------- --------- 13,698 10,960 Less: Accumulated depreciation............................................................ (8,168) (6,602) --------- --------- $ 5,530 $ 4,358 --------- --------- --------- --------- Intangible assets: Goodwill.................................................................................. $ 2,375 $ 2,375 Other intangible assets................................................................... 1,013 1,013 --------- --------- 3,388 3,388 Less: Accumulated amortization............................................................ (3,296) (2,862) --------- --------- $ 92 $ 526 --------- --------- --------- --------- Accrued expenses and other current liabilities: Accrued compensation...................................................................... $ 4,807 $ 2,687 Accrual for contractual matters (See Note 8).............................................. 532 757 Other current liabilities................................................................. 2,102 1,066 --------- --------- $ 7,441 $ 4,510 --------- --------- --------- ---------
31 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3--RELATED PARTY TRANSACTIONS: TRANSACTIONS WITH AXEL JOHNSON Related party transactions with Axel Johnson not disclosed elsewhere in the consolidated financial statements are as follows: DUE FROM/(TO) AXEL JOHNSON Amounts due from/(to) Axel Johnson consist of cash remittances made by the Company to Axel Johnson from its operating bank accounts offset by cash advances to the Company from Axel Johnson for purchases of property and equipment, acquisitions, current income tax liabilities and fluctuating working capital needs. Neither Axel Johnson nor the Company has charged interest on the balances due. The following is an analysis of the balance due from/(to) Axel Johnson:
DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (IN THOUSANDS) Balance at beginning of the period...................................... $ 5,186 $ 3,175 $ 1,454 Cash remittances to Axel Johnson, net of cash advances.................. 1,818 6,563 4,929 Charges from Axel Johnson for: Income taxes.......................................................... (4,366) (2,217) (899) Pension and thrift plan............................................... (1,028) (898) (850) Insurance and workers' compensation................................... (512) (534) (652) Administrative services............................................... (527) (549) (526) Interest on note payable.............................................. (630) -- -- Property, liability and general insurance............................. (633) (193) (180) IPO related costs..................................................... (401) -- -- Other charges......................................................... (236) (161) (101) --------- --------- --------- Balance at the end of the period........................................ $ (1,329) $ 5,186 $ 3,175 --------- --------- --------- --------- --------- ---------
NOTE PAYABLE TO AXEL JOHNSON In August 1996, the Company declared a dividend of $25,000,000, evidenced by a note payable to Axel Johnson, bearing interest at a rate of 7.5% per annum. The principal was paid out of the proceeds of the Company's initial public offering on December 24, 1996. EMPLOYEE BENEFIT PROGRAMS The Company participates in various employee benefit programs which are sponsored by Axel Johnson. These programs include medical, dental and life insurance and workers' compensation. In general the Company reimburses Axel Johnson for its proportionate cost of these programs based on historical experience and relative headcount. The costs reimbursed to Axel Johnson include costs for reported claims, as well as incurred but not reported claims. The Company recorded expense related to the reimbursement of these costs of approximately $512,000, $534,000 and $652,000 in 1996, 1995 and 1994, respectively. The costs are charged to cost of revenues, research and development expenses and selling, general and administrative expenses based on the relative aggregate compensation of the employees in each of these categories. The Company believes the allocation by Axel Johnson of the proportionate cost is reasonable but is not necessarily indicative of the costs that would have been incurred had the Company maintained its own benefit plans. 32 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3--RELATED PARTY TRANSACTIONS: (CONTINUED) ADMINISTRATIVE SERVICES Axel Johnson provides limited services to the Company, including certain treasury, accounting, tax, internal audit, legal and human resources functions. The costs of these functions have been allocated to the Company based on estimates of actual costs incurred. Management believes that such allocations are reasonable. Such charges and allocations are not necessarily indicative of the costs that would have been incurred if the Company had been a separate entity. The allocated costs of these services amounting to $527,000, $549,000 and $526,000 in 1996, 1995 and 1994, respectively, have been included in selling, general and administrative expenses in the consolidated statements of operations. In December 1996, the Company entered into a transitional administrative services agreement with Axel Johnson, pursuant to which Axel Johnson will continue to provide the services outlined above for an initial annual fee of $622,000. CREDIT AGREEMENT The Company and Axel Johnson entered into a credit agreement, pursuant to which Axel Johnson has agreed to provide a revolving credit/working capital facility (the "Credit Agreement") to the Company in an aggregate amount of $15,000,000. The Credit Agreement has a term of 24 months, and any loans thereunder bear interest during each calendar quarter at a rate per annum equal to the sum of the three month London Interbank Offered Rate (LIBOR), plus 2.0% initially on the date when the loan is made and adjusted thereafter on the first business day of each calendar quarter. Additionally, the Company is required to pay a commitment fee of 0.5% per annum on the unused portion of the Credit Agreement. The Company is required to maintain compliance with certain covenants under the Credit Agreement. As of December 31, 1996, $15,000,000 was available, and during 1996 no borrowings were made, under the Credit Agreement. LARVAN LEASE The Company leases its principal facilities from Larvan Properties ("Larvan"), a general partnership in which the Company owns a one third interest. The Company paid $278,000, $278,000 and $278,000 in rent expense to Larvan and earned partnership income of $36,000, $36,000 and $46,000 in 1996, 1995, and 1994, respectively. NOTE 4--CAPITAL STOCK: In October 1996, the Company's Board of Directors approved a plan to recapitalize the Company by authorizing (i) Class A Common Stock consisting of 100,000,000 shares, (ii) Class B Common Stock consisting of 11,900,000 shares and (iii) 5,000,000 shares of undesignated Preferred Stock. Additionally, the Company's existing Common Stock was reclassified as Class B Common Stock and a 1,190 to one stock split of the Class B Common Stock was effected. Such recapitalization was effected on December 11, 1996. These accompanying consolidated financial statements have been restated to reflect the recapitalization and the stock split in all periods presented. The rights, preferences and privileges of each class of Common Stock are identical except for voting rights. Each share of Class A Common Stock entitles its holder to one vote and each share of Class B Common Stock entitles its holder to four votes for each share of Class A Common Stock into which Class B Common Stock is convertible. The Class B Common Stock is convertible into Class A Common Stock on a share-for-share basis, subject to adjustment for dividends, stock splits, subdivisions or combinations. 33 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4--CAPITAL STOCK: (CONTINUED) The Board of Directors has the authority to issue up to 5,000,000 undesignated shares of Preferred Stock in one or more series and to fix the rights, preferences, privileges and restrictions thereof, including dividend rights, conversion rights, voting rights, terms of redemption, liquidation preferences, sinking fund terms and the number of shares constituting any series or the designation of such series, without any further vote or action by stockholders. In December 1996, the Company completed an initial public offering of 7,000,000 shares of Class A Common Stock at a price of $12 per share of which 5,800,000 were sold by the Company and 1,200,000 shares were sold by Axel Johnson. After deducting underwriting discount of $4,872,000 and issuance costs of $1,449,000, the Company received net proceeds of $63,279,000 in December 1996. Subsequent to December 31, 1996, the underwriters exercised their over-allotment option to sell additional shares and sold an additional 1,050,000 shares of which 350,000 were sold by the Company and 700,000 were sold by Axel Johnson. Net proceeds to the Company in January 1997 were $3,906,000 after deducting the underwriting discount of $294,000. NOTE 5--INCOME TAXES: The provision for income taxes consists of the following:
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (IN THOUSANDS) Current: Federal.................................................................. $ 3,481 $ 1,782 $ 764 State.................................................................... 885 435 135 --------- --------- --------- 4,366 2,217 899 --------- --------- --------- Deferred: Federal.................................................................. (731) (63) (149) State.................................................................... (198) (69) 23 --------- --------- --------- (929) (132) (126) --------- --------- --------- Provision for income taxes............................................... $ 3,437 $ 2,085 $ 773 --------- --------- --------- --------- --------- ---------
The following is a reconciliation of the U.S. federal income tax rate to the Company's effective income tax rate:
1996 1995 1994 ----- ----- ----------- Provision at statutory rate..................................................... 34% 34% 34% State income taxes, net of federal tax benefits............................... 5 5 7 Research and development credits.............................................. (1) (2) (11) Non deductible goodwill amortization.......................................... 2 7 22 Other......................................................................... 1 1 2 -- -- -- Effective rate.................................................................. 41% 45% 54% -- -- -- -- -- --
34 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5--INCOME TAXES: (CONTINUED) Deferred tax assets/liabilities are comprised of the following:
DECEMBER 31, -------------------- 1996 1995 --------- --------- (IN THOUSANDS) Deferred tax assets: Inventory................................................................ $ 838 $ 509 Accrued expenses......................................................... 1,047 579 Reserves................................................................. 257 310 Other.................................................................... 99 17 --------- --------- 2,241 1,415 --------- --------- Deferred tax liabilities: Depreciation and amortization............................................ 474 513 Other.................................................................... -- 64 --------- --------- 474 577 --------- --------- Net deferred tax asset..................................................... $ 1,767 $ 838 --------- --------- --------- ---------
NOTE 6--EMPLOYEE BENEFIT PLANS THRIFT PLAN The Company participates in the Axel Johnson Thrift Plan (the "Thrift Plan") qualified under Section 401(k) of the Internal Revenue Code. The Thrift Plan allows employees to defer up to 16% of their compensation not to exceed the amount allowed by the applicable Internal Revenue Service guidelines. The Company matches 60% of employee contributions made on a pre-tax basis and 30% of employee contributions made on a post-tax basis, subject to a maximum of 6% of total eligible employee compensation. Company contributions vest ratably over five years of service or two years of plan participation, whichever occurs first. Contributions by the Company under the Thrift Plan amounted to $379,000, $345,000 and $297,000 in 1996, 1995 and 1994, respectively. PENSION PLAN The Company's employees participate in a noncontributory defined benefit pension plan sponsored by Axel Johnson. Benefits under the plan are based on years of service and employees' compensation. The plan's assets are invested principally in equity and fixed income securities. It is Axel Johnson's policy to satisfy the minimum funding requirements of the Employee Retirement Income Security Act of 1974 (ERISA). 35 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6--EMPLOYEE BENEFIT PLANS (CONTINUED) Net periodic pension cost was determined by measuring the Projected Benefit Obligation ("PBO") for the Company's employees using a discount rate of 7.3%, 8.5% and 8.3%, and an assumed long term rate of compensation of 4.5%, 5.3% and 4.0% in 1996, 1995 and 1994, respectively. The PBO for such employees was determined using a discount rate of 7.5% and 7.3% at December 31, 1996 and 1995, respectively. The PBO so measured was $3,819,000 and $3,566,000 at December 31, 1996 and 1995, respectively. Certain elements of pension cost, including expected return on assets (which was 9.5% in 1996 and 9% in 1995 and 1994), and net amortization, were allocated based on the relationship of the PBO for the Company to the total PBO of the defined benefit pension plan. The elements of pension cost allocated to the Company using this method were:
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (IN THOUSANDS) Service cost........................................................ $ 556 $ 496 $ 504 Interest cost....................................................... 273 245 192 Net amortization.................................................... (2) (7) (3) Expected return on assets........................................... (261) (213) (173) --------- --------- --------- Net periodic pension cost....................................... $ 566 $ 521 $ 520 --------- --------- --------- --------- --------- ---------
The Company's employees also are eligible to participate in the Axel Johnson retirement restoration plan. This plan is for employees whose benefits under the defined benefit pension plans are reduced due to limitations under federal tax laws. The Company's pension expense for this plan, using the same methodology as described above, was $83,000, $32,000 and $33,000 in 1996, 1995 and 1994, respectively. The PBO at December 31, 1996 and 1995, was $370,000 and $150,000, respectively. EMPLOYEE STOCK PURCHASE PLAN Effective October 1996, the Company's Board of Directors adopted an Employee Stock Purchase Plan (the "Purchase Plan"), for which 310,000 shares of Class A Common Stock have been reserved for issuance. The Purchase Plan permits eligible employees to purchase Class A Common Stock through payroll deductions at 85% of the lower of the fair market value of the Class A Common Stock at the beginning or at the end of each offering period subject to various limitations. The Purchase Plan became effective upon the closing of the Offering however no shares were purchased during 1996. STOCK OPTION PLAN FOR NON-EMPLOYEE DIRECTORS In October 1996, the Company adopted a Stock Option Plan for Non-Employee Directors (the "Directors' Plan") and reserved a total of 205,000 shares of the Company's Class A Common Stock for issuance thereunder. The Directors' Plan provides for the grant of stock options pursuant to an automatic grant mechanism to members of the Board of Directors who are not employees of the Company or of Axel Johnson. Each non-employee director will receive an initial grant, upon first becoming a director (or, in the case of current non-employee directors, upon consummation of the Offering), to purchase a total of 18,000 shares of Class A Common Stock, and each year thereafter will receive an option to purchase a total of 6,000 shares of Class A Common Stock. Each option is granted at an exercise price equal to fair market value on date of grant. Each initial grant vests in three equal annual occurrences, and each annual grant vests in full on the three years following the date of grant. Options expire one year after termination of Board Service or ten years after the date of grant. The Directors Plan became effective upon the closing of 36 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6--EMPLOYEE BENEFIT PLANS (CONTINUED) the Offering in December 1996. As of December 31, 1996, no options were exercisable and the weighted average remaining contractual life of outstanding options was ten years. The following table summarizes activity under the plan:
RANGE OF PRICE WEIGHTED AVERAGE PER SHARE PRICE PER SHARE SHARES --------------- ----------------- ------------------- (IN THOUSANDS) Options outstanding as of December 31, 1995..................................... N o t a p p l i c a b 1 e Options granted............................ 54 $12.00-$12.00 $ 12.00 Options cancelled or expired............... -- -- -- Options exercised.......................... -- -- -- -- --------------- ------ Options outstanding as of December 31, 1996..................................... 54 $12.00-$12.00 $ 12.00 -- --
STOCK INCENTIVE PLAN In October 1996, the Company's Board of Directors approved a Stock Incentive Plan (the "Incentive Plan") for which 2,485,000 shares of Class A Common Stock have been reserved for issuance thereunder. The Incentive Plan, which became effective upon the closing of the Offering, provides for the grant of incentive stock options, non-qualified stock options, stock appreciation rights and stock bonus awards to employees or eligible consultants. The Incentive Plan is administered by the Compensation Committee of the Board of Directors (the "Administrator"). With respect to any participant who owns stock possessing more than ten percent of the voting power of all classes of the Company's outstanding capital stock (a 10% stockholder), the exercise price of any incentive stock option granted must equal 110% of the fair market value on the grant date. The exercise price of incentive stock options for all other employees shall be no less than 100% of the fair market value per share on the date of the grant. The maximum term of an option granted under the Incentive Plan may not exceed ten years from the date of grant (five years in the case of an incentive stock option granted to a 10% stockholder). Options generally vest over a five year period from the date of grant. As of December 31, 1996, no options were exercisable and the weighted average remaining contractual life of outstanding options was ten years. The following table summarizes activity under the plan:
RANGE OF PRICE WEIGHTED AVERAGE PER SHARE PRICE PER SHARE SHARES --------------- ----------------- --------------- (IN THOUSANDS) Options outstanding as of December 31, 1995..................................... N o t a p p l i c a b 1 e Options granted............................ 1,292 $12.00-$12.00 $ 12.00 Options cancelled or expired............... -- -- -- Options exercised.......................... -- -- -- ----- --------------- ------ Options outstanding as of December 31, 1996..................................... 1,292 $12.00-$12.00 $ 12.00 ----- -----
FAIR VALUE OF STOCK OPTIONS The weighted average fair value of options granted during 1996 under the Company's two stock options plans was $5.15 per option. In determining the fair value of options granted during 1996 the 37 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6--EMPLOYEE BENEFIT PLANS (CONTINUED) Company used the Black-Scholes option pricing model and assumed a weighted average of the following: a risk free interest rate of 6.0 %, an average expected option life of 4.04 years, an expected volatility of 47% and a zero dividend yield. The fair value of options with graded vesting was calculated using different estimated lives for each group of options depending on the length of the vesting period for that group. The difference between as reported and pro forma net income and earnings per share was not material because options were granted late in December 1996. In future years, the difference between as reported and pro forma net income and earnings per share is expected to be material and such disclosures will be made. NOTE 7--LEASES: The Company leases its primary facilities from a related party under a lease which expires in January 1998. (See Note 3.) Total rent expense in 1996, 1995 and 1994, was $552,000, $515,000, and $585,000, respectively. Future annual minimum lease payments under all noncancelable operating leases as of December 31, 1996, are as follows:
AMOUNT ------------- (IN THOUSANDS) Years ending December 31, 1997......................................................................... $ 465 1998......................................................................... 183 1999......................................................................... 155 2000......................................................................... 140 2001 and thereafter.......................................................... 60 ------ $ 1,003 ------ ------
NOTE 8--COMMITMENTS AND CONTINGENCIES: There are potential unasserted claims against the Company relating to pricing deficiencies under two product supply contracts subject to General Services Administration ("GSA") regulations. Management has completed an assessment of its performance under the GSA contracts, assessed its potential liability with the assistance of the Company's outside experts and legal counsel, and voluntarily disclosed the identified pricing deficiencies to the GSA contracting officer responsible for the Company's contracts. Although the ultimate resolution of this matter potentially could involve purchase price rebates and associated legal, audit and other costs of up to an aggregate of approximately $1,300,000 or more, management believes, after consultation with its outside experts and legal counsel, that the Company's exposure for this matter is not likely to exceed $800,000, which includes estimated purchase price rebates and associated legal, audit and other costs, and the Company has established a reserve for this amount less an initial payment of $268,000 made in December 1996. In management's opinion, the ultimate resolution of this matter will not have a material adverse effect on the Company's financial position or results of operations. In its distribution agreements, the Company typically agrees to indemnify its customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. 38 LARSCOM INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9--SUBSEQUENT EVENTS: On March 20, 1997, the Company entered into an operating lease under which the Company agreed to pay approximately $155,000 per month for 119,000 square feet of space located close to the Company's current facilities in Santa Clara, California. The lease commences in August 1997 and lasts for seven years. The Company has an option to extend the lease for a period of five years subject to certain conditions. These facilities are intended to replace the Company's current facilities. NOTE 10--UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA:
QUARTERS ENDED -------------------------------------------- MARCH 31, JUNE 30, SEPT. 30, DEC. 31, 1996 1996 1996 1996 ----------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Sales................................................................ $ 11,848 $ 18,776 $ 18,357 $ 17,463 Gross profit......................................................... $ 6,422 $ 10,442 $ 10,156 $ 9,475 Net income........................................................... $ 357 $ 2,190 $ 1,554 $ 829 Supplemental net income per share(1)................................. $ 0.03 $ 0.15 $ 0.12 $ 0.07
QUARTERS ENDED -------------------------------------------- MARCH 31, JUNE 30, SEPT. 30, DEC. 31, 1995 1995 1995 1995 ----------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Sales................................................................ $ 10,458 $ 12,740 $ 13,456 $ 12,009 Gross profit......................................................... $ 6,250 $ 7,297 $ 7,595 $ 6,374 Net income........................................................... $ 394 $ 785 $ 921 $ 429 Supplemental net income per share(1)................................. $ 0.03 $ 0.06 $ 0.06 $ 0.03
- ------------------------ (1) See Note 1 of Notes to the Consolidated Financial Statements for an explanation of the determination of net income and of shares used to compute supplemental net income per share. 39 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no disagreements with accountants on accounting and financial disclosure. 40 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the Company's Proxy Statement. 41 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) The following documents are filed as a part of this Report: 1. Financial statements--See Item 8 of this report 2. Exhibits
EXHIBIT NUMBER - --------- 3.1 (1) Certificate of Incorporation of the Registrant 3.2 (1) Amended and Restated Certificate of Incorporation of the Registrant as filed in the State of Delaware on December 11, 1996 3.3 (1) By-laws of the Registrant 3.4 (1) Form of Amended By-laws of the Registrant 10.1 (1) Form of Larscom Incorporated Stock Option Plan For Non-Employee Directors 10.2 (1) Form of Larscom Incorporated Stock Incentive Plan 10.3 (1) Form of Larscom Incorporated Stock Purchase Plan 10.4 (1) Lease Agreement between Larvan Properties and the Company 10.5 (1) Partnership Agreement among Vanderson Construction, Donn H. Byrne, John D. Brady, Thomas J. Cunningham, Jr. and the Company 10.6 (1) Form of Services Agreement between Axel Johnson and the Company 10.7 (1) Form of Credit Agreement between Axel Johnson and the Company 10.8 (1) Form of Tax Sharing Agreement between Axel Johnson and the Company 10.9 (1) Note between Axel Johnson and the Company dated August 23, 1996 10.10 (1) Form of Registration Rights Agreement between Axel Johnson and the Company 10.11 (2) Lease Agreement between Berg & Berg Enterprises Inc. and the Company 11.1 (2) Statement re-computation of per share earnings 21.1 (2) Subsidiaries of the Registrant 23.1 (2) Consent of Independent Accountants 24 (2) Power of Attorney 27 (2) Financial Data Schedule
- ------------------------ (1) Incorporated by reference to identically numbered Exhibit to the Company's Registration Statement on Form S-1 (Commission File No. 333-14001), which became effective on December 18, 1996. (2) Filed herewith b) Reports of Form 8-K No reports on Form 8-K were filed during the fourth quarter ended December 31, 1996. c) Exhibits See Item 14(a) 2 above. d) Exhibits 42 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Larscom Incorporated /s/ DEBORAH M. SOON ------------------------------------------ (Deborah M. Soon, President and Chief By Executive Officer 43 EX-10.11 2 EX-10.11 EXHIBIT 10.11 LEASE AGREEMENT BETWEEN BERG & BERG ENTERPRISES INC. AND THE COMPANY STANDARD FORM LEASE PARTIES: This Lease, executed in duplicate at Cupertino, California, on March 20, 1997, by and between Berg & Berg Enterprises, Inc., a California Corporation, and Larscom Incorporated, a Delaware Corporation, hereinafter called respectively Lessor and Lessee, without regard to number or gender. USE: WITNESSETH: That Lessor hereby leases to Lessee, and Lessee hires from Lessor, for the purpose of conducting therein office, research and development, light manufacturing, and warehouse activities, and any other legal activity; and for no other purpose without obtaining the prior written consent of Lessor. PREMISES: The real property with appurtenances as shown on Exhibit A (the "Premises") situated in the City of Milpitas, County of Santa Clara, State of California, and more particularly described as follows: The Premises includes 118,708 square feet of building, including all improvements thereto, including the right to use up to 415 unreserved parking spaces. The address for the Premises is 1795 McCandless Drive, Milpitas, California. Lessee's pro-rata share of the Premises is 100%. Lessee's pro-rata share of the Project is 16.82%. TERM: The term shall be for eighty-four (84) months unless extended pursuant to Section 35 of this Lease (the "Lease Term"), commencing on the Commencement Date as defined in Section 1 and ending eighty-four (84) months thereafter. RENT: Base rent shall be payable in monthly installments as follows:
BASE RENT ESTIMATED CAC* TOTAL ---------- --------------- ----------- Months 1 through 12................................ $ 136,514 27,896* $ 164,410
Monthly base rent to increase by 4% on the annual anniversary of the Commencement Date each year during the Lease Term over the prior year's rent. - ------------------------ * CAC charges to be adjusted per Common Area Charges Section below. Base rent as scheduled above shall be payable in advance on or before the first day of each calendar month during the Lease Term. The term "Rent," as used herein, shall be deemed to be and to mean the base monthly rent and all other sums required to be paid by Lessee pursuant to the terms of this Lease. Rent shall be paid in lawful money of the United States of America, without offset or deduction, and shall be paid to Lessor at such place or places as may be designated from time to time by Lessor. Rent for any period less than a calendar month shall be a pro rata portion of the monthly installment. Upon execution of this Lease, Lessee shall deposit with Lessor the first month's rent. SECURITY DEPOSIT: Lessee shall deposit with Lessor the sum of One Hundred Thirty Six Thousand Five Hundred Fourteen Dollars ($136,514) (the "Security Deposit"). The Security Deposit shall be held by Lessor as security for the faithful performance by Lessee of all of the terms, covenants, and conditions of this Lease applicable to Lessee. If Lessee commits a default as provided for herein, including but not limited to a default with respect to the provisions contained herein relating to the condition of the Premises, Lessor may (but shall not be required to) use, apply or retain all or any part of the Security Deposit for the payment of any amount which Lessor may spend by reason of default by Lessee. If any portion of the Security Deposit is so used or applied, Lessee shall, within ten days after written demand therefor, deposit cash with Lessor in an amount sufficient to restore the Security Deposit to its original amount. Lessee's failure to do so shall be a default by Lessee. Any attempt by Lessee to transfer or encumber its interest in the Security Deposit shall be null and void. Upon execution of this Lease, Lessee shall deposit with Lessor the Security Deposit. Security Deposit to be returned within twenty (20) days of Lessee meeting all termination obligations under Lease. COMMON AREA CHARGES: Lessee shall pay to Lessor, as additional Rent, an amount equal to Lessee's total common area charges of the Premises and a pro-rata share of the Project costs as defined below (the 44 common area charges for the Premises and Project are referred to herein as ("CAC")). Lessee shall pay to Lessor as Rent, on or before the first day of each calendar month during the Lease Term, subject to adjustment and reconciliation as provided hereinbelow, the sum of Twenty Seven Thousand Eight Hundred Ninety Six Dollars ($27,896), said sum representing Lessee's estimated monthly payment of Lessee's percentage share of CAC. It is understood and agreed that Lessee's obligation under this paragraph shall be prorated to reflect the Commencement Date and the end of the Lease Term. Upon occupancy, Lessee shall pay Lessor first months estimated CAC. Lessee's estimated monthly payment of CAC payable by Lessee during the calendar year in which the Lease commences is set forth above. At or prior to the commencement of each succeeding calendar year term (or as soon as practical thereafter), Lessor shall provide Lessee with Lessee's estimated monthly payment for CAC which Lessee shall pay to Lessor as Rent. Within 120 days of the end of the calendar year and the end of the Lease Term, Lessor shall provide Lessee a statement of actual CAC incurred including capital reserves for the preceding year or other applicable period in the case of a termination year. If such statement shows that Lessee has paid less than its actual percentage, then Lessee shall on demand pay to Lessor the amount of such deficiency. If such statement shows that Lessee has paid more than its actual percentage, then Lessor shall, at its option, promptly refund such excess to Lessee or credit the amount thereof to the Rent next becoming due from Lessee. Lessor reserves the right to revise any estimate of CAC if the actual or projected CAC show an increase or decrease in excess of 10% from an earlier estimate for the same period. In such event, Lessor shall provide a revised estimate to Lessee, together with an explanation of the reasons therefor, and Lessee shall revise its monthly payments accordingly. Lessor's and Lessee's obligation with respect to adjustments at the end of the Lease Term or earlier expiration of this Lease shall survive the Lease Term or earlier expiration. As used in this Lease, CAC shall include but is not limited to: (i) items as specified in Sections 5(b), 6, 16 and 31; (ii) all costs and expenses including but not limited to supplies, materials, equipment and tools used or required in connection with the operation and maintenance of the Premises and the Project; (iii) licenses, permits and inspection fees; (iv) all other costs incurred by Lessor in maintaining and operating the Premises and the Project; (v) all reserves for capital replacements and government regulations imposed on the Premises and/or the Project not related to Lessee's use and occupancy of the Premises; and (vi) an amount equal to five percent (5%) of the aggregate of all CAC, as compensation for Lessor's accounting and processing services. Lessee shall have the right to review the basis and computation analysis used to derive the CAC applicable to this Lease annually and if any variances in excess of ten percent (10%) are found, Lessor shall pay the reasonable cost of audit. The Project (the "Project") is shown on attached Exhibit A.1. CAC shall not include any cost related to: (a) hazardous or toxic materials unless some type of area-wide assessment is made by a government agency or commission; (b) structural defects or construction defects or non-compliance with codes existing as of the Commencement Date with respect to the Building Shell and, if all work on the Lessee Interior Improvements is performed by Lessor, then also with respect to the Lessee Interior Improvements; (c) leasing and marketing costs or costs incurred in enforcing or administering leases (except for above accounting); (d) casualty damage covered by insurance or costs for which Lessor obtains reimbursement from other sources; and (e) legal fees, brokerage commissions and advertising costs incurred in connection with the leasing of the Building; (f) repairs, alterations, additions, improvements or replacements made to correct any defect in the design, materials or workmanship of the Building; (g) executive salaries of Landlord; (h) payments of principal or interest on any mortgage or other encumbrance including ground lease payments and points, commissions and legal fees associated with financing; (i) depreciation; (j) charitable or political contributions; (k) costs incurred in advertising and promotional activities for the Building; (l) capital improvement costs to the extent that Lessee has paid to Lessor reserve amounts for such capital improvements. If Lessee's share of the cost of capital improvement exceeds $5,000, there are no reserves paid by Lessee to Lessor available for the capital improvement, and the capital improvement is not required due to Lessee's particular use of the Premises, such capital improvement cost shall be amortized over the estimated useful life of the improvement, not to exceed 10 years at Wells Fargo prime rate plus one percent (1%). Lessee shall pay to Lessor the amortized costs of such improvement on a monthly basis over the Lease Term. Notwithstanding the above exceptions to CAC, Lessee shall not be relieved of any of Lessee's obligations under this Lease. 45 LATE CHARGES: Lessee hereby acknowledges that a late payment made by Lessee to Lessor of Rent and other sums due hereunder will cause Lessor to incur costs not contemplated by this Lease, the exact amount of which will be extremely difficult to ascertain. Such costs include, but are not limited to, processing and accounting charges, and late charges, which may be imposed on Lessor according to the terms of any mortgage or trust deed covering the Premises. Accordingly, if any installment of Rent or any other sum due from Lessee is not received by Lessor or Lessor's designee within ten (10) days after such amount is due, Lessee shall pay to Lessor a late charge equal to five (5%) percent of such overdue amount. The parties hereby agree that such late charge represents a fair and reasonable estimate of the costs Lessor will incur by reason of late payments made by Lessee. Acceptance of such late charges by Lessor shall in no event constitute a waiver of Lessee's default with respect to such overdue amount, nor shall it prevent Lessor from exercising any of the other rights and remedies granted hereunder. QUIET ENJOYMENT: Lessor covenants and agrees with Lessee that upon Lessee paying Rent and performing its covenants and conditions under this Lease, Lessee shall and may peaceably and quietly have, hold and enjoy the Premises for the Lease Term, subject, however, to the rights reserved by Lessor hereunder. IT IS FURTHER MUTUALLY AGREED BETWEEN THE PARTIES AS FOLLOWS: 1. POSSESSION: Possession shall be deemed tendered and the term shall commence upon the first to occur on or after August 1, 1997 of the following (the "Commencement Date"): (i) the Premises are Substantially Complete or (ii) Lessee occupies the Premises and commences to conduct business operations or (iii) if Lessor is prevented from or delayed in completing its work under this Lease due to Lessee Delays, such work will be deemed Substantially Complete as of the date on which it would have been Substantially Complete had it not been for such Lessee Delays or (iv) the Premises are available for occupancy by Lessee and the Premises meet all requirements for occupancy. It is the intention of Lessee and Lessor that August 1, 1997 shall be the Commencement Date. "SUBSTANTIALLY COMPLETE" shall mean that: (i) Lessor has tendered possession of Premises to Lessee, (ii) Lessor has met all legal requirements for occupancy, (iii) The Lessee Interior Improvements are materially complete per the approved plans, exclusive of telephone or other communication systems, punchlist items and there remains no incomplete or defective items of work which would materially adversely affect Lessee's intended use of the Premises, and (iv) said interior of the building is in a "broom clean" condition. 1.1 COMMENCEMENT DATE MEMORANDUM: When the actual Commencement Date is determined, the parties shall execute a Commencement Date Memorandum setting forth the Commencement Date, the expiration date of the Lease Term and the actual square footage of the Premises and any required adjustments to base rent and CAC, but failure to do so shall not affect the continuing validity and enforceability of this Lease, which shall remain in full force and effect. 2. BUILDING SHELL AND LESSEE'S IMPROVEMENTS: The "Building Shell", as defined in the attached Exhibit B shall be constructed at Lessor's sole cost and expense by independent contractors to be employed by and under the supervision of Lessor in accordance with the site plan and elevations to be prepared by Lessor. The "Lessee Interior Improvements" shall be defined as all items not part of the Building Shell and shall be constructed by independent contractors to be employed by and under the supervision of Lessor, in accordance with complete plans and specifications prepared by Lessor for submission to the City of Milpitas ("Lessee Improvement Plans"), complete with all mechanical and electrical design, approved by Lessee, and then to be attached hereto as Exhibit D. Lessee and its designated representatives, shall at all times during the construction of the Building Shell and the Lessee Interior Improvements have access to the Premises to monitor the progress of construction and Lessor's compliance with its obligation hereunder; provided however, that such access shall not unreasonably interfere with the activities of Lessor or its contractors. If Lessor notifies Lessee that any fittings, finishes or other materials included in the 46 specifications for the Lessee Interior Improvements cannot be obtained within forty-five (45) days after placing an order therefor, Lessee shall be responsible for selecting alternative fittings, finishes or other materials which can be obtained within forty-five (45) day period, or, if Lessee does not specify any alternative, Lessee shall be responsible for any delay beyond said forty-five (45) day period including Rent for each day of delay. Lessor shall be responsible for ensuring that the Building Shell and Lessee Interior Improvements conform to the approved plans and all applicable statutes, rules, regulations, ordinances, and Milpitas Building Department interpretations necessary for occupancy. The building will have two separate electrical meters. For any contract to be entered into between Lessor and any contractor furnishing labor or materials in connection with the construction of the Lessee Interior Improvements where the payment due under such contract is estimated by Lessor to be in excess of One Hundred Thousand Dollars $100,000, Lessor shall request bids from at least three (3) qualified contractors selected by Lessor for bidding. Lessor will accept the lowest bid. Lessee shall have the opportunity to review the qualified bidders list and may select a bidder of their choice for any bid provided the bidder meets Lessor's reasonable requirements. Lessor shall be responsible for and shall pay the cost of the Lessee Interior Improvements up to the amount of Two Million Three Hundred Seventy Four Thousand One Hundred Sixty Dollars ($2,374,160) (the "TI Allowance"), being Twenty Dollars ($20.00) per square foot times 118,708 square feet. In the event the cost of the Lessee Interior Improvements is more than the TI Allowance, the monthly base rent under the Lease shall be increased by $16.86 per month for every $1,000 dollars the costs exceed the TI Allowance up to a maximum of $900,000. Costs in excess of the TI Allowance and $900,000 overage, if any, will not be incurred without advance approval of Lessee. Any approved cost over the TI Allowance and $900,000 overage shall be paid for by Lessee in cash within fifteen (15) days after Lessor has provided Lessee with evidence that the work approved is complete. Lessor shall be entitled to a construction management fee covering its overhead and profit on the TI Allowance and $900,000 overage of six percent (6%). All costs for Lessee Interior Improvements shall be documented and subject to verification by Lessee. Lessee may have its subcontractors install security, data and telephone during TI construction provided such subcontractors do not interfere with the work of Lessor. Lessor shall use its best efforts to cause the Commencement Date of the initial term to occur not later than August 1, 1997. If the Commencement Date has not occurred by August 31, 1997, Lessee shall receive one day of base rent abatement for each day after August 31, 1997 until the Commencement Date. Lessor and Lessee agree that having a Commencement Date after August 31, 1997 will cause Lessee and Lessor to incur costs not contemplated by this Lease, the exact amount of which will be extremely difficult to ascertain. Accordingly, the parties hereby agree that Lessee's right to the abatement of base rent specified herein represents a fair and reasonable settlement for both parties and neither party shall have further liability to the other for any damages. If the Commencement Date has not occurred by September 30, 1997, Lessee may at its sole option, by written notice to Lessor, have the right to terminate this Lease at any time after September 30, 1997 until the Commencement Date. Notwithstanding anything to the contrary herein, all dates stated herein shall be extended for the number of days Lessor is unable to Substantially Complete the Premises as a result of delays (i) due to governmental actions (other than governmental action of refusing to approve work which fails to comply with the law or the building permit) which occurs after receipt of normal building permits, (ii) due to acts of God, (iii) due to circumstances beyond Lessor's control, (iv) resulting from the City of Milpitas failing to issue a building permit within thirty (30) days after plan submittal by Lessor, and (v) due to Lessee Delays. "Lessee Delays" means a delay in Substantial Completion resulting from (a) Lessee's failure to meet Lessee's deadlines for approval as shown on Exhibit E, (b) delays due to change orders, (c) delays due to Lessee's failure to meet the deadlines for approving any plans or change orders, and (d) delays because of the inability to obtain any product, materials, design, color, fitting, or finish pursuant to this Section 2. Lessee shall have a maximum of 5 business days to approve or disapprove any preliminary plans and 3 business days to approve or 47 disapprove change orders and a maximum of 10 business days to approve or disapprove any final plans. If Lessee does not disapprove any plans or change orders within the time period set forth herein in writing, Lessor may proceed on the basis that the plans or change orders are approved by Lessee. If plans or change orders are disapproved, Lessee shall state the reason for disapproval and Lessor and Lessee shall act in good faith to resolve any issues. Lessor shall charge Lessee $250 per change order after the tenth (10th) change order for processing. 3. USES PROHIBITED: Lessee shall not commit, or suffer to be committed, any waste upon the Premises, or any nuisance, or other act or thing which may disturb the quiet enjoyment of any other tenant in or around the buildings in which the subject Premises are located or allow any sale by auction upon the Premises, or allow the Premises to be used for any improper, immoral, unlawful or objectionable purpose, or place any loads upon the floor, walls, or ceiling which may endanger the structure, or use any machinery or apparatus which will in any manner vibrate or shake the Premises or the building of which it is a part, or place any harmful liquids in the drainage system of the building. No waste materials or refuse shall be dumped upon or permitted to remain upon any part of the Premises outside of the building proper. No materials, supplies, equipment, finished products or semi-finished products, raw materials or articles of any nature shall be stored upon or permitted to remain on any portion of the Premises outside of the building structure, unless approved by the local, state federal or other applicable governing authority. Lessor consents to Lessee's use of materials which are incidental to the normal, day-to-day operations of any office user, such as copier fluids, cleaning materials, etc., but this does not relieve Lessee of any of its obligations not to contaminate the Premises and related real property or violate any Hazardous Materials Laws. 4. ALTERATIONS AND ADDITIONS: Lessee shall not make, or suffer to be made, any alteration or addition to said Premises, or any part thereof, without the express, advance written consent of Lessor; any addition or alteration to said Premises, except movable furniture and trade fixtures, shall become at once a part of the realty and belong to Lessor at the end of the Lease Term or earlier termination of this Lease. Alterations and additions which are not deemed as trade fixtures shall include HVAC systems, lighting systems, electrical systems, partitioning, carpeting, or any other installation which has become an integral part of the Premises. Lessee agrees that it will not proceed to make such alterations or additions until all required government permits have been obtained and after having obtained consent from Lessor to do so, until five (5) days from the receipt of such consent, so that Lessor may post appropriate notices to avoid any liability to contractors or material suppliers for payment for Lessee's improvements. Lessee shall at all times permit such notices to be posted and to remain posted until the completion of work. At the end of the Lease Term or earlier termination of this Lease, Lessee shall remove and shall be required to remove its special tenant improvements, all related equipment, and any additions or alterations installed by Lessee at or during the Lease Term and Lessee shall return the Premises to the condition that existed before the installation of the tenant improvements. Notwithstanding the above, Lessor agrees to allow any reasonable alterations and improvements and will use its best efforts to notify Lessee at the time of approval if such improvements or alterations are to be removed at the end of the Lease Term or earlier termination of this Lease. Lessee may make any non-structural alteration up to $25,000 without the approval of Lessor subject to the obligation to remove such alteration if required by Lessor. 5. MAINTENANCE OF PREMISES: (a) Lessee shall at its sole cost and expense keep, repair, and maintain the interior of the Premises, including, but not limited to, all lighting systems, temperature control systems, and plumbing systems in Good Condition and Repair, including any required replacements. Lessee shall maintain all wall surfaces and floor coverings in Good Condition and Repair, free of holes, gouges, or defacements and provide interior and exterior window washing as needed. (b) Lessor shall, at Lessee's expense, keep, repair, and maintain in Good Condition and Repair including replacements (based on a pro-rata share of (i) costs based on square footage or (ii) costs directly related to Lessee's use of the Premises) the following, which shall be included in the monthly CAC: 48 1. The exterior of the building, any appurtenances and every part thereof, including but not limited to, glazing, sidewalks, parking areas, electrical systems, HVAC systems, roof membrane, and painting of exterior walls. 2. The HVAC by a service contract with a licensed air conditioning and heating contractor which contract shall provide for a minimum of quarterly maintenance of all air conditioning and heating equipment at the Premises including HVAC repairs or replacements which are either excluded from such service contract or any existing equipment warranties. 3. The landscaping by a landscape contractor to water, maintain, trim and replace, when necessary, any shrubbery and landscaping at the Premises. 4. The roof membrane by a service contract with a licensed reputable roofing contractor which contract shall provide for a minimum of semi-annual maintenance, cleaning of storm gutters, drains, removing of debris, and trimming overhanging trees, repair of the roof and application of a finish coat every five years to the building at the Premises. 5. Exterior pest control. 6. Fire monitoring services. Payment of CAC relieves Lessee of any obligations for replacement of the roof membrane, HVAC units, parking lot and exterior painting. CAC reserves for replacements of the above four items are fixed for the entire Lease Term. (c) Lessee hereby waives any and all rights to make repairs at the expense of Lessor as provided in Section 1942 of the Civil Code of the State of California, and all rights provided for by Section 1941 of said Civil Code. (d) Lessor shall be responsible for the repair of any structural defects in the Premises including the roof structure (not membrane), exterior walls and foundation during the Lease Term. 6. INSURANCE: A) HAZARD INSURANCE: Lessee shall not use, or permit said Premises, or any part thereof, to be used, for any purpose other than that for which the Premises are hereby leased; and no use shall be made or permitted to be made of the Premises, nor acts done, which may cause a cancellation of any insurance policy covering the Premises, or any part thereof, nor shall Lessee sell or permit to be kept, used or sold, in or about said Premises, any article which may be prohibited by a fire, flood and extended coverage insurance policy. Lessee shall comply with any reasonable requirements, pertaining to said Premises, of any insurance organization or company, necessary for the maintenance of reasonable fire and extended coverage insurance, covering the Premises. Lessor shall, at Lessee's sole cost and expense, purchase and keep in force fire and extended coverage insurance, covering loss or damage to the Premises in an amount equal to the full replacement cost of the Premises, as determined by Lessor, with proceeds payable to Lessor. In the event of a loss per the insurance provisions of this paragraph, Lessee shall be responsible for deductibles up to a maximum of $5,000 per occurrence. Lessee acknowledges that the insurance referenced in this paragraph does not include coverage for Lessee's personal property. B) LOSS OF RENTS INSURANCE: Lessor shall, at Lessee's sole cost and expense, purchase and maintain in full force and effect, a policy of rental loss insurance, in an amount equal to the amount of Rent payable by Lessee commencing on the date of loss for the next ensuing one (1) year, as reasonably determined by Lessor with proceeds payable to Lessor ("Loss of Rents Insurance"). C) LIABILITY AND PROPERTY DAMAGE INSURANCE: Lessee, as a material part of the consideration to be rendered to Lessor, hereby waives all claims against Lessor and Lessor's Agents for damages to goods, wares and merchandise, and all other personal property in, upon, or about the Premises, and for injuries to persons in, upon, or about the Premises, from any cause arising at any time, and Lessee 49 will hold Lessor and Lessor's Agents exempt and harmless from any damage or injury to any person, or to the goods, wares, and merchandise and all other personal property of any person, arising from the use or occupancy of the Premises by Lessee, or from the failure of Lessee to keep the Premises in Good Condition and Repair, as herein provided. Lessee shall, at Lessee's sole cost and expense, purchase and keep in force a standard policy of commercial general liability insurance and property damage policy covering the Premises and all related areas insuring the Lessee having a combined single limit for both bodily injury, death and property damage in an amount not less than five million dollars ($5,000,000.00). The limits of said insurance shall not, however, limit the liability of Lessee hereunder. Lessee shall, at its sole cost and expense, comply with all of the insurance requirements of all local, municipal, state and federal authorities now in force, or which may hereafter be in force, pertaining to Lessee's use and occupancy of the said Premises. D) PERSONAL PROPERTY INSURANCE: Lessee shall obtain, at Lessee's sole cost and expense, a policy of fire and extended coverage insurance including coverage for direct physical loss special form, and a sprinkler leakage endorsement insuring the personal property of Lessee. The proceeds from any personal property damage policy shall be payable to Lessee. All insurance policies required in 6 C) and 6 D) above shall: (i) provide for a certificate of insurance evidencing the insurance required herein, being deposited with Lessor ten (10) days prior to the Commencement Date, and upon each renewal, such certificates shall be provided 30 days prior to the expiration date of such coverage, (ii) be in a form reasonably satisfactory to Lessor and shall provide the coverage required by Lessee in this Lease, (iii) be carried with companies with a Best Rating of A minimum, (iv) specifically provide that such policies shall not be subject to cancellation, reduction of coverage, or other change except after 30 days prior written notice to Lessor, and (v) name Lessor, Lessor's lender, and any other party with an insurable interest in the Premises as additional insureds by endorsement to policy. Lessee agrees to pay to Lessor, as additional Rent, on demand, the full cost of the insurance polices referenced in 6 A) and 6 B) above as evidenced by insurance billings to Lessor which shall be included in the CAC. If Lessee does not occupy the entire Premises, the insurance premiums shall be allocated to the portion of the Premises occupied by Lessee on a pro-rata square footage or other equitable basis, as determined by Lessor. It is agreed that Lessee's obligation under this paragraph shall be prorated to the reflect the Commencement Date and the end of the Lease Term. Lessor and Lessee hereby waive any rights each may have against the other related to any loss or damage caused to Lessor or Lessee as the case may be, or to the Premises or its contents, and which may arise from any risk generally covered by fire and extended coverage insurance. The parties shall provide that their respective insurance policies insuring the property or the personal property include a waiver of any right of subrogation which said insurance company may have against Lessor or Lessee, as the case may be. Lessee may provide coverages in subparagraphs A and B above at anytime with thirty (30) days written notice to Lessor and CAC will be reduced accordingly. 7. ABANDONMENT: Lessee shall not vacate or abandon the Premises at any time during the Lease Term; and if Lessee shall abandon, vacate or surrender said Premises, or be dispossessed by process of law, or otherwise, any personal property belonging to Lessee and left on the Premises shall be deemed to be abandoned, at the option of Lessor. Notwithstanding the above, the Premises shall not be considered vacated or abandoned if Lessee maintains the Premises in Good Condition and Repair, provides security and is not in default. 8. FREE FROM LIENS: Lessee shall keep the subject Premises and the property in which the subject Premises are situated, free from any and all liens including but not limited to liens arising out of any work performed, materials furnished, or obligations incurred by Lessee. However, the Lessor shall allow Lessee to contest a lien claim, so long as the claim is discharged prior to any foreclosure proceeding being initiated against the property and provided Lessee provides Lessor a bond if the lien exceeds $5,000. 50 9. COMPLIANCE WITH GOVERNMENTAL REGULATIONS: Lessor represents and warrants that, as of the Commencement Date, the Building Shell and Lessee Interior Improvements shall be in compliance with all applicable laws. If such representation shall prove to be inaccurate, Lessor shall perform all work and pay all costs necessary to ensure the accuracy of such representation and warranty. Lessee shall, at its sole cost and expense, comply with all of the requirements of all local, municipal, state and federal authorities in force, or which may hereafter be in force, pertaining to the Premises, and shall faithfully observe in the use and occupancy of the Premises all local and municipal ordinances and state and federal statutes now in force or which may hereafter be in force. Except as stated above, Lessee shall not be required to pay for the construction of any single improvement required under this paragraph in excess of $5,000, unless such improvement is required to comply with Lessee's particular use of the Premises; or such improvement is required as a result ofLessee or Lessee's Agents voluntary modifications made by Lessee.voluntarily made be less Ifif such structural or capital improvements are not required due to Lessee's particular use of the Premises, or such improvement is not the result of voluntary modifications to the Premises by Lessee, and such improvement cost exceeds $5,000, such improvement cost shall be amortized over the estimated useful life of the improvement, not to exceed ten (10) years at Wells Fargo prime rate plus one percent (1%). Lessee shall pay to Lessor the amortized costs of such improvement on a monthly basis over the Lease Term. 10. INTENTIONALLY OMITTED. 11. ADVERTISEMENTS AND SIGNS: Lessee shall not place or permit to be placed, in, upon or about the Premises any unusual or extraordinary signs, or any signs not approved by the city, local, state, federal or other applicable governing authority. Lessee shall not place, or permit to be placed upon the Premises, any signs, advertisements or notices without the written consent of the Lessor, and such consent shall not be unreasonably withheld. A sign so placed on the Premises shall be so placed upon the understanding and agreement that Lessee will remove same at the end of the Lease Term or earlier termination of this Lease and repair any damage or injury to the Premises caused thereby, and if not so removed by Lessee, then Lessor may have the same removed at Lessee's expense. 12. UTILITIES: Lessee shall pay for all water, gas, heat, light, power, telephone and other utilities supplied to the Premises. Any charges for sewer usage, PG&E and telephone site service or related fees shall be the obligation of Lessee and paid for by Lessee. If any such services are not separately metered to Lessee, Lessee shall pay a reasonable proportion of all charges which are jointly metered, the determination to be made by Lessor acting reasonably and on any equitable basis. Lessor and Lessee agree that Lessor shall not be liable to Lessee for any disruption in any of the utility services to the Premises. 13. ATTORNEY'S FEES: In case suit should be brought for the possession of the Premises, for the recovery of any sum due hereunder, because of the breach of any other covenant herein, or to enforce, protect, or establish any term, conditions, or covenant of this Lease or the right of either party hereunder, the losing party shall pay to the Prevailing Party reasonable attorney's fees which shall be deemed to have accrued on the commencement of such action and shall be enforceable whether or not such action is prosecuted to judgment. The term "Prevailing Party" shall mean the party that received substantially the relief requested, whether by settlement, dismissal, summary judgment, judgment, or otherwise. 14.1 DEFAULT: The occurrence of any of the following shall constitute a default and breach of this Lease by Lessee: a) Any failure by Lessee to pay Rent or to make any other payment required to be made by Lessee hereunder when due if not cured within ten (10) days after written notice thereof by Lessor to Lessee; b) The abandonment or vacation of the Premises by Lessee except as provided in Section 7; c) A failure by Lessee to observe and perform any other provision of this Lease to be observed or performed by Lessee, where such failure continues for thirty days after written notice thereof by Lessor to Lessee; provided, however, that if the nature of such default is such that the same cannot be reasonably cured within such thirty (30) day period, Lessee shall not be deemed to be in default if Lessee shall, within such period, commence such cure and thereafter diligently prosecute the same to completion; d) The making by Lessee of any general assignment for the benefit of creditors; the filing by or against Lessee of a petition to have Lessee adjudged a bankrupt or of a petition for reorganization or arrangement under any law relating 51 to bankruptcy; e) the appointment of a trustee or receiver to take possession of substantially all of Lessee's assets or Lessee's interest in this Lease, or the attachment, execution or other judicial seizure of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease. 14.2 SURRENDER OF LEASE: In the event of any such default by Lessee, then in addition to any other remedies available to Lessor at law or in equity, Lessor shall have the immediate option to terminate this Lease before the end of the Lease Term and all rights of Lessee hereunder, by giving written notice of such intention to terminate. In the event that Lessor terminates this Lease due to a default of Lessee, then Lessor may recover from Lessee: a) the worth at the time of award of any unpaid Rent which had been earned at the time of such termination; plus b) the worth at the time of award of unpaid Rent which would have been earned after termination until the time of award exceeding the amount of such rental loss that the Lessee proves could have been reasonably avoided; plus c) the worth at the time of award of the amount by which the unpaid Rent for the balance of the Lease Term after the time of award exceeds the amount of such rental loss that the Lessee proves could have been reasonably avoided; plus d) any other amount necessary to compensate Lessor for all the detriment proximately caused by Lessee's failure to perform his obligations under this Lease or which in the ordinary course of things would be likely to result therefrom; and e) at Lessor's election, such other amounts in addition to or in lieu of the foregoing as may be permitted from time to time by applicable California law. As used in (a) and (b) above, the "worth at the time of award" is computed by allowing interest at the rate of Wells Fargo's prime rate plus two percent (2%) per annum. As used in (c) above, the "worth at the time of award" is computed by discounting such amount at the discount rate of the Federal Reserve Bank of San Francisco at the time of award plus one percent (1%). 14.3 RIGHT OF ENTRY AND REMOVAL: In the event of any such default by Lessee, Lessor shall also have the right, with or without terminating this Lease, to re-enter the Premises and remove all persons and property from the Premises; such property may be removed and stored in a public warehouse or elsewhere at the cost of and for the account of Lessee. 14.4 ABANDONMENT: In the event of the vacation or abandonment, except as provided in Section 7, of the Premises by Lessee or in the event that Lessor shall elect to re-enter as provided in paragraph 14.3 above or shall take possession of the Premises pursuant to legal proceeding or pursuant to any notice provided by law, and Lessor does not elect to terminate this Lease as provided in Section 14.2 above, then Lessor may from time to time, without terminating this Lease, either recover all Rent as it becomes due or relet the Premises or any part thereof for such term or terms and at such rental rates and upon such other terms and conditions as Lessor, in its sole discretion, may deem advisable with the right to make alterations and repairs to the Premises. In the event that Lessor elects to relet the Premises, then Rent received by Lessor from such reletting shall be applied; first, to the payment of any indebtedness other than Rent due hereunder from Lessee to Lessor; second, to the payment of any cost of such reletting; third, to the payment of the cost of any alterations and repairs to the Premises; fourth, to the payment of Rent due and unpaid hereunder; and the residue, if any, shall be held by Lessor and applied to the payment of future Rent as the same may become due and payable hereunder. Should that portion of such Rent received from such reletting during any month, which is applied by the payment of Rent hereunder according to the application procedure outlined above, be less than the Rent payable during that month by Lessee hereunder, then Lessee shall pay such deficiency to Lessor immediately upon demand therefor by Lessor. Such deficiency shall be calculated and paid monthly. Lessee shall also pay to Lessor, as soon as ascertained, any costs and expenses incurred by Lessor in such reletting or in making such alterations and repairs not covered by the rentals received from such reletting. 14.5 NO IMPLIED TERMINATION: No re-entry or taking possession of the Premises by Lessor pursuant to Section 14.3 or Section 14.4 of this Lease shall be construed as an election to terminate this Lease unless a written notice of such intention is given to Lessee or unless the termination thereof is decreed by a court of competent jurisdiction. Notwithstanding any reletting without termination by Lessor because of any default by Lessee, Lessor may at any time after such reletting elect to terminate this Lease for any such default. 52 15. SURRENDER OF LEASE: The voluntary or other surrender of this Lease by Lessee, or a mutual cancellation thereof, shall not work a merger, and shall, at the option of Lessor, terminate all or any existing subleases or sub tenancies, or may, at the option of Lessor, operate as an assignment to him of any or all such subleases or sub tenancies. 16. TAXES: Lessee shall pay and discharge punctually and when the same shall become due and payable without penalty, all real estate taxes, personal property taxes, taxes based on vehicles utilizing parking areas in the Premises, taxes computed or based on rental income (other than federal, state and municipal net income taxes), environmental surcharges, privilege taxes, excise taxes, business and occupation taxes, school fees or surcharges, gross receipts taxes, sales and/or use taxes, employee taxes, occupational license taxes, water and sewer taxes, assessments (including, but not limited to, assessments for public improvements or benefit), assessments for local improvement and maintenance districts, and all other governmental impositions and charges of every kind and nature whatsoever, regardless of whether now customary or within the contemplation of the parties hereto and regardless of whether resulting from increased rate and/or valuation, or whether extraordinary or ordinary, general or special, unforeseen or foreseen, or similar or dissimilar to any of the foregoing (all of the foregoing being hereinafter collectively called "Tax" or "Taxes") which, at any time during the Lease Term, shall be applicable or against the Premises, or shall become due and payable and a lien or charge upon the Premises under or by virtue of any present or future laws, statutes, ordinances, regulations, or other requirements of any governmental authority whatsoever. The term "Environmental Surcharge" shall include any and all expenses, taxes, charges or penalties imposed by the Federal Department of Energy, Federal Environmental Protection Agency, the Federal Clean Air Act, or any regulations promulgated thereunder, or any other local, state or federal governmental agency or entity now or hereafter vested with the power to impose taxes, assessments or other types of surcharges as a means of controlling or abating environmental pollution or the use of energy (i) generally imposed on similar properties in a wide geographic area without regard to whether the properties subject to the tax are contaminated by Hazardous Materials and which is a part of a comprehensive plan imposed by a governmental unit or (ii) imposed with respect to the Premises as the result of the presence of Hazardous Materials for which Lessee is required to indemnify Lessor under Section 33 below or to undertake remediation pursuant to Section 33.5 below. The term "Tax" shall include, without limitation, all taxes, assessments, levies, fees, impositions or charges levied, imposed, assessed, measured, or based in any manner whatsoever (i) in whole or in part on the Rent payable by Lessee under this Lease, (ii) upon or with respect to the use, possession, occupancy, leasing, operation or management of the Premises, (iii) upon this transaction or any document to which Lessee is a party creating or transferring an interest or an estate in the Premises, (iv) upon Lessee's business operations conducted at the Premises, (v) upon, measured by or reasonably attributable to the cost or value of Lessee's equipment, furniture, fixtures and other personal property located on the Premises or the cost or value of any leasehold improvements made in or to the Premises by or for Lessee, regardless of whether title to such improvements shall be in Lessor or Lessee, or (vi) in lieu of or equivalent to any Tax set forth in this Section 16. In the event any such Taxes are payable by Lessor and it shall not be lawful for Lessee to reimburse Lessor for such Taxes, then the Rent payable thereunder shall be increased to net Lessor the same net rent after imposition of any such Tax upon Lessor as would have been payable to Lessor prior to the imposition of any such Tax. It is the intention of the parties that Lessor shall be free from all such Taxes and all other governmental impositions and charges of every kind and nature whatsoever. However, nothing contained in this Section 16 shall require Lessee to pay any Federal or State income, franchise, estate, inheritance, succession, transfer or excess profits tax imposed upon Lessor. If any general or special assessment is levied and assessed against the Premises, Lessor agrees to use its best reasonable efforts to cause the assessment to become a lien on the Premises securing repayment of a bond sold to finance the improvements to which the assessment relates which is payable in installments of principal and interest over the maximum term allowed by law. It is understood and agreed that Lessee's obligation under this paragraph will be prorated to reflect the Commencement Date and the end of the Lease Term. It is further understood that if Taxes cover the Premises and Lessee does not occupy the entire Premises, the Taxes will be allocated to the portion of the Premises occupied by Lessee based on a pro-rata square footage or other 53 equitable basis, as determined by Lessor. Taxes billed by Lessor to Lessee shall be included in the monthly CAC. Subject to any limitations or restrictions imposed by any deeds of trust or mortgages now or hereafter covering or affecting the Premises, Lessee shall have the right to contest or review the amount or validity of any Tax by appropriate legal proceedings but which is not to be deemed or construed in any way as relieving, modifying or extending Lessee's covenant to pay such Tax at the time and in the manner as provided in this Section 16. However, as a condition of Lessee's right to contest, if such contested Tax is not paid before such contest and if the legal proceedings shall not operate to prevent or stay the collection of the Tax so contested, Lessee shall, before instituting any such proceeding, protect the Premises and the interest of Lessor and of the beneficiary of a deed of trust or the mortgagee of a mortgage affecting the Premises against any lien upon the Premises by a surety bond, issued by an insurance company acceptable to Lessor and in an amount equal to one and one-half (1 1/2) times the amount contested or, at Lessor's option, the amount of the contested Tax and the interest and penalties in connection therewith. Any contest as to the validity or amount of any Tax, whether before or after payment, shall be made by Lessee in Lessee's own name, or if required by law, in the name of Lessor or both Lessor and Lessee. Lessee shall defend, indemnify and hold harmless Lessor from and against any and all costs or expenses, including attorneys' fees, in connection with any such proceedings brought by Lessee, whether in its own name or not. Lessee shall be entitled to retain any refund of any such contested Tax and penalties or interest thereon which have been paid by Lessee. Nothing contained herein shall be construed as affecting or limiting Lessor's right to contest any Tax at Lessor's expense. 17. NOTICES: Unless otherwise provided for in this Lease, any and all written notices or other communication (the "Communication") to be given in connection with this Lease shall be given in writing and shall be given by personal delivery, facsimile transmission or by mailing by registered or certified mail with postage thereon or recognized overnight courier, fully prepaid, in a sealed envelope addressed to the intended recipient as follows: (a) to the Lessor 10050 Bandley Drive at: Cupertino, California 95014 Attention: Carl E. Berg Fax No: (408) 725-1626 (b) to the Lessee 1795 McCandless Drive at: Milpitas, California Attention: Fax No:
or such other addresses, facsimile number or individual as may be designated by a Communication given by a party to the other parties as aforesaid. Any Communication given by personal delivery shall be conclusively deemed to have been given and received on a date it is so delivered at such address provided that such date is a business day, otherwise on the first business day following its receipt, and if given by registered or certified mail, on the day on which delivery is made or refused or if given by recognized overnight courier, on the first business day following deposit with such overnight courier and if given by facsimile transmission, on the day on which it was transmitted provided such day is a business day, failing which, on the next business day thereafter. 18. ENTRY BY LESSOR: Lessee shall permit Lessor and its agents to enter into and upon said Premises at all reasonable times using the minimum amount of interference and inconvenience to Lessee and Lessee's business, subject to any security regulations of Lessee, for the purpose of inspecting the same or for the purpose of maintaining the building in which said Premises are situated, or for the purpose of making repairs, alterations or additions to any other portion of said building, including the erection and maintenance of such scaffolding, canopies, fences and props as may be required, without any rebate of Rent and without any liability to Lessee for any loss of occupation or quiet enjoyment of the Premises; and shall permit Lessor and his agents, at any time within ninety (90) days prior to the end of the Lease Term, to place upon said Premises any usual or ordinary "For Sale" or "For Lease" signs and exhibit the Premises to prospective tenants at reasonable hours. 54 19. DESTRUCTION OF PREMISES: In the event of a partial destruction of the said Premises during the Lease Term from any cause which is covered by Lessor's property insurance, Lessor shall forthwith repair the same, provided such repairs can be made within ninety (90) days after receipt of building permit under the laws and regulations of State, Federal, County, or Municipal authorities, but such partial destruction shall in no way annul or void this Lease, except that Lessee shall be entitled to a proportionate reduction of Rent while such repairs are being made to the extent of payments received by Lessor under its Loss of Rents Insurance coverage. With respect to any partial destruction which Lessor is obligated to repair or may elect to repair under the terms of this paragraph, the provision of Section 1932, Subdivision 2, and of Section 1933, Subdivision 4, of the Civil Code of the State of California are waived by Lessee. In the event that the building in which the subject Premises may be situated is destroyed to an extent greater than thirty-three and one-third percent (33 1/3%) of the replacement cost thereof, and the repairs will take more than ninety (90) days after permits to repair, Lessee or Lessor may terminate Lease. Lessor may, at its sole option, elect to terminate this Lease, whether the subject Premises is insured or not. A total destruction of the building in which the subject Premises are situated shall terminate this Lease. Notwithstanding the above, Lessor is only obligated to repair or rebuild to the extent of available insurance proceeds including any deductible amount. Should Lessor determine that insufficient or no insurance proceeds are available for repair or reconstruction of Premises, Lessor, at its sole option, may terminate the Lease. Lessee shall have the option of continuing this Lease by agreeing to pay all repair costs to the subject Premises. 20. ASSIGNMENT AND SUBLETTING: Lessee shall not assign this Lease, or any interest therein, and shall not sublet the said Premises or any part thereof, or any right or privilege appurtenant thereto, or cause any other person or entity (a bona fide subsidiary or affiliate of Lessee excepted) to occupy or use the Premises, or any portion thereof, without the advance written consent of Lessor if the proposed sublessee or assignee is a user or generator of Hazardous Materials. Any such assignment or subletting without such consent shall be void, and shall, at the option of the Lessor, terminate this Lease. This Lease shall not, or shall any interest therein, be assignable, as to the interest of Lessee, by operation of law, without the written consent of Lessor. Notwithstanding Lessor's obligation to provide reasonable approval, Lessor reserves the right to withhold its consent for any proposed sublessee or assignee of Lessee if the proposed sublessee or assignee is a user or generator of Hazardous Materials. Whether or not Lessor's consent to a sublease or assignment is required, in the event of any sublease or assignment, Lessee shall be and shall remain primarily liable for the performance of all conditions, covenants, and obligations of Lessee hereunder and, in the event of a default by an assignee or sublessee, Lessor may proceed directly against the original Lessee hereunder and/or any other predecessor of such assignee or sublessee without the necessity of exhausting remedies against said assignee or sublessee. 21. CONDEMNATION: If any part of the Premises shall be taken for any public or quasi-public use, under any statute or by right of eminent domain or private purchase in lieu thereof, and a part thereof remains which is susceptible of occupation hereunder, this Lease shall as to the part so taken, terminate as of the date title vests in the condemnor or purchaser, and the Rent payable hereunder shall be adjusted so that the Lessee shall be required to pay for the remainder of the Lease Term only that portion of Rent as the value of the part remaining. The rental adjustment resulting will be computed at the same Rental rate for the remaining part not taken; however, Lessor shall have the option to terminate this Lease as of the date when title to the part so taken vests in the condemnor or purchaser. If all of the Premises, or such part thereof be taken so that there does not remain a portion susceptible for occupation hereunder, this Lease shall thereupon terminate. If a part or all of the Premises be taken, all compensation awarded upon such taking shall be payable to the Lessor. Lessee may file a separate claim and be entitled to any award granted to Lessee. 22. EFFECTS OF CONVEYANCE: The term "Lessor" as used in this Lease, means only the owner for the time being of the land and building constituting the Premises, so that, in the event of any sale of said land or building, or in the event of a Lease of said building, Lessor shall be and hereby is entirely freed and relieved of all covenants and obligations of Lessor hereunder, and it shall be deemed and construed, without further agreement between the parties and the purchaser of any such sale, or the Lessor of the building, that the purchaser or lessor of the building has assumed and agreed to carry out any and all 55 covenants and obligations of the Lessor hereunder. If any security is given by Lessee to secure the faithful performance of all or any of the covenants of this Lease on the part of Lessee, Lessor may transfer and deliver the security, as such, to the purchaser at any such sale of the building, and thereupon the Lessor shall be discharged from any further liability. 23. SUBORDINATION: This Lease, in the event Lessor notifies Lessee in writing, shall be subordinate to any ground lease, deed of trust, or other hypothecation for security now or hereafter placed upon the real property at which the Premises are a part and to any and all advances made on the security thereof and to renewals, modifications, replacements and extensions thereof. Lessee agrees to promptly execute any documents which may be required to effectuate such subordination. Notwithstanding such subordination, if Lessee is not in default and so long as Lessee shall pay the Rent and observe and perform all of the provisions and covenants required under this Lease, Lessee's right to quiet possession of the Premises shall not be disturbed or effected by any subordination. 24. WAIVER: The waiver by Lessor of any breach of any term, covenant or condition, herein contained shall not be construed to be a waiver of such term, covenant or condition or any subsequent breach of the same or any other term, covenant or condition therein contained. The subsequent acceptance of Rent hereunder by Lessor shall not be deemed to be a waiver of Lessee's breach of any term, covenant, or condition of the Lease. 25. HOLDING OVER: Any holding over after the end of the Lease Term requires Lessor's written approval prior to the end of the Lease Term, which, notwithstanding any other provisions of this Lease, Lessor may withhold. Such holding over shall be construed to be a tenancy at sufferance from month to month. Lessee shall pay to Lessor monthly base rent equal to one and one-half (1.5) times the monthly base rent installment due in the last month of the Lease Term and all other additional rent and all other terms and conditions of the Lease shall apply, so far as applicable. Holding over by Lessee without written approval of Lessor shall subject Lessee to the liabilities and obligations provided for in this Lease and by law, including, but not limited to those in Section 2 of this Lease. Lessee shall indemnify and hold Lessor harmless against any loss or liability resulting from any delay caused by Lessee in surrendering the Premises, including without limitation, any claims made or penalties incurred by any succeeding lessee or by Lessor. No holding over shall be deemed or construed to exercise any option to extend or renew this Lease in lieu of full and timely exercise of any such option as required hereunder. 26. LESSOR'S LIABILITY: If Lessee should recover a money judgment against Lessor arising in connection with this Lease, the judgment shall be satisfied only out of the Lessor's interest in the Premises and neither Lessor or any of its partners shall be liable personally for any deficiency. 27. ESTOPPEL CERTIFICATES: Lessee shall at any time during the Lease Term, upon not less than ten (10) days prior written notice from Lessor, execute and deliver to Lessor a statement in writing certifying that, this Lease is unmodified and in full force and effect (or, if modified, stating the nature of such modification) and the dates to which the Rent and other charges have been paid in advance, if any, and acknowledging that there are not, to Lessee's knowledge, any uncured defaults on the part of Lessor hereunder or specifying such defaults if they are claimed. Any such statement may be conclusively relied upon by any prospective purchaser or encumbrancer of the Premises. Lessee's failure to deliver such a statement within such time shall be conclusive upon the Lessee that (a) this Lease is in full force and effect, without modification except as may be represented by Lessor; (b) there are no uncured defaults in Lessor's performance. 28. TIME: Time is of the essence of the Lease. 29. CAPTIONS: The headings on titles to the paragraphs of this Lease are not a part of this Lease and shall have no effect upon the construction or interpretation of any part thereof. This instrument contains all of the agreements and conditions made between the parties hereto and may not be modified orally or in any other manner than by an agreement in writing signed by all of the parties hereto or their respective successors in interest. 56 30. PARTY NAMES: Landlord and Tenant may be used in various places in this Lease as a substitute for Lessor and Lessee respectively. 31. EARTHQUAKE INSURANCE: As a condition of Lessor agreeing to waive the requirement for earthquake insurance, Lessee agrees that it will pay, as additional Rent, which shall be included in the monthly CAC, an amount not to exceed Forty-Seven Thousand Five Hundred Dollars ($47,500) per year for earthquake insurance if Lessor desires to obtain some form of earthquake insurance in the future, if and when available, on terms acceptable to Lessor asdetermined in the sole and absolute discretion of Lessor. 32. HABITUAL DEFAULT: Notwithstanding anything to the contrary contained in Section 14 herein, Lessor and Lessee agree that if Lessee shall have defaulted in the payment of Rent for three or more times during any twelve month period during the Lease Term, then such conduct shall, at the option of the Lessor, represent a separate event of default which cannot be cured by Lessee. Lessee acknowledges that the purpose of this provision is to prevent repetitive defaults by the Lessee under the Lease, which constitute a hardship to the Lessor and deprive the Lessor of the timely performance by the Lessee hereunder. 33. HAZARDOUS MATERIALS 33.1 DEFINITIONS: As used in this Lease, the following terms shall have the following meaning: a. The term "Hazardous Materials" shall mean (i) polychlorinated biphenyls; (ii) radioactive materials and (iii) any chemical, material or substance now or hereafter defined as or included in the definitions of "hazardous substance" "hazardous water", "hazardous material", "extremely hazardous waste", "restricted hazardous waste" under Section 25115, 25117 or 15122.7, or listed pursuant to Section 25140 of the California Health and Safety Code, Division 20, Chapter 6.5 (Hazardous Waste Control Law), (ii) defined as "hazardous substance" under Section 25316 of the California Health and Safety Code, Division 20, Chapter 6.8 (Carpenter-Presley-Tanner Hazardous Substances Account Act), (iii) defined as "hazardous material", "hazardous substance", or "hazardous waste" under Section 25501 of the California Health and Safety Code, Division 20, Chapter 6.95 (Hazardous Materials Release, Response, Plans and Inventory), (iv) defined as a "hazardous substance" under Section 25181 of the California Health and Safety Code, Division 201, Chapter 6.7 (Underground Storage of Hazardous Substances), (v) petroleum, (vi) asbestos, (vii) listed under Article 9 or defined as "hazardous" or "extremely hazardous" pursuant to Article II of Title 22 of the California Administrative Code, Division 4, Chapter 20, (viii) defined as "hazardous substance" pursuant to Section 311 of the Federal Water Pollution Control Act, 33 U.S.C. 1251 et seq. or listed pursuant to Section 1004 of the Federal Water Pollution Control Act (33 U.S.C. 1317), (ix) defined as a "hazardous waste", pursuant to Section 1004 of the Federal Resource Conservation and Recovery Act, 42 U.S.C. 6901 et seq., (x) defined as "hazardous substance" pursuant to Section 101 of the Comprehensive Environmental Responsibility Compensations, and Liability Act, 42 U.S.C. 9601 et seq., or (xi) regulated under the Toxic Substances Control Act, 156 U.S.C. 2601 et seq. b. The term "Hazardous Materials Laws" shall mean any local, state and federal laws, rules, regulations, or ordinances relating to the use, generation, transportation, analysis, manufacture, installation, release, discharge, storage or disposal of Hazardous Material. c. The term "Lessor's Agents" shall mean Lessor's agents, representatives, employees, contractors, subcontractors, directors, officers and partners. d. The term "Lessee's Agents" shall mean Lessee's agents, representatives, employees, contractors, subcontractors, directors, officers, partners, invitees or any other person in or about the Premises except Lessor's Agents. If Hazardous Materials in, on or about the Premises occur as a result of parties other than Lessee's Agents, representatives, employees, contractors, subcontractors, directors, officers and partners or invitees, Lessor shall use reasonable efforts to locate and recover from the responsible party any costs or damages resulting from the introduction of Hazardous to the Premises. If, notwithstanding such diligent effort, the Lessor is unsuccessful, 57 then Lessee shall be responsible, at Lessee's expense, for the cleanup of such Hazardous Materials according to applicable laws. 33.2 LESSEE'S RIGHT TO INVESTIGATE: Lessee shall be entitled to cause such inspection, soils and ground water tests, and other evaluations to be made of the Premises as Lessee deems necessary regarding (i) the presence and use of Hazardous Materials in or about the Premises, and (ii) the potential for exposure to Lessee's employees and other persons to any Hazardous Materials usedand stored by previous occupants in or about the Premises. Lessee shall provide Lessor with copies of all inspections, tests and evaluations. Lessee shall indemnify, defend and hold Lessor harmless from any cost, claim or expense arising from such entry by Lessee or from the performance of any such investigation by such Lessee. 33.3 LESSOR'S REPRESENTATIONS: Lessor hereby represents and warrants to the best of Lessor's knowledge that the Premises are, as of the date of this Lease, in compliance with all Hazardous Material Laws. 33.4 LESSEE'S OBLIGATION TO INDEMNIFY: Lessee, at its sole cost and expense, shall indemnify, defend, protect and hold Lessor and Lessor's Agents harmless from and against any and all cost or expenses, including those described under subparagraphs i, ii and iii herein below set forth, arising from or caused in whole or in part, directly or indirectly by: a. Lessee's or Lessee's Agents' use, analysis, storage, transportation, disposal, release, threatened release, discharge or generation of Hazardous Material to, in, on, under, about or from the Premises; or b. Lessee's or Lessee's Agents failure to comply with Hazardous Material laws; or c. Any release of Hazardous Material to, in, on, under, about, from or onto the Premises caused by or occurring as a result of acts or omissions of Lessee or Lessee's Agents or occurring during the Lease Term, except ground water contamination from other parcels where the source is from off the Premises not arising from or caused by Lessee or Lessee's Agents. The cost and expenses indemnified against include, but are not limited to the following: i. Any and all claims, actions, suits, proceedings, losses, damages, liabilities, deficiencies, forfeitures, penalties, fines, punitive damages, cost or expenses; ii. Any claim, action, suit or proceeding for personal injury (including sickness, disease, or death), tangible or intangible property damage, compensation for lost wages, business income, profits or other economic loss, damage to the natural resources of the environment, nuisance, pollution, contamination, leaks, spills, release or other adverse effects on the environment; iii. The cost of any repair, clean-up, treatment or detoxification of the Premises necessary to bring the Premises into compliance with all Hazardous Material Laws, including the preparation and implementation of any closure, disposal, remedial action, or other actions with regard to the Premises, and expenses (including, without limitation, reasonable attorney's fees and consultants fees, investigation and laboratory fees, court cost and litigation expenses). 33.5 LESSEE'S OBLIGATION TO REMEDIATE CONTAMINATION: Lessee shall, at its sole cost and expense, promptly take any and all action necessary to remediate contamination of the Premises by Hazardous Materials during the Lease Term as provided in Section 33.4. 33.6 OBLIGATION TO NOTIFY: Lessor and Lessee shall each give written notice to the other as soon as reasonably practical of (i) any communication received from any governmental authority concerning Hazardous Material which related to the Premises and (ii) any contamination of the Premises by Hazardous Materials which constitutes a violation of any Hazardous Material Laws. 33.7 SURVIVAL: The obligations of Lessee under this Section 33 shall survive the Lease Term or earlier termination of this Lease. 58 33.8 CERTIFICATION AND CLOSURE: On or before the end of the Lease Term or earlier termination of this Lease, Lessee shall deliver to Lessor a certification executed by Lessee stating that, to the best of Lessee's knowledge, there exists no violation of Hazardous Material Laws resulting from Lessee's obligation in Paragraph 33. If pursuant to local ordinance, state or federal law, Lessee is required, at the expiration of the Lease Term, to submit a closure plan for the Premises to a local, state or federal agency, then Lessee shall furnish to Lessor a copy of such plan. 33.9 PRIOR HAZARDOUS MATERIALS: Lessee shall have no obligation to clean up or to hold Lessor harmless with respect to, any Hazardous Material or wastes discovered on the Premises which were not introduced into, in, on, about, from or under the Premises during the Lease Term or ground water contamination from other parcels where the source is from off the Premises not arising from or caused by Lessee or Lessee's Agents. 34. BROKERS: Lessor and Lessee represent that they have not utilized or contacted a real estate broker or finder with respect to this Lease other than Wayne Mascia Associates ("WMA") and Lessee agrees to indemnify and hold Lessor harmless against any claim, cost, liability or cause of action asserted by any broker or finder claiming through Lessee other than WMA. Lessor shall at its sole cost and expense pay the brokerage commission per Lessor's standard commission schedule to WMA in connection with this transaction. Lessor represents and warrants that it has not utilized or contacted a real estate broker or finder with respect to this Lease other than WMA and Lessor agrees to indemnify and hold Lessee harmless against any claim, cost, liability or cause of action asserted by any broker or finder claiming through Lessor. 35. OPTION TO EXTEND A. OPTION: Lessor hereby grants to Lessee one (1) option to extend the Lease Term, with the extended term to be for a period of five (5) years, on the following terms and conditions: (i) Lessee shall give Lessor written notice of its exercise of its option to extend no earlier than twenty-four (24) calendar months, nor later than six (6) calendar months before the Lease Term would end but for said exercise. Time is of the essence. (ii) Lessee may not extend the Lease Term pursuant to any option granted by this Section 35 if Lessee is in default as of the date of the exercise of its option. If Lessee has committed a default by Lessee as defined in Section 14 or 32 that has not been cured or waived by Lessor in writing by the date that any extended term is to commence, then Lessor may elect not to allow the Lease Term to be extended, notwithstanding any notice given by Lessee of an exercise of this option to extend. (iii) All terms and conditions of this Lease shall apply during the extended term, except that the base rent and rental increases for each extended term shall be determined as provided in Section 35 (B) below (iv) Lessee must provide Lessor written notice of its exercise of its option as provided hereunder at least nine (9) months before the Lease Term would end but for said exercise for purposes of negotiating rental terms. Lessee may withdraw its notice of exercise of an extension option for any reason prior to six (6) months before the Lease Term would end but for said exercise. Lessor shall provide Lessee with Lessor's proposed base monthly rent for the option period within twenty (20) days of Lessee's written request. However, once Lessee delivers a notice of exercise of an option to extend the Lease Term it may not be withdrawn unless notice in writing is provided to Lessor at least six (6) months before the Lease Term would end but for said exercise and, subject to the provisions of this Section 35, such notice shall operate to extend the Lease Term. Upon any extension of the Lease Term pursuant to this Section 35, the term "Lease Term" as used in this Lease shall thereafter include the then extended term. (v) The option rights of Larscom Incorporated granted under this Section 35 are granted for Larscom Incorporated's personal benefit and may not be assigned or transferred by Larscom 59 Incorporated or exercised if Larscom Incorporated is not occupying the Premises at the time of exercise. B. EXTENDED TERM RENT--OPTION PERIOD: The monthly Rent for the Premises during the extended term shall equal the fair market monthly Rent for the Premises as of the commencement date of the extended term, but in no case, less than the Rent during the last month of the prior Lease term. Promptly upon Lessee's exercise of the option to extend, Lessee and Lessor shall meet and attempt to agree on the fair market monthly Rent for the Premises as of the commencement date of the extended term. In the event the parties fail to agree upon the amount of the monthly Rent for the extended term prior to commencement thereof, the monthly Rent for the extended term shall be determined by appraisal in the manner hereafter set forth; provided, however, that in no event shall the monthly Rent for the extended term be less than in the immediate preceding period. Annual base rent increases during the extended term shall be four percent (4%) per year. In the event it becomes necessary under this paragraph to determine the fair market monthly Rent of the Premises by appraisal, Lessor and Lessee each shall appoint a real estate appraiser who shall be a member of the American Institute of Real Estate Appraiser ("AIREA") and such appraisers shall each determine the fair market monthly Rent for the Premises taking into account the value of the Premises and the amenities provided by the outside areas, the common areas, and the Building, and prevailing comparable Rentals in the area. Such appraisers shall, within twenty (20) business days after their appointment, complete their appraisals and submit their appraisal reports to Lessor and Lessee. If the fair market monthly Rent of the Premises established in the two (2) appraisals varies by five percent (5%) or less of the higher Rent, the average of the two shall be controlling. If said fair market monthly Rent varies by more than five percent (5%) of the higher Rental, said appraisers, within ten (10) days after submission of the last appraisal, shall appoint a third appraiser who shall be a member of the AIREA and who shall also be experienced in the appraisal of Rent values and adjustment practices for commercial properties in the vicinity of the Premises. Such third appraiser shall, within twenty (20) business days after his appointment, determine by appraisal the fair market monthly Rent of the Premises taking into account the same factors referred to above, and submit his appraisal report to Lessor and Lessee. The fair market monthly Rent determined by the third appraiser for the Premises shall be controlling, unless it is less than that set forth in the lower appraisal previously obtained, in which case the value set forth in said lower appraisal shall be controlling, or unless it is greater than that set forth in the higher appraisal previously obtained in which case the Rent set for in said higher appraisal shall be controlling. If either Lessor or Lessee fails to appoint an appraiser, or if an appraiser appointed by either of them fails, after his appointment to submit his appraisal within the required period in accordance with the foregoing, the appraisal submitted by the appraiser properly appointed and timely submitting his appraisal shall be controlling. If the two appraisers appointed by Lessor and Lessee are unable to agree upon a third appraiser within the required period in accordance with the foregoing, application shall be made within twenty (20) days thereafter by either Lessor or Lessee to AIREA, which shall appoint a member of said institute willing to serve as appraiser. The cost of all appraisals under this subparagraph shall be borne equally be Lessor and Lessee. 36. APPROVALS: Whenever in this Lease the Lessor's or Lessee's consent is required, such consent shall not be unreasonably or arbitrarily withheld or delayed. In the event that the Lessor or Lessee does not respond to a request for any consents which may be required of it in this Lease within ten business days of the request of such consent in writing by the Lessee or Lessor, such consent shall be deemed to have been given by the Lessor or Lessee. 37. AUTHORITY: Each party executing this Lease represents and warrants that he or she is duly authorized to execute and deliver the Lease. If executed on behalf of a corporation, that the Lease is executed in accordance with the by-laws of said corporation (or a partnership that the Lease is executed in accordance with the partnership agreement of such partnership), that no other party's approval or consent to such execution and delivery is required, and that the Lease is binding upon said individual, corporation (or partnership) as the case may be in accordance with its terms. 60 38. INDEMNIFICATION OF LESSOR: Except to the extent caused by the sole negligence or willful misconduct of Lessor or Lessor's Agents, Lessee shall defend, indemnify and hold Lessor harmless from and against any and all obligations, losses, costs, expenses, claims, demands, attorney's fees, investigation costs or liabilities on account of, or arising out of the use, condition or occupancy of the Premises or any act or omission to act of Lessee or Lessee's Agents or any occurrence in, upon, about or at the Premises, including, without limitation, any of the foregoing provisions arising out of the use, generation, manufacture, installation, release, discharge, storage, or disposal of Hazardous Materials by Lessee or Lessee's Agents. It is understood that Lessee is and shall be in control and possession of the Premises and that Lessor shall in no event be responsible or liable for any injury or damage or injury to any person whatsoever, happening on, in, about, or in connection with the Premises, or for any injury or damage to the Premises or any part thereof. This Lease is entered into on the express condition that Lessor shall not be liable for, or suffer loss by reason of injury to person or property, from whatever cause, which in any way may be connected with the use, condition or occupancy of the Premises or personal property located herein. The provisions of this Lease permitting Lessor to enter and inspect the Premises are for the purpose of enabling Lessor to become informed as to whether Lessee is complying with the terms of this Lease and Lessor shall be under no duty to enter, inspect or to perform any of Lessee's covenants set forth in this Lease. Lessee shall further indemnify, defend and hold harmless Lessor from and against any and all claims arising from any breach or default in the performance of any obligation to Lessee's part to be performed under the terms of this Lease. The provisions of Section 38 shall survive the Lease Term or earlier termination of this Lease with respect to any damage, injury or death occurring during the Lease Term. 39. SUCCESSORS AND ASSIGNS: The covenants and conditions herein contained shall, subject to the provisions as to assignment, apply to and bind the heirs, successors, executors, administrators and assigns of all of the parties hereto; and all of the parties hereto shall be jointly and severally liable hereunder. 40. MISCELLANEOUS PROVISIONS: All rights and remedies hereunder are cumulative and not alternative to the extent permitted by law and are in addition to all other rights or remedies in law and in equity. 41. CHOICE OF LAW: This lease shall be construed and enforced in accordance with the substantive laws of the State of California. The language of all parts of this lease shall in all cases be construed as a whole according to its fair meaning and not strictly for or against either Lessor or Lessee. 42. ENTIRE AGREEMENT: This Lease is the entire agreement between the parties, and there are no agreements or representations between the parties except as expressed herein. Except as otherwise provided for herein, no subsequent change or addition to this Lease shall be binding unless in writing and signed by the parties hereto. IN WITNESS WHEREOF, Lessor and Lessee have executed these presents, the day and year first above written. 61 LESSOR LESSEE BERG & BERG ENTERPRISES, INC. LARSCOM INCORPORATED By: /s/ CARL E. BERG By: /s/ DEBORAH M. SOON ------------------------- ------------------------- signature of authorized signature of authorized representative representative Carl E. Berg Carl E. Berg ------------------------- ------------------------- printed name printed name President President & CEO ------------------------- ------------------------- title title 3/20/97 3/20/97 ------------------------- ------------------------- date date 62 EXHIBIT A Exhibit A shows a one page map of the premises located at 1795 McCandless Drive. 63 EXHIBIT A.1 Exhibit A.1 shows a one page map of whole development project including vacant space for 1795 McCandless Drive. 64 EXHIBIT B Berg & Berg ("Building Shell") includes the following items in customary quantities and quality. All items not listed are part of Lessee Interior Improvements. Exterior walls Foundation Floor slabs Roof structure and membrane Glazing Exit doors Truck doors Landscaping Parking and paving Storm sewer line to building Sanitary sewer line to building Water line to building Paint of exterior walls Shell architecture and engineering All permits for the above items 65 EXHIBIT C Exhibit C is not used 66 EXHIBIT D Exhibit D is a one page diagram of the proposed internal design of the building at 1795 McCandless Drive. 67 EXHIBIT E Lessee Approval Deadlines Lease signed 03/20/97 Approval of site plan Approved Approval of building elevation Approved Approval of restroom, stairs and underground plumbing 04/5/97 Approval of preliminary floor plan, single line 04/5/97 Approval of interior plans and specifications 04/5/97 Final selection of all material and interior finishes for construction such as carpet, ceramic tile, paint and any other lessee selected materials & finishes 04/20/97
Lessee shall not unreasonably withhold approval of final shell or interior plans if they conform in general to the preliminary site plan, preliminary elevation, and floor plans. The Commencement Date shall be extended one day for each day Lessee does not meet each deadline set forth on this Exhibit E which shall be considered a Lessee Delay and Lessee shall pay Rent for any delays that effect the Substantial Completion Date. 68 EX-11.1 3 EX-11.1 EXHIBIT 11.1 STATEMENT RE. COMPUTATION OF SUPPLEMENTAL NET INCOME PER SHARE LARSCOM INCORPORATED STATEMENT REGARDING COMPUTATION OF SUPPLEMENTAL NET INCOME PER SHARE(1) (IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, -------------------- 1996 1995 --------- --------- Net income.................................................................................. $ 4,930 $ 2,529 Add: Interest paid net of income tax........................................................ 371 --------- --------- $ 5,301 $ 2,529 --------- --------- --------- --------- Weighted average shares outstanding: Class A and B Common Stock.................................................................. 12,107 11,900 Additional shares that would be used to pay the $25.0 million dividend to Axel Johnson(2)........................................................................ 2,210 2,293 --------- --------- Shares used to compute supplemental net income per share.................................... 14,317 14,193 --------- --------- --------- --------- Supplemental net income per share........................................................... $ 0.37 $ 0.18
- ------------------------ Note: the Company has not included a computation of supplemental net income per share for 1994 as the Company does not believe that to do so would be meaningful. (1) This Exhibit should be read in conjunction with Note 1 of Notes to Consolidated Financial Statements. (2) Calculated using the assumed net proceeds of $10.90 per share of common stock in the Company's Initial Public Offering EX-21.1 4 EX-21.1 EXHIBIT 21.1 LIST OF SUBSIDIARIES
NAME PLACE OF INCORPORATION % OWNERSHIP - ------------------------------ ------------------------------------ ------------- Larscom Limited England and Wales 100%
EX-23.1 5 EX-23.1 EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-18251) of Larscom Incorporated of our report dated January 17, 1997, except for Note 9 which is as of March 24, 1997 appearing on page 23 of this Form 10-K. /s/ Price Waterhouse LLP PRICE WATERHOUSE LLP San Jose, California March 24, 1997 EX-24 6 EX-24 EXHIBIT 24 LARSCOM INCORPORATED POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Deborah M. Soon as his attorney in fact, each with full power of substitution, for him and any and all capacities, to sign any and all amendments to this Form 10-K for the year ending December 31, 1996, and to file the same, with exhibits and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratify and confirming our signatures as they may be signed by our said attorney to any and all amendments to said Form 10-K.
NAME TITLE DATE - --------------------------- --------------------------------------------------------------- ------------------- Bruce D. Horn.............. Vice President, Finance and Chief Financial Officer (Chief Financial Officer and Principal Accounting Officer) March 25, 1997 Paul E. Graf............... Director March 25, 1997 Kevin N. Kalkhoven......... Director March 26, 1997 Harvey L. Poppel........... Director March 21, 1997 Joseph F. Smorada.......... Director March 25, 1997
EX-27 7 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED FINANCIAL STATEMENTS INCLUDED UNDER ITEM AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 46,403 0 9,603 125 8,654 67,283 13,698 8,168 73,043 11,339 0 0 0 177 61,268 73,043 66,444 66,444 29,949 27,531 0 0 630 8,367 3,437 4,930 0 0 0 4,930 .37 .37
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