-----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, RmBASh2clBQRQzUP8gpflsxLNW6/dwGxy/Pj1MEcTOJUP5GrRVkAcc13jMGhngk4 HWo6EFQdJxAV+RhRgQAaEQ== 0001047469-99-012802.txt : 19990402 0001047469-99-012802.hdr.sgml : 19990402 ACCESSION NUMBER: 0001047469-99-012802 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: EXCEL SWITCHING CORP CENTRAL INDEX KEY: 0001036261 STANDARD INDUSTRIAL CLASSIFICATION: COMMUNICATIONS EQUIPMENT, NEC [3669] IRS NUMBER: 042992806 STATE OF INCORPORATION: MA FISCAL YEAR END: 1227 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 333-35791 FILM NUMBER: 99581551 BUSINESS ADDRESS: STREET 1: 255 INDEPENDENCE DR CITY: HYANNIS STATE: MA ZIP: 02601 BUSINESS PHONE: 5088623000 MAIL ADDRESS: STREET 1: 255 INDEPENDENCE DR CITY: HYANNIS STATE: MA ZIP: 02601 FORMER COMPANY: FORMER CONFORMED NAME: EXCEL INC DATE OF NAME CHANGE: 19970325 10-K 1 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission File Number 0-23263 EXCEL SWITCHING CORPORATION (Exact name of registrant as specified in its charter) MASSACHUSETTS 04-2992806 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 255 INDEPENDENCE DRIVE HYANNIS, MASSACHUSETTS 02601 (Address of principal executive offices) (Zip code) (508) 862-3000 (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: Common Stock, $.01 par value Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES: /X/ NO: / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. /X/ The aggregate market value of the Registrant's Common Stock held by non-affiliates of the Registrant as of March 22, 1999 was $194,825,744 based on the price of $26.875, the closing price of the Common Stock on that date as reported on the Nasdaq National Market. As of March 22, 1999, 34,465,955 shares of the Registrant's Common Stock were issued and outstanding. DOCUMENTS INCORPORATED BY REFERENCE (1) Specified portions of the Company's Proxy Statement, which is expected to be filed within 120 days after the end of the Company's fiscal year, are incorporated by reference into Part III (Items 10, 11, 12 and 13) of this Report. 1 EXCEL SWITCHING CORPORATION FORM 10-K TABLE OF CONTENTS
PAGE ---- PART I Item 1 Business 3 Item 2 Properties 10 Item 3 Legal Proceedings 11 Item 4 Submission of Matters to a Vote of Security Holders 11 PART II Item 5 Market for Registrant's Common Equity and Related Stockholder Matters 12 Item 6 Selected Financial Data 13 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 7A Quantitative and Qualitative Disclosures about Market Risk 28 Item 8 Financial Statements and Supplemental Data 29 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 29 PART III Item 10 Directors and Executive Officers of the Registrant 29 Item 11 Executive Compensation 29 Item 12 Security Ownership of Certain Beneficial Owners and Management 29 Item 13 Certain Relationships and Related Transactions 30 Item 14 Exhibits, Financial Statement Schedules, and Reports on Form 8-K 30 Signatures 32
2 PART I ITEM 1. BUSINESS INFORMATION CONTAINED IN THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS SUCH AS STATEMENTS OF THE COMPANY'S PLANS, OBJECTIVES, EXPECTATIONS AND INTENTIONS, THAT CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY, SUCH AS "MAY", "WILL", "EXPECT", "ANTICIPATE", "BELIEVE", "PLAN", "INTEND", "COULD", "ESTIMATES", "IS BEING" OR "GOAL" OR OTHER VARIATIONS OF THESE TERMS OR COMPARABLE TERMINOLOGY. SUCH STATEMENTS ARE SUBJECT TO RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE ANTICIPATED. THE CAUTIONARY STATEMENTS MADE IN THIS REPORT SHOULD BE READ AS BEING APPLICABLE TO ALL FORWARD-LOOKING STATEMENTS WHENEVER THEY APPEAR IN THIS REPORT. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE THOSE DISCUSSED IN THE RISK FACTORS SET FORTH IN ITEM 7 BELOW (THE "RISK FACTORS") AS WELL AS THOSE DISCUSSED ELSEWHERE HEREIN. Excel Switching Corporation is a leading provider of open switching platforms for telecommunications networks worldwide. The Company develops, manufactures, markets and supports a family of open, programmable, carrier-class switches that address the complex enhanced services and wireless and wireline infrastructure needs of network providers. Excel's products offer network providers the flexibility to address multiple market applications and the scalability to deploy a variety of system capacities. The Company's programmable switching platforms enable network providers to deliver improved networking functionality at a lower cost than purchasing, upgrading or reprogramming traditional, closed, central office switches. The Company's products are currently deployed in telecommunications networks in 60 countries throughout the world. Excel offers a family of programmable switching platforms that are designed with distributed architecture and open software to maximize performance and provide multiple levels of programmability and redundancy. Excel's open switching platforms integrate with a wide variety of host computer systems, operating systems and application development environments. The Company's product family scales from approximately 100 to 30,720 ports. Using Excel's patented Programmable Protocol Language ("PPL"), application developers can customize the switching software to their unique requirements, allowing them to introduce new services and applications rapidly. As customer requirements evolve, the Excel platform can be upgraded without requiring extensive and complex programming changes to the underlying software. The Company sells to a variety of customers in the worldwide telecommunications market. Excel's customers integrate the Company's open, programmable switching platforms with their product offerings to address a variety of market applications for network providers, ranging from enhanced services such as voice messaging, one number services and prepaid debit cards, to wireless and wireline infrastructure services such as tandem, end-office, mobile switching centers, intelligent base station controllers and wireless local loop. Excel's products and technology are contained within the framework of Open Network Expansion Architecture ("ONE Architecture(TM)") which was introduced in February 1998. ONE Architecture is Excel's concept that its switching solutions provide an open, scalable and cost-effective solution for the telecommunication needs of network providers. ONE Architecture encompasses the existing family of switching products and related embedded software technologies described below. EXCEL PRODUCT FAMILY The Company offers a family of open, programmable switching products for application developers, OEMs, systems integrators and network service providers. The Company's product family includes the EXS-2000 (formerly referred to as the LNX), a 2,048 port switching platform and the EXS-1000 (formerly referred to as the CSN), a 1,024 port switching platform. Multiple nodes of EXS-2000s or EXS-1000s can be easily linked to form an EXS system of up to 30,720 ports. The LNX and CSN product names have been changed to EXS-2000 and EXS-1000, respectively, to better reflect the continuity and common architecture shared across the entire EXS product line. All of the Company's EXS products can be used in a wide range of enhanced services and wireless and wireline infrastructure applications. 3 All of Excel's products share a common embedded software architecture, allowing any specific application to run on any platform, and are designed with multiple levels of redundancy. All EXS switching platforms share a set of common card components which include network interface line cards such as T1, E1 and J1 interfaces, and service resource cards such as multi-function Digital Signal Processors, Primary Rate ISDN, SS7, DASS2 and DPNSS. Excel's network interface line cards provide direct connectivity to, and ease of integration with, a variety of international signaling protocols. The service resource cards provide customers with a range of common channel signaling and switching applications, offering network providers the ability to control their applications and the flexibility to expand to other services or signaling protocols as needed. Multiple cards can be installed on a single chassis to manage various signaling and call control capabilities or to provide fault tolerant configurations. In addition, the Company offers network interface line cards and service resource cards separately to allow customers to upgrade or enhance previously deployed switching platforms. The EXS-2000 is a 2,048 port, non-blocking, open, programmable switching platform that provides high performance and fault tolerance in a small chassis. With all modules supporting redundant configurations, the EXS-2000 is designed for central office environments requiring a high level of reliability and ease of maintainability. The EXS-2000 can operate as a stand-alone switch or as a node in Excel's patented EXS switching system, currently supporting scalability up to 30,720 non-blocking ports. The EXS-2000 consists of the 2,048 port matrix card residing in a 20-slot chassis, a host interface and a fully configurable combination of network interface line and service resource cards. All EXS-2000 cards can be replaced while the system is operating ("hot-swappable"), providing ease of maintenance and upgrading without interruption of service. The predecessor to the EXS-2000, the XLDX, is a 1,536 port programmable platform first installed in a central office environment in 1988. XLDX systems are still supported by the Company for customers with an XLDX installed base. The EXS-1000 is a 1,024 port, non-blocking, open, programmable switching platform that provides the same features and scalability as the EXS-2000 but in a more compact chassis. The EXS-1000 utilizes the same common cards for network line interfaces and service resources as well as utilizes common channel signaling packet engines and host interfaces as the EXS-2000, with the same reliability features such as hot-swappability and full redundancy. The EXS-1000 is suited for wireless applications where space constraints dictate the need for carrier-class switching within a compact chassis. The EXS system is an open, non-blocking system comprised of multiple EXS-2000 and or EXS-1000 programmable switching platforms distributed across EXNET, the Company's fiber optic expansion network. The current EXNET network can support up to 30,720 ports, encompassing combinations of EXS-2000s and or EXS-1000s. The patented EXS architecture is designed to allow further expansion beyond the current 30,720 ports. Parallel EXNET fiber networks can also be used to create fully redundant systems to ensure maximum availability and fault tolerance. Because each EXS node is a self-contained EXS-2000 or EXS-1000 switching platform, processing power can scale linearly as the system is expanded. Individual EXS-2000 or EXS-1000 nodes can be isolated and serviced without the entire system being brought out-of-service, providing ease of maintenance. Since each node can operate and process calls independently, total system reliability and availability is increased. The Company also offers another switching product, the PCX, which is designed for the customer premise equipment marketplace. The PCX is designed to provide a total solution in a small chassis and address the needs of midrange switching applications. The PCX is a PC-based, 512 port, non-blocking, open, programmable switching platform that supports the same programmable features and shares the same hardware and software architecture as the EXS-2000 and EXS-1000 platforms. With its PC-based platform, the PCX can support an internal host processor as well as internal voice processing resources. The PCX enables application developers to combine Excel's programmable switching features with industry-standard voice processing technology for a single, stand-alone solution. Although, sales of the PCX product were not significant in 1998, the Company continues to supply PCX components and support the existing installed customer base. A unique aspect of Excel's distributed architecture is its embedded patented Selective Space Switching technology which allows the platform's internal bus to switch traffic between any input or output port, DSP, packet engine resource or EXNET Controller without losing critical port capacity. Unlike traditional switches, with Selective Space Switching 4 technology, available port capacity is not compromised as additional modules are added. When resource modules are added, the platform's switching capacity increases, and its full non-blocking switch port capacity is retained. Unlike traditional, proprietary switches, Excel's programmable platforms share a common, open, embedded software architecture designed to be programmable by third parties. The open programmability of Excel's switching platforms is based on its Application Programming Interface ("API") and its patented Programmable Protocol Language ("PPL"). The API is a message-based protocol designed for communication between the programmable switching platform and the application software located on a host computer. Excel's open API allows the application software to access call processing control, configuration, maintenance and alarm reporting functions within the switch at a level that is not currently available in competitive products. The API also allows multiple host computers to attach to the EXS platform to provide multiple applications on a single platform or application load sharing architectures. Excel's API is embedded within the Company's switching product family. Excel's PPL is a patented technology that provides an easy and convenient mechanism for developers and operators to implement modifications without having to write complex software code. PPL provides a development environment at multiple programmable levels including signaling protocol and the call control and application service layers of the system software. PPL programmability is currently available at all layers except the application service layer. The Company is currently developing PPL programmability for the service layer. PPL provides the customer greater control over their development of competitive custom service offerings and an ability to independently customize the switching platform to add functionality. Software, including protocols, is developed and modified using a graphical user interface development environment, requiring the user to have only limited software programming experience. PPL can be layered in the call control layer to customize the EXS API to match external application requirements. This allows developers to create their own host-to-switch API to optimize their applications and services. With PPL, support personnel can implement detailed changes to the switching software on site without using expensive equipment or requiring additional technical personnel. These benefits provide increased software maintainability while reducing development costs and eliminating customized work for Excel and its customers. Excel's EXS programmable switching platforms supports the worldwide telecommunications industry's Signaling System 7 ("SS7") requirements. All phone systems require signaling to supervise or monitor the circuit, alert for incoming calls and transmit routing and destination signals over the network. Excel's products are also used in the Intelligent Network (IN), via its SS7 products. Excel's SS7 provides a robust, high-reliability, scalable SS7 solution that supports multiple layers of the SS7 model. Because it uses PPL technology, Excel's SS7 is highly programmable. With Excel's SS7, developers can build custom IN services, enabling service providers to offer a wide variety of competitive services to their subscribers. Excel's SS7 products support both domestic and international standards, and enable the Excel switch to operate either as an Intelligent Peripheral (IP) or a Service Switching Point (SSP) in the Intelligent Network. The Company's PPL, API and Selective Space Switching software technology are embedded within the system software of the switching products. The Company also sells certain separate software tools and applications including a PPL toolkit assists in the development of custom protocols and services, independent of the switch architecture. In September 1998, Excel acquired XNT Systems, Inc, a former Excel customer. Prior to the acquisition, XNT supplied network service providers with intelligent switch-control and comprehensive call-processing and control software applications that managed the underlying Excel switch platform. The acquired XNT technology enhances Excel's ability to offer its network service providers a turnkey infrastructure switching solution containing such service capabilities as tandem and end-office switching. In September 1998, the Company also acquired Quantum Telecom Solutions, Inc., a former Excel customer. Prior to the acquisition, Quantum provided its customers with software to configure and manage Excel switching platforms for use in networks. Both of these acquisitions provided Excel with switch-related technology and applications that increased both the functionality and the ease of programmability of the Excel switching platforms. On December 31, 1998, both acquired entities were merged into the Company. 5 CUSTOMERS During 1998, the Company sold its products to more than 150 customers engaged in a variety of areas of the telecommunications industry. The Company's customers include application developers, OEMs, systems integrators and service providers. Approximately 10.2% and 19.6% of the Company's revenues in 1997 and 1998, respectively, were derived from sales to QUALCOMM Incorporated and approximately 26.0% of the Company's revenues in 1997 were derived from sales to Comverse Network Systems (formerly Boston Technology, Inc.). No other customer accounted for greater than 10% of the Company's revenues for these periods. The primary end-users of the Company's products are public network providers, including LECs, IXCs, CLECs, wireless carriers and PTTs. The Company's products also are used by a number of large corporations to satisfy specific telecommunications requirements. CUSTOMER SERVICE, SUPPORT AND TRAINING The Company provides pre- and post-sales engineering services and has a technical assistance center that provides support and service by telephone. The Company offers a variety of engineering services such as customer application design review, protocol development, product training, performance testing and field support. The Company has a fully equipped training facility and provides a wide range of training courses to its customers, both on- and off-site. The Company also has a fully equipped applications lab with call traffic load capabilities where customers can test and verify new applications or enhancements to existing applications. The Company's technical assistance center provides telephone support and service on a 24-hour, seven-day-a-week basis. To ensure that the Company is providing quality support services, the Company has a formal customer satisfaction program which involves senior management review and regularly scheduled customer support surveys. In addition, Company personnel meet regularly with customers to discuss product quality and customer satisfaction. The Company provides a product warranty on its hardware products, which generally covers a period of 14 months from shipment. This warranty coverage includes technical assistance, as well as product repair or product replacement, depending upon the circumstances of the warranty claim. In late 1998, Excel began to offer a warranty on the software embedded within its products. This warranty covers a period of 90 days and provides that the Excel embedded software shall be free from certain defects. In addition, Excel began to offer its customers an option to purchase service and support contract covering post-sales support. These post-sales support agreements provide additional technical support and professional services such as training, application planning, design consultation and implementation assistance. Under these agreements, customers generally will be charged an annual fee based upon the level of support requested. Through December 31, 1998, revenue from such agreements and other fees for support and services has been immaterial. SALES AND MARKETING The Company has historically sold its products primarily to application developers, OEMs and systems integrators which incorporated the Company's products into their service and product offerings. During 1998, the Company began selling more of its products directly to service providers. The Company's principal marketing activities are to identify customers that could benefit from the Company's products, identify new markets for the Company's products and increase sales to existing customers. The sale of the Company's products is a multi-step and interdisciplinary process which can typically range from 12 to 24 months or more from initial customer contact to large-scale commercialization of a customer's application or service based on the Company's products. The initial evaluation stage, typically three to six months, is primarily the role of the Company's sales, marketing and engineering personnel, and members of the Company's senior management. The sales process involves educating potential customers on the functionality and benefits derived from using the Company's products. The next stage, which can involve members of both the Company's customer support and research and development organizations, involves providing the customer with the required training and technical support to integrate the Company's products into a new application or service. This stage of the sales process is generally the longest and is dependent upon an application or service provider's own internal application or service development program. 6 The Company sells to its customers through its own sales force, from its headquarters, as well as from sales offices in California, Georgia, Illinois, Massachusetts, Ohio and Texas. In addition, the Company has home-based sales representatives in Connecticut and Maryland. The Company has foreign sales offices in Brussels, Belgium and Tokyo, Japan. The Company currently has no other offices outside the United States, but is exploring the establishment of additional foreign sales offices in Europe and Asia. To date, the Company has no firm commitments to establish such international sales offices and there can be no assurance that the Company will actually open any foreign offices. In addition, the Company maintains an inside sales group, located at its headquarters, which is responsible for platform configuration and price quotations, order administration and telephone sales activities. In order to create awareness, market demand and sales opportunities, the Company engages in a number of marketing activities which include exhibiting products and customer applications at industry trade shows, advertising in selected publications aimed at targeted markets, public relations activities with trade and business press, publication of technical articles and the distribution of sales literature, technical specifications and documentation. RESEARCH AND PRODUCT DEVELOPMENT Management believes that the Company's success will depend on its ability to develop and introduce in a timely fashion new products and enhancements to its existing products. The Company has in the past made, and intends to continue to make, significant investments in product and technological development. Extensive product development input is obtained through customers and the Company's monitoring of end-user needs and changes in the marketplace. The Company is focusing its development efforts on: providing enhanced functionality to its products including increased port capacity, reliability and performance; the development of network switching software; the improvement of third-party application integration including packet data technology such as VoIP, RAS and other protocols; and enhancement of development tools. These research and development projects are being designed to: enhance the Company's turnkey switching solution for use by network service providers; enhance the ability to integrate voice, data and media resources onto a single switching platform; and to enable customers to shorten their application development cycle thereby improving time-to-market and reducing initial investment in research and development. The Company may experience difficulties that could delay or prevent the successful development, introduction or marketing of such new products and enhancements. It is possible that new products and enhancements may not adequately meet the requirements of the marketplace and achieve market acceptance. Announcements of currently planned or other new product offerings by the Company or its competitors may cause customers to defer or cancel the purchase of existing Company products. The Company's inability to develop on a timely basis new products or enhancements to existing products, or the failure of such new products or enhancements to achieve market acceptance, could have a material adverse effect on the Company's business, financial condition and results of operations. The development of new, technologically advanced products is a complex and uncertain process requiring the accurate anticipation of technological and market trends. The introduction of new or enhanced products also requires the Company to manage the transition from older products in order to minimize disruption in customer ordering patterns, avoid excessive levels of older product inventories and ensure that adequate supplies of new products can be delivered to meet anticipated customer demand. There can be no assurance that the Company will successfully develop, introduce or manage the transition to new products. Furthermore, products such as those offered by the Company may contain undetected or unresolved errors when they are first introduced or as new versions are released. Despite extensive testing by the Company, errors may be found in new products or upgrades after commencement of commercial shipments, resulting in delays in or loss of market acceptance and sales, diversion of development resources, injury to the Company's reputation or increased service and warranty costs, any of which could have a material adverse effect on the Company's business, financial condition and results of operations. The Company's engineering, research and development expenditures totaled approximately $11.1 million, $13.3 million and $22.7 million in 1996, 1997 and 1998, respectively. During 1998, Excel incurred one-time charges totaling $7.5 million for acquired in-process research and development relating to the acquisitions of XNT Systems, Inc. and Quantum Telecom Solutions, Inc. See "Management's Discussion and Analysis of Financial Condition" and "Notes to Consolidated Financial Statements" for more detailed disclosures relating to these acquisitions. 7 The Company performs most of its research and product development activities at its principal offices in Hyannis, Massachusetts. In addition, the Company performs research and product development activities in offices located in New Jersey and New Hampshire. The Company has maintained International Standard Organization (ISO) 9001 registration for quality assurance in design, production, installation and service since originally receiving ISO 9002 certification in 1996 and ISO 9001 certification in 1997. MANUFACTURING The Company's manufacturing operations consist primarily of materials planning and procurement, final assembly, testing and quality control. The Company uses several independent manufacturers to provide certain printed circuit boards, chassis and subassemblies. The Company's manufacturing process enables it to configure its products to meet a wide variety of individual customer requirements. The Company plans to strengthen manufacturing capability both in its existing facilities and through expansion of activities with independent manufacturers. Future growth of the Company will require extension of existing internal and external manufacturing resources, hiring of additional technical personnel, improved coordination of supplier relationships with the Company's inventory ordering and management practices, and expansion of information systems to accommodate planned growth across these areas. Although the Company generally uses standard parts and components for its products, many critical components are purchased from sole or single source vendors for which alternative sources may not be currently available. Some of these components are available from only one supplier, for which there is no substitute at this time. Also, from time to time, Excel provides or resells various third party applications for use with its switching products. If supply of these components or third party applications should cease or become unavailable, the Company would be required to redesign its products or stop providing such applications with its products. Although the Company works closely with well-established vendors, the Company has no supply commitments from its vendors and generally purchases components on a purchase order basis as opposed to entering into long term procurement agreements with vendors. With respect to third party applications, the Company intends to enter into supply contracts to assure availability. To date, the Company has generally been able to obtain adequate supplies in a timely matter from its primary vendors or, when necessary to meet production needs, from alternate vendors. In addition, the Company has been able to maintain relationships with application developers who provide third party applications. The Company believes that, in most cases, alternate vendors can be identified if current vendors are unable to fulfill needs. However certain applications may be only available from a single developer. Delays or failure to identify an alternate vendor, if required, a reduction or interruption in supply, a significant increase in the price of components or the inability to maintain a relationship with a particular application developer would materially and adversely affect the Company's business, financial condition, results of operations and customer relationships. COMPETITION The markets in which the Company competes are characterized by intense competition, with a large number of suppliers providing different types of products to different segments of such markets. The telecom industry has also been subject to rapid consolidation of equipment suppliers by larger telecom and data network service providers. The Company currently competes principally on the basis of: (i) the breadth of its products' features and benefits; (ii) the flexibility, scalability, quality, ease of use, reliability and cost effectiveness of its products; and (iii) the Company's reputation and the depth of its expertise, customer service and support. While the Company believes that overall, it currently competes favorably with respect to these factors, there can be no assurance that the Company will be able to continue to do so. The Company competes or may compete directly or indirectly with the following categories of companies: (i) other manufacturers of programmable switches such as Cisco Systems, Inc. (primarily through its recent acquisition of Summa Four, Inc.), Redcom Laboratories, Inc. and Harris Corporation; (ii) large, well-established switch and telecommunications equipment manufacturers such as Alcatel Alsthom Compagnie Generale d'Electricite SA, Lucent Technologies Inc., Northern Telecom Limited, Siemens AG and Telefonaktiebolaget LM Ericsson; and (iii) to a lesser degree, systems integrators and application developers whose switches are based on PC card-level products manufactured by companies such as Aculab Inc., Dialogic Corporation and Natural MicroSystems Corporation. In 8 addition, several smaller companies have begun recently to manufacture programmable switching platforms. Due to the rapidly evolving markets in which the Company competes, additional competitors with significant market presence and financial resources, including large telecommunications equipment manufacturers and computer hardware and software companies, may enter those markets, thereby further intensifying competition. Additionally, there can be no assurance that one or more of the Company's application developers will not begin to develop or market products in competition with the Company. Many of the Company's current and potential competitors have significantly greater financial, selling and marketing, technical, manufacturing and other resources than the Company. As a result, these competitors may be able to devote greater resources to the development, promotion, sale and support of their products than the Company. The Company, however, does not believe any of its competitors are currently dominant in its industry segment. Some of the Company's competitors currently offer financing alternatives to their customers, a service that the Company does not generally provide at this time. The Company is investigating the possibility of establishing a relationship with an independent leasing company to offer a financing alternative to some or all of Excel's customers. It is not certain that the Company will be able to establish such a relationship or offer such financing alternatives in the future. Moreover, these companies may introduce additional products that are competitive with those of the Company or enter into strategic relationships to offer complete solutions which the Company does not currently offer. It is unknown whether the Company's products would compete effectively with such products. The Company believes that its open, programmable switching platform, with the Company's patented Selective Space Switching technology and Programmable Protocol Language, offers its customers a competitive advantage for flexible, scaleable and cost-effective switching capabilities. Although the Company believes these technological features represent advantages over its competitors, maintaining these advantages will require continued investment by the Company in research and development, selling and marketing and customer service and support. In addition, as the Company enters new markets, distribution channels, technical requirements and levels and bases of competition may be different than those in the Company's current markets. Accordingly, it is uncertain whether the Company will be able to compete successfully against either current or potential competitors in the future. INTELLECTUAL PROPERTY The Company relies upon a combination of patent, copyright and trademark and trade secret laws as well as confidentiality procedures and contractual restrictions to establish and protect its proprietary rights. The Company has also entered into confidentiality and invention assignment agreements with its employees and consultants and enters into non-disclosure agreements with its suppliers, distributors and customers so as to limit access to and disclosure of its proprietary information. There can be no assurance such measures will be adequate to deter and prevent misappropriation of the Company's technologies or independent third-party development of similar technologies. 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 United States and thus make the possibility of piracy of the Company's technology and products more likely. As of December 31, 1998, a total of 11 U.S. patents and nine foreign patents have been issued to the Company. The Company has a total of 21 U.S. patent applications and 62 international and foreign national patent applications pending. The U.S. issued patents cover various aspects of: (i) the architecture and division of call processing responsibility in the Company's PCX product; (ii) the design and internal construction of a rack-mountable chassis used with the Company's PCX product; (iii) the architecture of certain communications resource and I/O cards which may be used in conjunction with any of the Company's family of programmable switching platforms relating to the Company's Selective Space Switching technology; (iv) the PPL software which may be used, in conjunction with any of the Company's family of programmable switching platforms, to create or modify applications or communications protocols; (v) a line card redundancy arrangement for use in conjunction with the Company's EXS-2000 and EXS-1000 products; (vi) the architecture of and communication methods used with the Company's fiber optic expansion network, EXNET; and (vii) a universal application programming interface (API) used in the Company's products. The U.S. patents will expire at various times between the years 2008 and 2014. The Company also has the following pending: two U.S. trademark registrations; three foreign trademark registrations; six U.S. trademark applications; and 19 foreign trademark applications. 9 The telecommunications 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 patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. Although the Company has from time to time received communications from third parties asserting that the Company's products infringe or may infringe proprietary rights of third parties, the Company generally believes that none of such claims, if determined adversely to the Company, would have a material adverse effect on the Company's business, financial condition or results of operations. However, the Company is presently involved in a legal proceeding involving among other things, a claim of patent infringement. See "Item 3 - Legal Proceedings" for further discussion. In its distribution agreements, the Company agrees to indemnify its customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. In certain limited instances, the amount of such indemnities may be greater than the revenues the Company may have received from the customer. 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 reasonable commercial terms, if at all. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company's business, financial condition and results of operations would be materially adversely affected. The Company changed its name from Excel Inc. to Excel Switching Corporation in September 1997. Searches performed on the term Excel have revealed several registrations and numerous uses of that term, and terms substantially similar to it, alone and in combination with other terms and designs. Accordingly, there can be no assurance that third parties will not assert trademark infringement claims relating to the name Excel Switching Corporation in the future. EMPLOYEES As of December 31, 1998, the Company employed 365 persons, including 162 in engineering, research and development, 85 in selling, marketing and customer service and support, 64 in manufacturing and 54 in finance, administration and management information systems. None of the Company's employees are represented by collective bargaining arrangements, and the Company believes that its relations with its employees are good. The Company expects to hire additional management, engineering, finance, sales and marketing personnel over the next 12 to 18 months to accommodate planned domestic and international expansion. The hiring of additional personnel will place additional demands on management's ability to assimilate, direct and supervise a growing work force. Accordingly, it is uncertain whether the Company will be successful in assimilating this growth in personnel. The Company's success depends to a significant degree upon the continuing contributions of its key management, sales, engineering, customer support and product development personnel. The loss of any of the key management or technical personnel could have a material adverse effect on the Company. The Company believes that its future success will depend in large part upon its ability to attract and retain highly-skilled managerial, sales, customer support and product development personnel. The Company has at times experienced and continues to experience difficulty in recruiting qualified personnel. Competition for qualified personnel in the Company's industry is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. Failure to attract and retain key personnel could have a material adverse effect on the Company's business, financial condition and results of operations. ITEM 2. PROPERTIES The Company's headquarters total approximately 128,000 square feet and are located in four buildings in Hyannis, Massachusetts. All of the buildings are owned by the Company and house the engineering, sales, marketing, administrative and manufacturing functions of the Company. During 1998, the Company initiated construction of an addition to connect two existing buildings, expected to be completed in 1999, which will add approximately 58,000 square feet of space for engineering and manufacturing activities. 10 The Company also leases sales and support offices in San Jose and San Diego, California; Atlanta, Georgia; Rolling Meadows, Illinois; Newton, Massachusetts; Cleveland, Ohio; and Grapevine, Texas and leases research facilities in Concord, New Hampshire and Paramus, New Jersey. In addition, the Company leases sales and support offices in Brussels, Belgium and Tokyo, Japan. The Company intends to expand the capabilities and size of these offices and open additional offices, both domestically and internationally, as needs arise. Although the Company anticipates that it will not require additional manufacturing space for at least the next 12 months, the Company's business, financial condition and results of operations could be materially adversely affected if it does not expand manufacturing capacity as required. The Company believes that its current facilities and planned expansions are adequate to meet its needs through the next 12 months. However, due to the limited supply of suitable additional or alternative office and manufacturing space in the Hyannis, Massachusetts area, there can be no assurance that the Company will not be required in the future to invest heavily in the renovation of space in the Hyannis vicinity or in relocating the Company's headquarters. ITEM 3. LEGAL PROCEEDINGS In 1998, the Company filed suit in the U.S. District Court for the District of Massachusetts alleging certain of Summa Four, Inc.'s ("Summa Four") telecommunication equipment infringes three patents owned by the Company and seeking a finding of infringement of each of the three patents, an injunction against further infringement, and damages. Summa Four filed a counterclaim asserting the breach of a certain confidentiality agreement, and seeking unspecified damages. The Company filed an answer denying the allegation of breach of the confidentiality agreement and raising several defenses to the claims raised in the counterclaim. On March 17, 1999, Summa served additional counterclaims alleging that certain of the Company's telecommunication equipment infringes a patent owned by Summa Four and seeking an injunction against further infringement and unspecified damages. The additional counterclaims further allege fraud, breach of duty of good faith and fair dealing, intentional misrepresentation and/or inducement, and unfair competition, and seek unspecified damages. The Company expects to file an answer denying the additional counterclaims and raise several defenses to the additional counterclaims. On March 20, 1999, the Court substituted Cisco Systems, Inc. ("Cisco") for Summa Four as defendant and counterclaimant, as a result of Cisco's acquisition of Summa Four. The case remains in the early stages of litigation and although the Company believes that the claims are without merit and intends to vigorously defend against such claims, there can be no assurance that this litigation will ultimately be resolved on terms that are favorable to the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. 11 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION - The Company's Common Stock is quoted on the Nasdaq National Market under the symbol "XLSW". The following table sets forth the quarterly high and low sale prices per share of Common Stock since the Company's initial public offering on November 4, 1997, as reported by the Nasdaq National Market.
Fiscal Year Ended December 31, 1998 High Low - ----------------------------------- ---- ---- First Quarter $25.75 $16.25 Second Quarter 27.00 18.00 Third Quarter 27.88 16.00 Fourth Quarter 38.88 16.75 Fiscal Year Ended December 27, 1997 Fourth Quarter (from November 4, 1997) $27.88 $14.25
NUMBER OF HOLDERS - As of March 22, 1999, there were approximately 130 holders of record of the Company's Common Stock, including multiple beneficial holders at depositories, banks and brokers listed as a single holder in the street name of each respective depository, bank or broker. The Company believes there are over 400 beneficial owners of its Common Stock. DIVIDEND POLICY - The Company does not expect to pay cash dividends on its Common Stock in the foreseeable future. The Company currently intends to retain all of its future earnings, if any, for use in the operation of the business. In addition, the Company's credit facility restricts the Company's payment of cash dividends. USE OF PROCEEDS OF INITIAL PUBLIC OFFERING - On November 4, 1997 the Securities and Exchange Commission declared effective the Company's Registration Statement on Form S-1, Commission file number 333-35791, relating to the initial public offering of the Company's Common Stock, $.01 par value. The offering commenced on November 4, 1997 and all shares covered by the Registration Statement were sold. The following sets forth certain information regarding the Company's application of the net proceeds therefrom through December 31, 1998. Net offering proceeds to the Company $87,106,000 Less: Purchases of property and equipment 11,053,000 Payments on long-term obligations 4,213,000 Payments related to acquisitions 9,419,000 Payments related to payroll 6,697,000 Interest payments on debt obligations 212,000 Payments related to vendor purchases or taxes 18,942,000 Payment relating to customer's note receivable 5,000,000 ------------ Remaining offering proceeds, December 31, 1998 $31,570,000 ------------- -------------
The Company has invested the net proceeds from the initial public offering in November 1997 in investment grade, interest-bearing securities. None of the net proceeds from the IPO were used to pay, directly or indirectly, directors, officers, persons owning ten percent or more of the Company's equity securities, or affiliates of the Company. 12 ITEM 6. SELECTED FINANCIAL DATA The following table contains certain selected consolidated financial data of the Company and is qualified in its entirety by the more detailed Consolidated Financial Statements included herein. This data should be read in conjunction with "Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations" and the Consolidated Financial Statements appearing elsewhere herein.
FISCAL YEAR 1994 1995 1996 1997 1998 --------- --------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) CONSOLIDATED STATEMENTS OF INCOME DATA: Revenues ...................................................... $ 20,723 $ 36,161 $ 62,050 $ 88,727 $ 123,258 Cost of ....................................................... 7,074 12,100 24,312 26,631 35,603 --------- --------- --------- --------- --------- revenues Gross profit ............................................ 13,649 24,061 37,738 62,096 87,655 --------- --------- --------- --------- --------- Operating expenses: Engineering, research and development ..................... 3,301 8,117 11,121 13,260 22,679 Selling and marketing ..................................... 362 2,923 6,621 11,486 15,906 General and administrative ................................ 2,903 4,238 6,426 7,949 11,069 Acquired in-process research and development -- -- -- -- 7,459 --------- --------- --------- --------- --------- Total operating expenses ............................. 6,566 15,278 24,168 32,695 57,113 --------- --------- --------- --------- --------- Income from operations ............................... 7,083 8,783 13,570 29,401 30,542 Other income (expense) ....................................... (4) 38 (384) 1,392 6,127 --------- --------- --------- --------- -------- Income before provision for income taxes ............. 7,079 8,821 13,186 30,793 36,669 Provision for income taxes .................................... 2,889 3,410 5,285 12,177 14,979 --------- --------- --------- --------- --------- Net income .................................................... $ 4,190 $ 5,411 $ 7,901 $ 18,616 $ 21,690 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Basic earnings per share ...................................... $ .15 $ .19 $ .65 $ .28 $ .65 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Diluted earnings per share .................................... $ .13 $ .17 $ .24 $ .54 $ .55 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Basic weighted average shares outstanding ..................... 27,946 27,962 28,090 28,756 33,216 Diluted weighted average shares outstanding ................... 31,341 31,822 32,697 34,361 39,242
DEC. 31, DEC. 31, DEC. 28, DEC. 27, DEC. 31, 1994 1995 1996 1997 1998 --------- --------- --------- --------- --------- (IN THOUSANDS) CONSOLIDATED BALANCE SHEET DATA: Working capital ............................................... $ 5,906 $ 10,238 $ 14,960 $ 116,374 $ 131,403 Total assets .................................................. 9,973 22,683 34,772 149,694 198,782 Long-term obligations, less current maturities ................ -- 3,537 3,837 108 4,858 Total stockholders' equity .................................... 6,471 12,125 20,086 125,915 161,441
13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH "ITEM 1. BUSINESS", "ITEM 6. SELECTED FINANCIAL DATA", "ITEM. 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK", THE COMPANY'S CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO AND THE INFORMATION DESCRIBED UNDER THE CAPTION "RISK FACTORS" BELOW. OVERVIEW Excel Switching Corporation has been profitable since it was founded in 1988 and has financed its operations principally through cash generated from operations as well as proceeds from its initial public offering in November 1997. The Company has experienced significant revenue growth resulting from increased acceptance of programmable switching as a means of addressing the enhanced services and wireless and wireline infrastructure needs of network providers. During the early years of the Company's operations, revenues from one customer represented substantially all of the Company's annual revenues. The Company has since continued to penetrate new markets and broaden its customer base, establishing customer relationships with other application developers, OEMs, systems integrators and network service providers. With an emphasis on product development, the Company has continued to improve the capacity, functionality and features of its switching products. On September 30, 1998, the Company acquired all the outstanding capital stock of XNT Systems, Inc. and Quantum Telecom Solutions, Inc, both former Excel customers. These transactions have been accounted for as purchases and, accordingly, Excel's results of operations include the results for these two entities only for periods subsequent to the date of acquisition. Prior to the acquisition, XNT supplied network service providers with intelligent switch control and comprehensive call-processing and control software applications that managed the underlying Excel switch platform. This acquisition enhanced Excel's ability to offer network service providers a turnkey infrastructure switching solution. Prior to the acquisition, Quantum provided its customers with software to configure and manage Excel switching platforms for use in networks. Both of these acquisitions provided Excel with switch-related technology and applications that increased both the functionality and the ease of programmability of the Excel switching platforms. Effective December 31, 1998, XNT and Quantum were merged into the Company and are no longer incorporated entities. During 1998, Excel sold its products to more than 150 customers engaged in a variety of areas of the global telecommunications industry. Through December 31, 1998, the majority of the Company's revenues have been derived from sales to application developers, OEMs and systems integrators. The Company's products are sold through its direct sales force primarily to application developers, OEMs and systems integrators, which incorporate the Company's products into their service and product offerings. In addition, the Company's products are sold directly to end-users, particularly network service providers. The Company sells each of its switching platforms with a varying combination of network interface line cards and service resource cards that are specified by customer and application requirements. The Company also sells additional network interface line cards and service resource cards that allow customers to expand capacity and functionality and provide for redundancy of their installed systems. Revenue is generally recognized when all significant contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. Revenue from product sales is recognized at the time of delivery and acceptance, and after consideration of all the terms and conditions of the customer contract. Revenue from providing services and post-sale support is recognized at the time of performance. The Company provides for anticipated product returns and warranty costs at the time of revenue recognition. In addition, the Company adjusts reserves for the realizability of accounts receivable and inventory. While the Company believes its estimates for post-sale support, warranty costs, sales returns and the realizability of accounts receivable and inventory are adequate, actual results could differ from those estimates. Revenues from sales of software development tools and services such as technical support, training and product maintenance have not been significant to date. The Company has not capitalized any software development costs and all research and development costs have been expensed as incurred. 14 The Company determines its requirements for its accrual for sales returns and allowances based upon a number of factors including the Company's historical sales credit activity, anticipated concessions on current sales, estimated product failures and sales trends. The accrual for sales returns and allowances was approximately $1.2 million, $4.4 million and $4.7 million at the end of fiscal years 1996, 1997 and 1998, respectively. The increase in the accrual for sales returns and allowances can be attributed to the volume increase in sales, the timing and significance of new product introductions and the increased complexity of the uses of the Company's equipment. During the first quarter of 1997, the amount of credits issued increased significantly, primarily as a result of the introduction of the EXS switching system and related technology. As a result of this increase in credit activity and in light of increasing sales volumes, management estimated that future claim volumes would be similar. During 1997, the provision for sales returns and allowances as a percentage of revenue averaged approximately 5.7%. In subsequent periods, as actual credits materialized at a lower than expected volume, the sales credit provision as a percentage of revenue declined. During 1998, this provision averaged 2.9% of revenues. Management does not anticipate a significant change in its requirements for its accrual for sales returns and allowances in the near term. However, new product introductions, sales trends and other activity will continue to influence management's estimates for such requirements. The Company's profitability is influenced by a number of factors, including pricing, cost of materials, product and technological advancements from research and development efforts and the expansion of its operations. The Company anticipates the addition of personnel and related infrastructure as it seeks to increase revenues, and to meet other strategic goals such as developing new products and technologies, broadening strategic partnerships with, and incorporating new applications for, its customers, entering new markets and expanding internationally. The Company anticipates that engineering, research and development expenses will increase in absolute dollars, and may increase as a percentage of revenues, as the Company pursues engineering efforts to provide enhanced functionality to its products, increase port capacity and develop additional software features. The Company also anticipates that selling and marketing expenses will increase in a similar fashion as the Company enters new markets and expands internationally. During 1998, the Company elected to change its fiscal year-end from the last Saturday in December to December 31 to better synchronize its fiscal periods with the majority of its customers and suppliers. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the percentage of revenues represented by certain items reflected in the Company's Consolidated Statements of Income:
FISCAL YEAR 1996 1997 1998 ------ ------ ------ Revenues ......................................................... 100.0% 100.0% 100.0% Cost of revenues ................................................. 39.2 30.0 28.9 ----- ------ ------ Gross profit ................................................ 60.8 70.0 71.1 ------ ------ ------ Operating Expenses: Engineering, research and development ....................... 17.9 14.9 18.4 Selling and marketing ....................................... 10.7 13.0 12.9 General and administrative .................................. 10.3 9.0 9.0 Acquired in-process research and development ................. -- -- 6.0 ------ ------ ------ Total operating expenses ......................................... 38.9 36.9 46.3 ------ ------ ------ Income from operations ........................................... 21.9 33.1 24.8 Other income (expense) ........................................... (.6) 1.6 5.0 ------ ------ ------ Income before provision for income taxes ......................... 21.3 34.7 29.8 Provision for income taxes ....................................... 8.5 13.7 12.2 ------ ------ ------ Net income ....................................................... 12.8% 21.0% 17.6% ------ ------ ------ ------ ------ ------
15 FISCAL YEAR ENDED DECEMBER 31, 1998 COMPARED TO FISCAL YEAR ENDED DECEMBER 27, 1997 REVENUES. The Company's revenues consist of sales, primarily in the United States, of its open, programmable switching platforms and related network interface line cards and service resource cards. Revenues increased 38.9% from $88.7 million in 1997 to $123.3 million for 1998. The Company believes that the increase resulted from a number of factors. The Company's efforts to enhance the scalability, performance, capacity and functionality of its products has contributed to an increased interest in Excel's programmable switching platforms as a means of addressing the evolving needs of the telecommunications industry. This includes enhancements in the areas of switch management, PPL and SS7 as well as in infrastructure solution offerings. Over the past several years, the Company's customer base has also broadened, resulting in increased sales from a larger number of sources. The introduction of new or enhanced offerings by this growing customer base as well as the expansion of their markets resulted in an increased demand for Excel's products. Excel also increased its efforts to provide customers with assistance in designing, planning and testing new customer applications. The Company expanded or established relationships with a growing number of network service providers, resulting in an increased amount of direct sales to end-users. Revenues also benefited by the expansion of the selling and marketing organizations, including the establishment of two international sales organizations. Revenues from the Company's five largest customers represented approximately 50.9% and 45.0% of the Company's revenues for 1997 and 1998, respectively. QUALCOMM Incorporated represented approximately 10.2% and 19.6% of the Company's revenues for these same periods, respectively. Additionally, 26.0% of the Company's revenues in 1997 were derived from Comverse Network Systems. No other customer represented greater than 10% of the Company's revenues for these periods. The Company anticipates that revenues in 1999 from Qualcomm may decrease from the previous two fiscal years on both an absolute dollar and percentage of sales basis. Although the Company's largest customers have varied from period to period, the Company believes that revenues derived from current and potential large customers will continue to represent a significant proportion of revenues, and that its results of operations in any given period will continue to depend to a significant extent upon sales to a limited number of customers. The volume level of future purchases, if any, by the Company's principal customers cannot be estimated based upon historical purchasing trends. Revenues from the Company's largest customers may significantly fluctuate period to period on both an absolute dollar basis and as a percentage of sales. GROSS PROFIT. Cost of revenues consists primarily of the cost of purchased components and subassemblies, contract manufacturing costs, labor and overhead relating to material procurement, final assembly, testing and quality control, and warranty and post-sale support costs. Cost of revenues increased 33.7% from $26.6 million in 1997 to $35.6 million for 1998. Gross margin increased from 70.0% in 1997 to 71.1% in 1998. The increase in gross margin was primarily attributable to lower component prices, changes in the product mix, particularly in the number of line and resource cards shipped, and increased manufacturing efficiencies as the Company increased its production volume in 1998. ENGINEERING, RESEARCH AND DEVELOPMENT. Engineering, research and development costs consist primarily of compensation and benefit related costs of engineering and development personnel, materials and supplies consumed in prototype development, related facility costs and depreciation of engineering and test equipment. All research and development costs, including software development costs, have been expensed as incurred. Engineering, research and development costs increased 71.0% from $13.3 million in 1997 to $22.7 million for 1998. As a percentage of revenues, these costs were 14.9% and 18.4%, respectively, in such periods. The increase in engineering, research and development costs in absolute dollars was primarily attributable to an increase in engineering and research personnel and, to a lesser extent, by increases in the consumption of prototype supplies and materials. Engineering and research personnel increased from 98 employees at the end of 1997 to 162 employees at the end of 1998. SELLING AND MARKETING. Selling and marketing costs consist primarily of compensation and benefit related costs for sales, marketing and customer support personnel, travel, advertising, trade show and other promotional activities and related facility costs. Selling and marketing costs increased 38.5% from $11.5 million in 1997 to $15.9 million for 1998. As a percentage of revenues, these costs were 13.0% and 12.9%, respectively, in such periods. The increase in selling and marketing costs in absolute dollars was primarily attributable to an increase in sales, marketing and customer support personnel. In addition, increases during 1998 in trade show and promotional activities as well as facility related costs contributed to the overall increase in selling and marketing activities. Sales, marketing and customer support personnel increased from 69 employees at the end of 1997 to 85 employees at the end of 1998. 16 GENERAL AND ADMINISTRATIVE. General and administrative costs include compensation and benefit related costs of management, finance, management information systems and administrative personnel, professional services, costs to maintain manufacturing and management information systems and other general corporate expenses. General and administrative costs increased 39.3% from $7.9 million in 1997 to $11.1 million for 1998. As a percentage of revenues, these costs were 9.0% in both periods. The increase in general and administrative costs in absolute dollars was primarily attributable to an increase in professional fees associated with recruiting activities and legal and accounting activities, including those related to acquisition investigations, international expansion and litigation. In addition, increases in administrative, finance and information technology personnel contributed to the overall general and administrative costs. General and administrative personnel increased from 44 employees at the end of 1997 to 54 employees at the end of 1998. ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT. In connection with the purchase of XNT in the fourth quarter of 1998, the Company allocated approximately $3.5 million of the $8.8 million purchase price to in-process research and development projects. In connection with the purchase of Quantum, also in the fourth quarter of 1998, the Company allocated approximately $4.0 million of the $8.9 million purchase price to in-process research and development projects. These allocations represent the estimated fair value related to the incomplete research and development projects. The estimated fair values were determined by an independent third party appraisal based upon risk-adjusted cash flow methodologies. These costs were expensed as non-recurring charges to operations as of the acquisition dates as the projects had not yet reached technological feasibility and had no alternative future use. XNT's primary projects in progress at the time of acquisition involved designing a technology and application platform for a next-generation ADS, XNT's core switch-control and call-processing control system. Overall, these projects were approximately 70% complete at the time of acquisition. The estimated revenues for the in-process technologies assumed compound annual growth rates of 60% in the five years following introduction, assuming the successful completion and market acceptance of the major research and development projects. These estimated revenues are expected to peak within five years of acquisition and then decline sharply as other new products and technologies enter the market. The cost of remaining efforts to complete the projects is estimated at approximately $583,000. It is expected that the remaining development work will be completed by the end of the third quarter of 1999. Quantum's critical in-process projects related to the SwitchKit toolkit which is a core switch control and application development toolkit. Overall, these projects were approximately 55% complete at the time of acquisition. The estimated revenues for the in-process technologies assumed compound annual growth rates of 32% in the three years following introduction, assuming the successful completion and market acceptance of the major research and development projects. These estimated revenues are expected to peak within three years of acquisition and then decline sharply as other new products and technologies enter the market. The cost of remaining efforts to complete the projects are estimated at approximately $1.2 million. It is expected that the remaining development work will be completed by the end of the second quarter of 1999. The nature of the efforts required to develop the acquired in-process technology into commercially viable products principally relate to the completion of all planning, designing and testing activities necessary to establish that the product can be produced to meet its design requirements including functionality, features and technical performance requirements. Although the Company currently expects that the acquired in-process technology will be successfully developed, it is possible that commercial or technical viability of these products will not be achieved. Furthermore, future developments in the telecommunications industry, changes in programmable switching technology, changes in other product offerings, changes in technology requirements of telecom service providers or other developments may cause the Company to alter or abandon these plans. The value assigned to acquired in-process technology was determined by estimating the completion percentage of research and development efforts at the acquisition date, forecasting risk-adjusted revenues considering the completion percentage, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present values. The completion percentages were estimated based on cost incurred to date, the importance of the completed development tasks and the elapsed portion of the total project time. The revenue projection used to value the in-process research and development is based upon management's estimate of the software component contributions of the 17 respective software technologies intended to be integrated with the Excel switching products. Net cash flow estimates include selling, marketing and general administrative expenses as well as research and development expenses. Operating expenses were estimated based on historical results and management's estimates regarding possible profit margin improvements. Due to purchasing power increases and general economies of scale, estimated operating expenses as a percentage of revenues were expected to decrease within two years following the acquisition. In addition, net cash flow estimates were adjusted to allow for fair return on working capital and fixed assets, charges for core technology leverage and a return on goodwill and other intangibles. An appropriate risk-adjusted discount rate was selected to discount the net cash flows back to their present value. The discount rates selected for developed and in-process technology were 15% and 20%, respectively. These rates were calculated based upon an estimate of the cost of capital and the required rates of returns typical for companies at a similar stage of development. In the selection of these discount rates, consideration was given to the Weighted Average Cost of Capital ("WACC"), which was determined, in part, by using the Capital Asset Pricing Model. The discount rate utilized for the in-process technology was higher than Excel's WACC due to the risk of realizing cash flows from products that had yet to reach technological feasibility. The remaining identified intangibles will be amortized on a straight-line basis over four to ten years based upon the expected useful lives of developed technologies, retention of workforce and other intangible assets. If these projects are not developed, the Company may not realize the value assigned to the in-process research and development projects. In addition, the value of other acquired intangible assets may also become impaired. OTHER INCOME (EXPENSE). Other income (expense), which primarily includes interest income and interest expense, increased from $1.4 million in 1997 to $6.1 million in 1998. This increase was primarily derived from a larger average balance of invested cash and securities during 1998. PROVISION FOR INCOME TAXES. The Company's effective rate for Federal and state income taxes was 39.5% and 40.8% for 1997 and 1998, respectively. The increase in the overall effective rate is primarily attributable to the effect of non-deductible goodwill and acquired in-process research and development related to the acquisition of XNT, offset by a decrease in the effective state income tax rate and the utilization of certain tax credits. FISCAL YEAR ENDED DECEMBER 27, 1997 COMPARED TO FISCAL YEAR ENDED DECEMBER 28, 1996 REVENUES. Revenues increased 43.0% from $62.1 million in 1996 to $88.7 million for 1997. The increase resulted, in part, from the Company's continuing efforts to enhance the scalability, performance, capacity and functionality of its products through the modification and introduction of features and products. The increase in revenues also resulted from the introduction of new or expanded offerings by existing customers incorporating the Company's products, the expansion of customers' existing markets and the introduction of new applications by new and existing customers. In addition, revenues increased due to increased market penetration resulting from the efforts of the Company's expanded selling and marketing organizations. Revenues from the Company's five largest customers represented approximately 57.1% and 50.9% of the Company's revenues for 1996 and 1997, respectively. Comverse represented approximately 36.7% and 26.0% of the Company's revenues for these same periods, respectively. Additionally, 10.2% of the Company's revenues in 1997 were derived from Qualcomm. GROSS PROFIT. Cost of revenues increased 9.5% from $24.3 million in 1996 to $26.6 million for 1997. Gross margin increased from 60.8% in 1996 to 70.0% in 1997. The increase in gross margin was primarily attributable to lower component prices, changes in product mix and increased manufacturing efficiencies as the Company increased its production volume in 1997, all of which the Company estimates represents approximately one-half of the gross margin increase from 1996 to 1997. In addition, gross margins for 1996 were negatively impacted by the introduction of the EXS switching system and related technology which resulted in valuation adjustments of certain existing inventory components, which the Company estimates represents the other half of the gross margin increase from 1996 to 1997. ENGINEERING, RESEARCH AND DEVELOPMENT. Engineering, research and development costs increased 19.2% from $11.1 million in 1996 to $13.3 million for 1997. As a percentage of revenues, these costs were 17.9% and 14.9%, respectively, in such periods. The increase in engineering, research and development costs in absolute dollars was 18 primarily attributable to an increase in engineering and research personnel partially offset by decreases in the consumption of prototype supplies and materials. Engineering and research personnel increased from 68 employees at the end of 1996 to 98 employees at the end of 1997. SELLING AND MARKETING. Selling and marketing costs increased 73.5% from $6.6 million in 1996 to $11.5 million for 1997. As a percentage of revenues, these costs were 10.7% and 13.0%, respectively, in such periods. The increase in selling and marketing costs in absolute dollars was primarily attributable to an increase in sales, marketing and customer support personnel and an increase in trade show and promotional activities during 1997. Sales, marketing and customer support personnel increased from 51 employees at the end of 1996 to 69 employees at the end of 1997. GENERAL AND ADMINISTRATIVE. General and administrative costs increased 23.7% from $6.4 million in 1996 to $7.9 million for 1997. As a percentage of revenues, these costs were 10.3% and 9.0%, respectively, in such periods. The increase in general and administrative costs in absolute dollars was primarily attributable to an increase in general and administrative personnel from 35 employees at the end of 1996 to 44 employees at the end of 1997. OTHER INCOME (EXPENSE). Other income (expense) increased from ($384,000) in 1996 to $1.4 million in 1997. This increase was primarily attributable to an increase in interest income derived from larger balances of invested cash and securities. PROVISION FOR INCOME TAXES. The Company's effective rate for Federal and state income taxes was 40.1% and 39.5% for 1996 and 1997, respectively. The decrease in effective rates is primarily attributable to a decrease in the effective state income tax rate and the utilization of certain tax credits. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1998, the Company's principal sources of liquidity consisted of cash, cash equivalents and marketable securities of approximately $118.1 million, working capital of approximately $131.4 million and $15.0 million of funds available under a bank line of credit. During 1996, 1997 and 1998, cash provided by operating activities totaled $7.3 million, $27.2 million and $29.7 million, respectively. The increase in 1997 was primarily attributable to an increase in profitability, accounts payable and accrued expenses. The increase in 1998 was primarily attributable to an $11.6 million tax benefit resulting from the exercise of common stock options. This increase was offset by an $18.1 million increase in accounts receivable. Management believes the increase in accounts receivable at December 31, 1998 is due to a number of factors including: the increase in sales volume in the fourth quarter of 1998 as compared to the same quarter of 1997; the timing of order placements and shipments within the quarter; and an increase in sales to international customers and to network providers and other end-users. Sales to such customers typically require longer payment terms than the Company historically has extended to its established customer base. The Company expects this trend to continue as it seeks to increase revenues and further expand its business internationally and with network service providers. The Company's investing activities consumed $4.1 million, $70.4 million and $12.9 million in 1996, 1997 and 1998, respectively. The increase in 1997 was primarily attributable to the net $67.0 million purchases of marketable securities largely due to the net proceeds received from the Company's initial public offering in November 1997. The decrease in 1998 was primarily attributable to the net proceeds of approximately $11.5 million received from the sale or maturity of marketable securities during 1998 as opposed to the net purchases of $66.9 million in marketable securities in 1997. Other significant contributing factors included: an increase in expenditures totaling approximately $11.0 million related to the acquisition of property and equipment and the construction of a new building; the $7.4 million paid, net of cash received, in connection with the acquisitions of XNT and Quantum; and a payment of $5.0 million made in connection with promissory note issued by a customer. In October 1998, the Company initiated construction of an addition to connect two existing buildings. Construction is scheduled for completion by the end of the third quarter of 1999 at an estimated cost of approximately $7.0 million. Management anticipates that available cash resources will fund this construction. 19 The Company's financing activities provided $48,000 and $87.1 million in 1996 and 1997 and consumed $2.3 million in 1998. During 1997, the Company received net proceeds of approximately $87.1 million from an initial public offering of common stock. During 1998, payments of $4.2 million on long-term debt obligations were offset by proceeds from the exercise of stock options of $1.5 million. In January 1998, the Company repaid all existing bank obligations totaling approximately $3.1 million under a Mortgage and Security Agreement, a promissory note payable and a Real Estate Promissory Note. In September 1998, the Company exercised an option for $875,000 to purchase a building under an existing capital lease arrangement. In connection with the acquisition of XNT and Quantum, the Company paid approximately $7.8 million and issued promissory notes totaling approximately $8.2 million. Such notes bear interest of 10% per annum and are payable at various dates through September 2001. Upon the occurrence of certain events, maturity of principal amounts may be accelerated or decelerated. The Company's unsecured line of credit arrangement with a bank provides up to $15.0 million in credit availability. Borrowings under this agreement bear interest, at the Company's discretion, at either the bank's base rate or the Eurodollar rate plus 1.75%. The agreement requires the Company to comply with certain financial covenants, including a ratio of liabilities to tangible net worth, a ratio of current assets to current liabilities and a minimum profitability covenant. The agreement also restricts the Company's ability to pay cash dividends. The Company was in compliance with these covenants as of December 31, 1998. There were no amounts outstanding under this line of credit during 1997 or 1998. The agreement expires June 30, 1999, however, the Company anticipates entering into a similar new or amended agreement. The Company does not have any other significant capital commitments and believes that available funds and cash generated from operations will be sufficient to meet the Company's working capital requirements for at least the foreseeable future. The Company plans to finance its long-term capital needs with available funds, together with available borrowings and cash flow from operations. To the extent that such funds are insufficient to finance the Company's activities, the Company may have to raise working capital through the issuance of additional equity or debt securities. However, such additional financial alternatives may not be available at such time or on acceptable terms. YEAR 2000 READINESS DISCLOSURE STATEMENT Many currently installed computer systems and software products are designed to accept only two-digit entries in the date code field. As a result, they may have problems properly recognizing 1/1/00 as January 1, 2000. In less than a year, computer systems and/or software used by many companies may need to be upgraded to comply with such "Year 2000" or "Y2K" requirements. Significant uncertainty exists in the software industry concerning the potential effects associated with the Year 2000 issue. In 1997, the Company commenced a program to review the Y2K compliance status of the Company's product offerings and the software and systems used in its internal business processes. Suppliers of the components that make up Excel's products, as well as service providers, are being contacted as part of the Company's Y2K assessment. The Company has integrated Y2K testing into the development process for all of its products. The Company believes that its entire EXS family of products, which includes the EXS, LNX and CSN systems, is generally Y2K compliant. Accordingly, the use or occurrence of dates on or after January 1, 2000 and the occurrence of leap years will not affect the performance of the Company's products with respect to the ability of such products to correctly create, store, process and output information related to such date data. Excel's programmable switches are controlled by a host computer owned and operated generally by a customer or end user, and are typically integrated into telecommunication applications by application developers, original equipment manufacturers and system integrators or other third parties. Excel's switch software is embedded, real time software. By design, date values are rarely used in Excel's products. Excel has thus far reviewed all its EXS products for Year 2000 compliance. The Company found no discrepancies with Y2K or leap year date processing during its internal testing. Excel believes that the PCX product line will also function properly with a host computer using DOS version 6.22 and beyond. This belief is based on an engineering review and internal test results of the PCX product line. In July 1998, Excel received ITAA*2000 certification from ITAA (Information Technology Association of America). ITAA's review examined eleven discrete process areas deemed necessary for a successful Y2K conversion. ITAA's certification indicates that Excel meets the information technology's best software development practices for addressing the Year 2000 issue. Through discussions with suppliers and or reviews of publicly disclosed information, 20 Excel also believes that its primary internal information systems used to support its operations (specifically, its ERP system, individual servers and workstations and common office applications) are Y2K compatible. The Company has also reviewed the product offerings resulting from the acquisitions of XNT and Quantum for Y2K compliance and believes they are generally Y2K compliant. Prior to being acquired by Excel, both XNT and Quantum performed their own Y2K assessment. Quantum's products use a 4-digit date code and, therefore, have no known Y2K problems. Excel received assurances from XNT that XNT's NT-based ADS software from version 5.14.98 forward had passed their internal Y2K testing. The DOS-based ADS software is scheduled for testing in the second quarter of 1999. These products and their related product development processes are currently being integrated into Excel's existing, ITAA-approved process for the development, test and release of enhancements. The Company is in the process of contacting its major customers and critical suppliers of components, equipment and services to determine whether products and services obtained by the Company from such vendors or sold by the customer to third parties are Y2K compliant. The Company's suppliers and customers are under no contractual obligation to provide such information to the Company. The Company intends to continue its efforts to monitor the Y2K compliance of suppliers and major customers. Based on the information available to date, the Company believes it will be able to complete its Y2K compliance review and make modifications, if necessary, prior to the end of 1999. The Company is prioritizing its efforts to focus on Y2K discrepancies that would significantly impact operations. Nevertheless, to the extent the Company is relying on vendors or suppliers to notify Excel or resolve Y2K issues within their own products, the Company may experience delays in implementing such changes. If key systems, or a significant number of systems were to fail as a result of Y2K problems, the Company could incur substantial costs and disruption of its business, which would potentially have a material adverse effect on the Company's business and results of operations. In addition, because the Company purchases many critical components from single or sole-source suppliers, failure of any such supplier to adequately address issues relating to the Y2K problem in its own products or internal systems may have a material adverse effect on the Company's business, financial condition and results of operations. Because a majority of the Company's products are sold through application developers, original equipment manufacturers and system integrators or other third parties, users of the Company's products may experience Y2K problems as a result of the integration of the Company's Y2K compliant products with noncompliant Y2K products of third party suppliers. In certain circumstances, the Company has warranted to customers that the use or occurrence of dates on or after January 1, 2000 will not adversely affect the performance of the Company's products with respect to the ability to create, store, process and output information related to such date data. If any of these customers experience Y2K problems, such customers could assert claims for damages against the Company. To date, the Company has not required a complete and separate budget for investigating and remedying issues related to Y2K compliance of the Company's own products or the software underlying systems used in its internal operations. The costs of Excel's Y2K initiative have been incorporated into existing workloads and budgets within the quality, engineering and information technology departments, and are not expected to be material to the Company's results of operations or financial position. Management will develop a contingency plan in the third quarter of 1999 based upon the results of Excel's supplier and customer readiness reviews. To the extent the Company has not adequately assessed its Y2K compliance, additional or significant Company resources may be spent on investigating and remedying Y2K issues and the expenditure of such resources may have a material adverse effect on the Company's business, financial condition and results of operations in the future. RISK FACTORS THIS REPORT CONTAINS STATEMENTS WHICH MAY BE "FORWARD-LOOKING" STATEMENTS AND ARE SUBJECT TO RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER SIGNIFICANTLY FROM EXPECTATIONS. IN PARTICULAR, STATEMENTS CONTAINED IN "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" WHICH ARE NOT HISTORICAL FACTS, INCLUDING, BUT NOT LIMITED TO, STATEMENTS REGARDING: THE ANTICIPATED ADEQUACY OF CASH RESOURCES TO MEET THE COMPANY'S WORKING CAPITAL REQUIREMENTS; ANTICIPATED REQUIREMENTS FOR THE ACCRUAL FOR SALES RETURNS AND ALLOWANCES; ANTICIPATED PAYMENT TERMS RELATING TO ACCOUNT RECEIVABLES; THE ANTICIPATED PROPORTION OF REVENUES TO BE DERIVED FROM A 21 LIMITED NUMBER OF CUSTOMERS; ANTICIPATED REVENUES FROM QUALCOMM; ANTICIPATED EXPENDITURES AND COMPLETION DATES WITH RESPECT TO RESEARCH AND DEVELOPMENT AND THE EXPANSION OF MARKETING AND SELLING EFFORTS; AND STATEMENTS REGARDING THE COMPANY'S READINESS FOR Y2K MAY CONSTITUTE FORWARD LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE THOSE DISCUSSED BELOW, AS WELL AS THOSE DISCUSSED ELSEWHERE IN THIS REPORT. FLUCTUATIONS IN RESULTS OF OPERATIONS. The Company's results of operations have varied significantly in the past and may vary significantly in the future, on a quarterly and annual basis, as a result of a variety of factors, many of which are outside the Company's control. These factors include, without limitation: (i) the timing and size of orders which are received and can be shipped in any particular period; (ii) the commercial success of the Company's products; (iii) delays in the introduction of products or product enhancements by the Company and the Company's ability to introduce new products and technologies on a timely basis; (iv) the financial stability of the Company's major customers; (v) the timing of new product introductions or announcements by the Company or its competitors; (vi) the availability of adequate supplies of key components and assemblies and the adequacy of third-party manufacturing capabilities; (vii) the seasonality of the placement of customer orders; (viii) the timing and nature of selling and marketing expenses such as tradeshows and advertising campaigns; (ix) the timing of development expenditures and personnel changes; (x) the publication of opinions about the Company and its products, or its competitors or their products, by industry analysts; (xi) customer order deferrals in anticipation of product enhancements or new product offerings by the Company or its competitors; and (xii) customer cancellation of orders and the gain or loss of significant customers, including those due to industry combinations. Moreover, any downturn in general economic conditions could precipitate significant reductions in corporate spending for telecommunications infrastructure, which could result in delays or cancellations of orders for the Company's products. The Company's expense levels are relatively fixed and are based, in significant part, on expectations of future revenues. Consequently, if revenue levels are below expectations, expense levels could be disproportionately high as a percentage of revenues, and the Company's business, financial condition and results of operations would be materially adversely affected. The Company has historically operated with little backlog because the Company generally ships its products within 60 days of acceptance of an order. As a result, revenues in any quarter are substantially dependent on orders booked and shipped in that quarter and on sales by the Company's customers to end users. The Company has experienced significant fluctuations in revenues, expenses and results from operations from quarter to quarter, and such fluctuations are likely to continue. The Company typically receives more product orders and generates greater revenues in the fourth quarter. During the last several years, revenues in the first quarter have typically been lower than those recorded in the preceding fourth quarter. The Company believes that this concentration of order placements in specific quarterly periods is due to customers' buying patterns and budgeting cycles. A significant portion of the Company's revenues have been generated from a limited number of customers and it is difficult to predict the timing of future orders and shipments to these and other customers. The Company anticipates that its results of operations in any given period will continue to depend to a significant extent upon sales to a small number of customers. The Company also believes that the purchase of its products generally involves a significant commitment of a customer's capital resources. Therefore, any downturn in any customer's business could have a material adverse effect on the Company's revenues, business, financial condition and quarterly results of operations. In addition, the Company historically has recognized a large portion of its revenues from sales booked and shipped in the last month of a quarter such that the magnitude of quarterly fluctuations may not become evident until late in, or at the end of, a particular quarter. Because a number of the Company's individual orders are for significant amounts, the failure to ship a significant order in a particular quarter could materially adversely affect revenues and results of operations for such quarter. To the extent that significant sales occur earlier than expected, results of operations for subsequent quarters may be materially adversely affected. Due to these and other factors, the Company's quarterly revenues, expenses and results of operations could vary significantly in the future, and period-to-period comparisons should not be relied upon as indications of future performance. The Company's ability to increase its revenues in future periods, sustain its level of revenues in future periods or sustain its rate of revenue growth on a quarterly or annual basis cannot be assured. Due to all of the foregoing factors, it is possible that in some future quarter, the Company's results of operations will be below the expectations of public market analysts and investors. In such event, the market price of the Company's Common Stock would likely be materially adversely affected. 22 CONCENTRATION OF CUSTOMERS. Approximately 10.2% and 19.6% of the Company's revenues in 1997 and 1998, respectively, were derived from sales to QUALCOMM and approximately 36.7% and 26.0% of the Company's revenues in 1996 and 1997, respectively, were derived from sales to Comverse Network Systems. In 1996, 1997 and 1998, the Company's five largest customers accounted for approximately 57.1%, 50.9% and 45.0%, respectively, of the Company's revenues. Although the Company's largest customers have varied from period to period, the Company anticipates that its results of operations in any given period will continue to depend to a significant extent upon sales to a small number of customers. None of the Company's customers have entered into a long-term supply agreement requiring any of them to purchase a minimum amount of product from the Company. Revenues from the Company's largest customers may significantly fluctuate period to period on both an absolute dollar basis and as a percentage of sales. The Company anticipates that revenues in 1999 from Qualcomm will decrease from the previous two fiscal years on both an absolute dollar and percentage of sales basis. It is unknown whether the Company's principal customers will continue to purchase product from the Company at current levels, if at all, or whether the Company will be able to replace such purchases with sales to other customers. The loss of one or more major customers could have a material adverse effect on the Company's business, financial condition and results of operations. HIGHLY COMPETITIVE MARKET. The market for telecommunications products is highly competitive and subject to rapid technological change. The telecom industry has also been subject to rapid consolidation of equipment suppliers by larger telecom and data network service providers. The Company competes or may compete directly or indirectly with the following categories of companies: (i) other manufacturers of programmable switches such as Cisco Systems, Inc. (primarily through its recent acquisition of Summa Four, Inc.), Redcom Laboratories, Inc. and Harris Corporation; (ii) large, well-established switch and telecommunications equipment manufacturers such as Alcatel Alsthom Compagnie Generale d'Electricite SA, Lucent Technologies Inc., Northern Telecom Limited, Siemens AG and Telefonaktiebolaget LM Ericsson; and (iii) to a lesser degree, systems integrators and application developers whose switches are based on PC card-level products manufactured by companies such as Aculab Inc., Dialogic Corporation and Natural MicroSystems Corporation. In addition, the Company may be subject to competition from several smaller companies that have begun to manufacture programmable switching platforms as well as from emerging data communications equipment manufacturers. Due to the rapidly evolving markets in which the Company competes, additional competitors with significant market presence and financial resources, including large telecommunications equipment manufacturers and computer hardware and software companies, may enter those markets, thereby further intensifying competition. Additionally, one or more of the Company's application developers may begin to develop or market products in competition with the Company. Increased competition could result in price reductions and loss of market share which would materially adversely affect the Company's business, financial condition and results of operations. Many of the Company's current and potential competitors have significantly greater financial, selling and marketing, technical, manufacturing and other resources than the Company. Some of the Company's competitors currently offer financing alternatives to their customers, a service that the Company generally does not provide at this time. The Company is investigating the possibility of establishing a relationship with an independent leasing company to offer a financing alternative to some or all of Excel's customers. It is not certain that the Company will be able to establish such a relationship or offer such financing alternatives in the future. Moreover, the Company's competitors may also foresee the course of market developments more accurately than the Company. Although the Company believes it has certain technological and other advantages over its competitors, realizing and maintaining such advantages will require a continued high level of investment by the Company in research and product development, marketing and customer service and support. It is not certain that the Company will have sufficient resources to continue to make such investments or that the Company will be able to make the technological advances necessary to compete successfully with its existing competitors or with new competitors. YEAR 2000 COMPLIANCE. The Company has implemented a Year 2000 compliance program designed to ensure that the Company's computer systems and applications will function properly beyond 1999. The Company believes that adequate resources have been allocated for this purpose and expects the Company's Year 2000 date conversion programs to be completed on a timely basis. The Company does not expect to incur significant expenditures to address this issue. However, there can be no assurance that the Company will identify all Year 2000 problems in its computer and other systems in advance of their occurrence or that the Company will be able to successfully remedy any problems that are discovered. The expenses of the Company's efforts to address such problems, or the expenses or liabilities to which the Company may become subject as a result of such problems, could have a material adverse effect on the Company's business, results of operations and financial condition. In addition, the revenue stream and financial stability 23 of existing customers may be adversely impacted by Year 2000 problems, which could cause fluctuations in the Company's revenues and operating profitability and which could have a material adverse effect on the Company's business, results of operations and financial condition. DEPENDENCE ON RELATIONSHIPS WITH APPLICATION DEVELOPERS, OEMS AND SYSTEMS INTEGRATORS. The Company sells a majority of its products to, and maintains strategic relationships with, application developers, original equipment manufacturers and systems integrators which incorporate the Company's products into their service and product offerings. As a result, sales of the Company's products are dependent upon the continued market acceptance of the service and product offerings of the Company's customers. Although the Company maintains contractual relationships with a substantial number of its customers, such contracts do not provide for minimum purchase requirements, nor do they contain provisions requiring the exclusive purchase of the Company's products. The development of an application or service for the telecommunications market can involve a substantial amount of time and expense. The delay or failure of a customer's application development program incorporating the Company's products could delay or prevent expected sales of the Company's products. The inability or cessation of customers to integrate the Company's products into their service and product offerings, product development delays by application developers and other customers, lack of market acceptance of the service and product offerings of the Company's customers or a customer's decision to market products manufactured by a competitor of the Company, or the manufacture of such products themselves, would have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, selling through indirect channels may limit the Company's information concerning the volume of products sold by the Company's customers to end users and the Company's contact with its end users. As a result, the Company's ability to forecast revenues accurately (notwithstanding the forecasts of its customers), evaluate end-user satisfaction and recognize emerging end-user requirements may be hindered. DEPENDENCE ON SINGLE AND SOLE SOURCE SUPPLIERS AND THIRD-PARTY MANUFACTURERS. The Company purchases many critical component from single or sole source vendors and relies upon a limited number of independent manufacturers, some of which are small, privately-held companies, to provide certain components and assemblies made to the Company's specifications. In addition, from time to time Company relies upon certain third-party software application vendors to supply certain software applications used with the Company's switching products. The inability to develop alternative sources for these products or to obtain sufficient quantities of these products could result in delays or reductions in product shipments which could materially adversely affect the Company's business, financial condition and results of operations. In the event of a reduction or interruption of supply, a significant amount of time, in some cases as much as three to four months, could be required before the Company would begin receiving adequate supplies from such alternative suppliers. Further, in such event, the Company's business, financial condition and results of operations would be materially adversely affected. In addition, the manufacture of certain of these single or sole source components is extremely complex, and the Company's reliance on the suppliers of these components exposes the Company to potential production difficulties and quality variations, which could negatively impact cost and timely delivery of the Company's products. Certain components and applications are available from only one supplier, for which there is no substitute at this time. If supply of these components should cease, the Company would be required to redesign its products or stop providing such applications with its products. It is not certain that supply problems will not occur or, if such problems do occur, that satisfactory solutions would be available. The Company does not have long-term contracts with its suppliers and therefore it is not certain that these suppliers will continue to be able to produce these components or to meet the Company's requirements. Any significant interruption in the supply, or degradation in the quality, of any such component could have a material adverse effect on the Company's business, financial condition and results of operations. Although the Company generally requires its customers to submit quarterly forecasts of their needs, the Company's customers frequently require rapid delivery after placement of a purchase order. Because the Company does not maintain significant component inventories, a delay in shipment by a supplier could lead to lost sales. Lead times for materials and components may vary significantly and depend on factors such as specific supplier performance, contract terms and general market demand for components. If orders vary from forecasts, the Company may experience excess or inadequate inventory of certain materials and components. While the Company has not experienced shortages and allocations of these components to date, any shortages in the future, including those occasioned by increased sales, could 24 result in delays in fulfillment of customer orders. Such delays, shortages and allocations could have a material adverse effect on the Company's business, financial condition and results of operations. EVOLVING MARKET FOR TELECOMMUNICATIONS SERVICES AND RAPID TECHNOLOGICAL CHANGE. The Company's future success will depend on continued growth in the market for telecommunications services. The global telecommunications marketplace is evolving and it is difficult to predict its potential size or future growth rate. It is not known whether deregulation and continued improvements and expansions of infrastructure will continue to cause this market to grow or that increased regulation will not present barriers to the sales of existing or future products. In addition, telecommunications applications and infrastructure needs may emerge for which the Company's products are not designed. If this market fails to grow or grows more slowly or in a different direction than the Company currently anticipates, the Company's business, financial condition and results of operations could be materially adversely affected. The telecommunications equipment market is also subject to rapid technological change, evolving industry standards and frequent new product introductions and enhancements that may render existing products obsolete. As a result, the Company's position in this market could erode rapidly due to unforeseen changes in product features and functions of competing products. The Company's growth and future results of operations will depend in part on its ability to respond to these changes by enhancing its existing products and developing and introducing, on a timely and cost-effective basis, new products and features to meet or exceed technological advances in the marketplace. The failure of the Company to respond to rapidly changing technologies could have a material adverse effect on the Company's business, financial condition and results of operations. RISKS RELATING TO ACQUISITIONS. During 1998, the Company acquired Quantum Telecom Solutions, Inc. and XNT Systems, Inc. The Company may also, from time to time, pursue the acquisition of other companies, assets, products and technologies although the Company has no present commitments or agreements with respect to any such acquisitions. Acquisitions involve a number of operating risks that could materially adversely affect the Company's results of operations, including the diversion of management's attention to assimilate the operations, products and personnel of the acquired companies, the acquired company's existing customer and support obligations, the amortization of acquired intangible assets and the potential loss of key employees of the acquired companies. Furthermore, acquisitions may involve businesses in which the Company lacks experience. Because management and the Company have limited experience in acquisitions and integrating acquired companies or technologies into its operations, it is not certain that the Company will be able to manage present and future acquisitions successfully, or that the Company will be able to integrate the operations, products or personnel gained through any such acquisitions without a material adverse effect on the Company's business, financial condition and results of operations. CONCENTRATED PRODUCT FAMILY AND RISK OF NEW PRODUCT INTRODUCTIONS. The Company currently derives substantially all of its revenues from its family of open, programmable switching platforms and expects that this concentration will continue in the foreseeable future. As a result, any decrease in the overall level of sales of, or the prices for, open, programmable switching platforms due to product enhancements, introductions or announcements by the Company's competitors, a decline in the demand for open, programmable switches, product obsolescence, price competition, technological change or any other reason could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Company intends to continue to invest in product and technology development, including increasing port capacity and performance, the development of additional related software applications and tools, the improvement of third-party application integration and the continued provision of updated product features and enhancements. The Company may experience difficulties that could delay or prevent the successful development, introduction or marketing of such new products and enhancements. It is not known whether the Company's new products and enhancements will adequately meet the requirements of the marketplace and achieve market acceptance. Announcements of currently planned or other new product offerings by the Company or its competitors may cause customers to defer or cancel the purchase of existing Company products. The Company's inability to develop on a timely basis new products or enhancements to existing products, or the failure of such new products or enhancements to achieve market acceptance, could have a material adverse effect on the Company's business, financial condition and results of operations. 25 The development of new, technologically advanced products is a complex and uncertain process requiring the accurate anticipation of technological and market trends. The introduction of new or enhanced products also requires the Company to manage the transition from older products in order to minimize disruption in customer ordering patterns, avoid excessive levels of older product inventories and ensure that adequate supplies of new products can be delivered to meet anticipated customer demand. It is not certain that the Company will successfully develop, introduce or manage the transition to new products. Furthermore, products such as those offered by the Company may contain undetected or unresolved errors when they are first introduced or as new versions are released. Despite extensive testing by the Company, errors may be found in new products or upgrades after commencement of commercial shipments, resulting in delays in or loss of market acceptance and sales, diversion of development resources, injury to the Company's reputation or increased service and warranty costs, any of which could have a material adverse effect on the Company's business, financial condition and results of operations. MANAGEMENT OF GROWTH, HIRING OF ADDITIONAL PERSONNEL AND DEPENDENCE ON KEY PERSONNEL. The Company has experienced growth in revenues and expansion of its operations which have placed significant demands on the Company's management, engineering staff and facilities. During 1998, the Company completed the acquisitions of two existing corporations and established operations internationally. The Company is also implementing additional financial and management procedures that the Company believes will address increasing demands on resources. However, the Company believes that further improvements in management and operational controls are needed, and will continue to be needed, to manage any future growth. Continued growth will also require the Company to hire more engineering, selling and marketing and administrative personnel, expand customer support capabilities, expand the infrastructure of its international operations, expand management information systems and improve its inventory management practices. The Company has at times experienced, and continues to experience, difficulty in recruiting qualified personnel. Recruiting qualified personnel is an intensely competitive and time-consuming process. It is not certain whether the Company will be able to attract and retain the necessary personnel to accomplish its growth strategies or that it will not experience constraints that will adversely affect its ability to satisfy customer demand in a timely fashion or to support satisfactorily its customers and operations. If the Company's management is unable to manage growth effectively, the Company's business, financial condition and results of operations could be materially adversely affected. While the Company believes its current and planned facilities are adequate to meet its needs through the next 12 months, future growth may require the Company to obtain additional or alternative facilities. Due to the limited supply of suitable additional or alternative office and manufacturing space in the Cape Cod, Massachusetts area, there can be no assurance that such space can be leased or acquired without substantial required renovations. Relocation of any segment of the Company's operations may disrupt business and have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the local permitting and variance procedures for the renovation or construction of buildings in the Cape Cod area is more onerous than found in metropolitan areas. Accordingly, it is not certain that the Company will not be required in the future to devote significant resources to the permitting and renovation of additional facilities or in relocating some or all of the Company's facilities. The Company's success depends to a significant degree upon the continued contributions of its President, Chief Executive Officer and principal stockholder, Robert P. Madonna, and its key management, engineering, selling and marketing and manufacturing personnel, many of whom would be difficult to replace. The Company does not have employment contracts with its key personnel. The loss of the services of any key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly software engineers, could have a material adverse effect on the Company's business, financial condition and results of operations. RISKS ASSOCIATED WITH INTERNATIONAL SALES. In 1997 and 1998, direct sales to customers located outside of the United States accounted for approximately 8% and 11%, respectively, of the Company's revenues in each such period. However, the Company sells a majority of its products to application developers, OEMs and systems integrators located within the United States which market products and services based on the Company's products worldwide. The Company intends to further expand its operations outside the United States and enter additional international markets, which will require significant management attention and financial resources. International sales are subject to a variety of risks, including difficulties in establishing and managing international distribution channels, in servicing and supporting products sold outside the United States and in translating products and related materials into foreign languages. International operations are also subject to difficulties in collecting accounts receivable, staffing and 26 managing personnel and enforcing intellectual property rights. Other factors that can adversely affect international operations include fluctuations in the value of foreign currencies and currency exchange rates, changes in import/export duties and quotas, introduction of tariff or non-tariff barriers and economic or political changes in international markets. Any inability to obtain foreign regulatory approvals on a timely basis could have a material adverse effect on the Company's business, financial condition and results of operations. If the Company's international sales increase, its revenues may also be affected to a greater extent by seasonal fluctuations resulting from lower levels of sales which typically occur during the summer months in Europe and other parts of the world. It is not certain that these factors will not have a material adverse effect on the Company's future international sales and, consequently, on the Company's business, financial condition and results of operations. LENGTH OF SALES CYCLE. The time between the date of initial contact with a potential customer and large-scale commercialization of a new customer application or system based on the Company's products is often lengthy, typically ranging from 12 to 24 months or more, and is subject to delays over which the Company has little or no control, including customers' budgetary constraints, customers' internal acceptance reviews, the success and continued internal support of customers' own development efforts, and the possibility of cancellation of projects by customers. Although the Company attempts to develop its products with the goal of shortening the time to market of its customers' products, the timing of the commercialization of a new customer application or service based on the Company's products is primarily dependent on the success and timing of a customer's own internal development program. Delays can also be caused by late deliveries by other vendors, changes in implementation priorities and slower than anticipated growth in demand for the services that the Company's products support. A delay in, or cancellation of, the sale of the Company's products could have a material adverse effect on the Company's business, financial condition and results of operations and cause the Company's results of operations to vary significantly from quarter to quarter. DEPENDENCE ON PROPRIETARY RIGHTS. The Company's success and its ability to compete are dependent, in part, upon its proprietary rights. The Company relies primarily on a combination of patent, copyright, trademark and trade secret laws, as well as confidentiality procedures and contractual restrictions to establish and protect its proprietary rights. It is not known whether such measures will be adequate to protect the Company's proprietary rights. Further, the Company may be subject to additional risks as it enters into transactions in countries where intellectual property laws are not well developed or are difficult to enforce. Legal protections of the Company's proprietary rights may be ineffective in such countries. Litigation to defend and enforce the Company's intellectual property rights could result in substantial costs and diversion of resources and could have a material adverse effect on the Company's business, financial condition and results of operations, regardless of the final outcome of such litigation. Despite the Company's efforts to safeguard and maintain its proprietary rights both in the United States and abroad, it is not known whether the Company will be successful in doing so or that the steps taken by the Company in this regard will be adequate to deter misappropriation or independent third-party development of the Company's technology or to prevent an unauthorized third party from copying or otherwise obtaining and using the Company's products or technology. There also can be no guarantees that others will not independently develop similar technologies or duplicate any technology developed by the Company. Any such events could have a material adverse effect on the Company's business, financial condition and results of operations. The Company has entered into agreements with a small number of its customers requiring the Company to deposit its source code and, on occasion, manufacturing blueprints, tooling diagrams and production specifications, in escrow with a third party. These escrow agreements typically provide that these customers have a non-exclusive, limited right to use such code and other materials in the event that there is a bankruptcy proceeding by or against the Company, if the Company ceases to conduct business or if the Company defaults on its support obligations. The use of such agreements may increase the likelihood of misappropriation by third parties. As the number of entrants to the Company's markets increases and the functionality of the Company's products increases and overlaps with the products of other companies, the Company may become subject to claims of infringement or misappropriation of the intellectual property rights of others. In its distribution agreements, the Company agrees to indemnify its customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. In certain limited instances, the amount of such indemnities may be greater than the revenues the Company may have received from the customer. There can be no guarantee that third parties will not assert infringement or misappropriation claims against the Company in the future with respect to current 27 or future products. Any claims or litigation, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require the Company to enter into royalty or licensing arrangements. Such royalty or licensing arrangements, if required, may not be available on terms acceptable to the Company, if at all, which could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Company changed its name from Excel Inc. to Excel Switching Corporation in September 1997. Searches performed on the term Excel have revealed several registrations and numerous uses of that term, and terms substantially similar to it, alone and in combination with other terms and designs. Accordingly, there can be no guarantee that third parties will not assert trademark infringement claims relating to the name Excel in the future. 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 United States, the Company's products must comply with various regulations including those promulgated by the Federal Communications Commission and standards established by Underwriters Laboratories and Bell Communications Research. Furthermore, there are regulations and standards imposed by various foreign countries where the Company's products are installed. The failure of the Company's products to comply, or delays in compliance, with the various existing and evolving industry regulations and standards could delay the introduction of the Company's products. Moreover, the enactment by federal, state or foreign governments of new laws or regulations, changes in the interpretation of existing laws or regulations or a reversal of the trend toward deregulation in the telecommunications industry could materially adversely affect the Company's customers, and thereby materially adversely affect the Company's business, financial condition and results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company, in the normal course of business, is subject to the risks associated with fluctuations in interest rates and changes in foreign currency exchange rates. INTEREST AND MARKET RISK. The Company maintains a portfolio of marketable, primarily fixed income, available-for-sale securities of various issuers, types and maturities. The Company has not used derivative financial instruments in its investment portfolio. The Company attempts to limits its exposure to interest rate and credit risk by placing its investments with high-quality financial institutions and has established investment guidelines relative to diversification and maturities designed to maintain safety and liquidation. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates decline. Due in part to these factors, the Company's future investment income may fall short of expectations due to changes in interest rates or the Company may suffer losses in principal if forced to sell securities which have seen a decline in market value due to changes in interest rates. The fair market value of investment securities held at December 31, 1998 was $115.1 million, including unrealized gains of approximately $107,000. 28 The table below provides information about the Company's investment portfolio in debt securities and includes cash flow and related weighted average interest rates by expected maturity periods. The Company's other investments bear interest at variable interest rates and will therefore be affected by changes in market interest rates.
Market Value FY 2000 to Variable DEC. 31, 1998 FY 1999 FY 2004 MATURITY ------------- ------- ------- -------- Investments (in thousands) $97,735 $46,761 $25,648 $25,326 Weighted Average Interest Rate 5.1% 5.4% 5.8% 3.9%
The Company's existing debt obligations are at fixed interest rates and therefore will not be affected by changes in market interest rates. Under the Company's line-of-credit arrangement with a bank, borrowings may bear interest at either the bank's base rate or the Eurodollar rate plus 1.75%. At December 31, 1998, no amounts were outstanding under this line. Any interest which may in the future become payable on the line-of-credit will be based upon variable interest rates and will therefore be affected by changes in market interest rates. FOREIGN CURRENCY RISK. To date, the Company's exposure to foreign currency fluctuations has been minimal. All sales transactions are denominated in US dollars. Letters of credit are utilized when warranted. The Company funds its international operations from US dollar bank accounts on an as-needed basis and, accordingly, does not maintain a significant amount of funds in foreign currencies. Presently, the Company does not hedge foreign currency exposure for its non-US dollar denominated operating expenses as such amounts have not been material in relation to the Company's domestic operating expenses. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and Supplementary Data of the Company are listed under Part IV, Item 14, in this Report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item 10 is hereby incorporated by reference to the information under the headings "Elections of Directors" and "Executive Officers" in the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year ended December 31, 1998. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item 11 is hereby incorporated by reference to the information under the heading "Executive Compensation" and "Options and Stock Plans" in the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year ended December 31, 1998. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is hereby incorporated by reference to the information under the heading "Security Ownership of Certain Beneficial Owners and Management" in the definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year ended December 31, 1998. 29 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 is hereby incorporated by reference to the information under the heading "Certain Transactions", if any, in the Company's definitive proxy statement to be filed by the Company within 120 days after the close of its fiscal year ended December 31, 1998. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report: PAGE (1) Financial Statements Report of Independent Public Accountants F-1 Consolidated Balance Sheets F-2 Consolidated Statements of Income F-3 Consolidated Statements of Stockholders' Equity and Comprehensive Income F-4 Consolidated Statements of Cash Flows F-5 Notes to Consolidated Financial Statements F-6 (2) Financial Statement Schedule Report of Independent Public Accountants Valuation and qualifying accounts Schedule II
30 (3) Listing of Exhibits:
EXHIBIT NO. REFERENCE - ----------- --------- 3.1 Restated Articles of Organization of the Company. A** 3.2 Restated By-laws of the Company. Filed herewith 4.1 Specimen certificate representing the Common Stock. A** 10.1 Amended and Restated 1997 Stock Option Plan (as approved by the Board of Directors Filed on March 22, 1999 and to become effective upon approval of the Stockholders at the herewith 1999 Annual Meeting of Stockholders on May 14, 1999). 10.2 Amended and Restated 1997 Non-Employee Director Stock Option Plan (as approved by Filed the Board of Directors on March. 22, 1999 and to become effective upon approval of herewith the Stockholders at the 1999 Annual Meeting of Stockholders on May 14, 1999). 10.3 1997 Employee Stock Purchase Plan. A** 10.4 Form of Stock Option Agreement of the Company used under Stock Option Program. A** 10.6 Purchase and Resale Agreement dated as of May 27, 1994 between the Company and A** Boston Technology, Inc. 10.7 Credit Agreement and Promissory Note dated as of December 21, 1995 between the A** Company and The First National Bank of Boston, as amended. 21.1 Subsidiaries of the Company Filed herewith 23.2 Consent of Arthur Andersen LLP Filed herewith 27 Financial Data Schedule Filed herewith
A Incorporated by reference to the Company's registration statement on Form S-1 (Registration No. 333-35791). The number set forth herein is the number of the Exhibit in said registration statement. ** In accordance with Rule 12b-32 under the Securities Exchange Act of 1934, as amended, reference is made to the documents previously filed with the Securities and Exchange Commission, which documents are hereby incorporated by reference. (B) REPORTS ON FORM 8-K The Company filed a current report on Form 8-K dated December 14, 1998 reflecting a change in fiscal year from the last Saturday in December to December 31 of each year. 31 SIGNATURES 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. EXCEL SWITCHING CORPORATION Dated: March 31, 1999 By: /S/ ROBERT P. MADONNA --------------------- Robert P. Madonna President, Chief Executive Officer & Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ----- /S/ ROBERT P. MADONNA Director, President, Chief Executive Officer and March 31, 1999 - --------------------- Chairman of the Board (Principal Executive Officer) Robert P. Madonna /S/ STEPHEN S. GALLIKER Vice President, Finance and Administration March 31, 1999 - ----------------------- Stephen S. Galliker and Chief Financial Officer (Principal Financial and Accounting Officer) /S/ CHRISTOPHER STAVROS Director, Vice President, General Counsel March 31, 1999 - ----------------------- Christopher Stavros and Clerk /S/ EDWARD L. BRESLOW Director March 31, 1999 - --------------------- Edward L. Breslow /S/ JOHN LOUGHLIN Director March 31, 1999 - --------------------- John Loughlin
32 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Excel Switching Corporation: We have audited the accompanying consolidated balance sheets of Excel Switching Corporation (a Massachusetts corporation) and subsidiaries as of December 27, 1997 and December 31, 1998, and the related consolidated statements of income, stockholders' equity and comprehensive income and cash flows for each of the three years in the period then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Excel Switching Corporation and subsidiaries as of December 27, 1997 and December 31, 1998, and the results of their operations and their cash flows for each of the three years in the period then ended, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Boston, Massachusetts January 26, 1999 F-1 EXCEL SWITCHING CORPORATION CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data)
ASSETS DECEMBER 27, DECEMBER 31, 1997 1998 CURRENT ASSETS: Cash and cash equivalents $ 47,968 $ 62,517 Marketable securities 66,929 55,579 Accounts receivable, net of reserves of $1,350 and $2,000 in 1997 and 1998, respectively 12,843 30,912 Inventories 4,740 5,404 Prepaid taxes 122 - Deferred tax asset 5,626 7,461 Other current assets 1,298 2,013 ------------- ------------- Total current assets 139,526 163,886 PROPERTY AND EQUIPMENT, NET 10,168 18,438 DEFERRED TAX ASSET - 990 INTANGIBLE ASSETS, NET OF ACCUMULATED AMORTIZATION - 9,702 OTHER ASSETS - 5,766 ------------- ------------- $ 149,694 $ 198,782 ------------- ------------- ------------- ------------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Current maturities of long-term obligations $ 4,213 $ 3,408 Accounts payable 4,177 5,102 Accrued expenses 11,156 16,874 Accrued income taxes 3,606 6,052 Deferred revenue - 1,047 ------------- ------------- Total current liabilities 23,152 32,483 DEFERRED INCOME TAXES 519 - LONG-TERM OBLIGATIONS, LESS CURRENT MATURITIES 108 4,858 COMMITMENTS (Note 13) STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value- Authorized--10,000,000 shares; no shares issued and outstanding - - Common stock, $.01 par value- Authorized--100,000,000 shares Issued and outstanding--32,592,000 and 34,020,043 shares at December 27, 1997 and December 31, 1998, respectively 326 340 Additional paid-in capital 88,134 101,864 Deferred compensation (491) (526) Accumulated other comprehensive income (20) 107 Retained earnings 37,966 59,656 ------------- ------------- Total stockholders' equity 125,915 161,441 ------------- ------------- $ 149,694 $ 198,782 ------------- ------------- ------------- -------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-2 EXCEL SWITCHING CORPORATION CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data)
FISCAL YEAR ENDED DECEMBER 28, DECEMBER 27, DECEMBER 31, 1996 1997 1998 REVENUES $ 62,050 $ 88,727 $ 123,258 COST OF REVENUES 24,312 26,631 35,603 -------------- -------------- -------------- Gross profit 37,738 62,096 87,655 -------------- -------------- -------------- OPERATING EXPENSES: Engineering, research and development 11,121 13,260 22,679 Selling and marketing 6,621 11,486 15,906 General and administrative 6,426 7,949 11,069 Acquired in-process research and development - - 7,459 -------------- -------------- -------------- Total operating expenses 24,168 32,695 57,113 -------------- -------------- -------------- Income from operations 13,570 29,401 30,542 OTHER INCOME (EXPENSE): Interest income and other expense, net 111 1,764 6,422 Interest expense (495) (372) (295) -------------- -------------- -------------- Total other income (expense) (384) 1,392 6,127 -------------- -------------- -------------- Income before provision for income taxes 13,186 30,793 36,669 PROVISION FOR INCOME TAXES 5,285 12,177 14,979 -------------- -------------- -------------- NET INCOME $ 7,901 $ 18,616 $ 21,690 -------------- -------------- -------------- -------------- -------------- -------------- BASIC EARNINGS PER SHARE $ .28 $ .65 $ .65 -------------- -------------- -------------- -------------- -------------- -------------- DILUTED EARNINGS PER SHARE $ .24 $ .54 $ .55 -------------- -------------- -------------- -------------- -------------- -------------- BASIC WEIGHTED AVERAGE SHARES OUTSTANDING 28,090 28,756 33,216 -------------- -------------- -------------- -------------- -------------- -------------- DILUTED WEIGHTED AVERAGE SHARES OUTSTANDING 32,697 34,361 39,242 -------------- -------------- -------------- -------------- -------------- --------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-3 EXCEL SWITCHING CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (in thousands, except share data)
COMMON STOCK ADDITIONAL NUMBER OF $.01 PAR PAID-IN DEFERRED SHARES VALUE CAPITAL COMPENSATION BALANCE, DECEMBER 31, 1995 28,089,600 $ 281 $ 667 $ (272) Compensation expense associated with stock options - - - 73 Forfeiture of stock options with deferred compensation - - (20) 7 Net income - - - - -------------- ------------- -------------- -------------- Comprehensive income - 1996 BALANCE, DECEMBER 28, 1996 28,089,600 281 647 (192) Compensation expense associated with stock options - - 424 (299) Exercise of stock options 2,400 - 2 - Proceeds of initial public offering of common stock, net of approximately $7,394,000 in issuance costs 4,500,000 45 87,061 - Unrealized loss on investments, net of taxes - - - - Net income - - - - -------------- ------------- -------------- -------------- Comprehensive income - 1997 BALANCE, DECEMBER 27, 1997 32,592,000 326 88,134 (491) Compensation expense associated with stock options - - 224 (35) Exercise of stock options 1,407,805 14 1,519 - Issuance of common stock under employee stock purchase plan 20,238 - 361 - Tax benefit from exercise of stock options - - 11,626 - Unrealized gain on investments, net of taxes - - - - Net income - - - - -------------- ------------- -------------- -------------- Comprehensive income - 1998 BALANCE, DECEMBER 31, 1998 34,020,043 $ 340 $ 101,864 $ (526) -------------- ------------- -------------- -------------- -------------- ------------- -------------- --------------
ACCUMULATED OTHER COMPREHENSIVE RETAINED COMPREHENSIVE INCOME EARNINGS TOTAL INCOME BALANCE, DECEMBER 31, 1995 $ - $ 11,449 $ 12,125 $ - Compensation expense associated with stock options - - 73 - Forfeiture of stock options with deferred compensation - - (13) - Net income - 7,901 7,901 7,901 -------------- -------------- -------------- -------------- Comprehensive income - 1996 $ 7,901 -------------- -------------- BALANCE, DECEMBER 28, 1996 - 19,350 20,086 - Compensation expense associated with stock options - - 125 - Exercise of stock options - - 2 - Proceeds of initial public offering of common stock, net of approximately $7,394,000 in issuance costs - - 87,106 - Unrealized loss on investments, net of taxes (20) - (20) (20) Net income - 18,616 18,616 18,616 -------------- -------------- -------------- -------------- Comprehensive income - 1997 $ 18,596 -------------- -------------- BALANCE, DECEMBER 27, 1997 (20) 37,966 125,915 - Compensation expense associated with stock options - - 189 - Exercise of stock options - - 1,533 - Issuance of common stock under employee stock purchase plan - - 361 - Tax benefit from exercise of stock options - - 11,626 - Unrealized gain on investments, net of taxes 127 - 127 127 Net income - 21,690 21,690 21,690 -------------- -------------- -------------- -------------- Comprehensive income - 1998 $ 21,817 -------------- -------------- BALANCE, DECEMBER 31, 1998 $ 107 $ 59,656 $ 161,441 -------------- -------------- -------------- -------------- -------------- --------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-4 EXCEL SWITCHING CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
FISCAL YEAR ENDED ----------------------------------------------------- DECEMBER 27, DECEMBER 28, 1996 1997 DECEMBER 31, 1998 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 7,901 $ 18,616 $ 21,690 Adjustments to reconcile net income to net cash provided by operating activities- Acquired in-process research and development - - 7,459 Depreciation and amortization 1,166 2,259 3,582 Unrealized gain (loss) on investments - (20) 127 Deferred income taxes (3,417) (1,346) (3,788) Deferred revenue - - 996 Compensation expense associated with stock options 60 125 189 Changes in assets and liabilities, net of acquisitions- Accounts receivable (2,020) (2,514) (17,737) Inventories (409) 2,618 (543) Prepaid taxes 401 (122) 122 Other current assets (132) (1,006) (713) Accounts payable (2,473) 2,281 182 Accrued expenses 3,877 5,349 4,361 Accrued income taxes 2,350 959 13,792 ------------- ------------- ------------- Net cash provided by operating activities 7,304 27,199 29,719 ------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment, net (4,053) (3,464) (11,010) Purchases of marketable securities, net - (66,929) 11,350 Change in other assets - - (754) Issuance of note receivable - - (5,000) Cash paid for acquisitions, net of cash acquired - - (7,437) ------------- ------------- -------------- Net cash used in investing activities (4,053) (70,393) (12,851) ------------- ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of long-term obligations 649 460 - Payments on long-term obligations (601) (475) (4,213) Proceeds from the sale of common stock - 87,106 - Proceeds from the exercise of stock options, excluding tax benefit - 2 1,533 Issuance of common stock under employee stock purchase plan - - 361 ------------- ------------- ------------- Net cash provided by (used in) financing activities 48 87,093 (2,319) ------------- ------------- -------------- NET INCREASE IN CASH AND CASH EQUIVALENTS 3,299 43,899 14,549 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 770 4,069 47,968 ------------- ------------- ------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 4,069 $ 47,968 $ 62,517 ------------- ------------- ------------- ------------- ------------- ------------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the year for- Interest $ 490 $ 377 $ 295 ------------- ------------- ------------- ------------- ------------- ------------- Taxes $ 5,951 $ 13,271 $ 4,131 ------------- ------------- ------------- ------------- ------------- ------------- SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Acquisition of property and equipment under capital lease obligations $ 489 $ - $ - ------------- ------------- ------------- ------------- ------------- ------------- During 1998, the Company acquired Quantum Telecom Solutions, Inc. and XNT Systems, Inc., as described in Note 2. These acquisitions are summarized as follows: Fair value of assets acquired, excluding cash $ - $ - $ 18,470 Cash paid, net of cash acquired - - (7,437) ------------- ------------- ------------- Liabilities assumed and promissory notes issued $ - $ - $ 11,033 ------------- ------------- ------------- ------------- ------------- -------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. F-5 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Excel Switching Corporation (the Company) is a leading provider of open switching platforms for telecommunications networks worldwide. The Company develops, manufactures, markets and supports a family of open, programmable, carrier-class switches that address the complex enhanced services and wireless and wireline infrastructure needs of network providers. The Company sells to a variety of customers in the worldwide telecommunications market, including applications developers, original equipment manufacturers (OEMs), system integrators and network service providers. The accompanying consolidated financial statements reflect the application of certain accounting policies as described below and elsewhere in these notes to consolidated financial statements. (a) PRINCIPLES OF CONSOLIDATION These consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany transactions have been eliminated. (b) CHANGE IN FISCAL YEAR-END During 1998, the Company elected to change its fiscal year-end from the last Saturday in December to December 31 to better synchronize its fiscal periods with the majority of its customers and suppliers. In the accompanying consolidated financial statements, 1996 refers to the year ended December 28, 1996; 1997 refers to the year ended December 27, 1997; and 1998 refers to the year ended December 31, 1998. (c) MANAGEMENT ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The market for telecommunications equipment in which the Company operates can be characterized as rapidly changing due to several factors including technological advancements, the introduction of new products and services by the Company and its competitors, and the increasing demands placed on equipment in worldwide telecommunications networks. Significant assets and liabilities with reported amounts based on estimates include accounts receivable, note receivable, inventory and accrued expenses for post sale support costs, warranty costs and sales returns and allowances. While the Company believes its estimates are adequate, actual results could differ from those estimates. F-6 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (d) REVENUE RECOGNITION Revenue is generally recognized when all significant contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. Revenue from product sales is recognized at time of delivery and acceptance, and after consideration of all the terms and conditions of the customer contract. Revenue from providing services and post-sale support are recognized at time of performance. The Company provides for anticipated product returns and warranty costs at the time of revenue recognition. (e) SOURCES OF SUPPLY AND THIRD-PARTY MANUFACTURING RELATIONSHIPS Certain components used in the manufacture of the Company's products are currently available only from single- or sole-source suppliers. In addition, the Company relies on a limited number of third parties to manufacture certain other components and subassemblies. Shortages resulting from a change in arrangements with these suppliers and manufacturers could cause delays in manufacturing and product shipments and possible deferral or cancellation of customer orders. (f) RESEARCH AND DEVELOPMENT AND SOFTWARE DEVELOPMENT COSTS Research and development costs have been charged to operations as incurred. The Company believes its current process for developing software is essentially completed concurrently with the establishment of technological feasibility. Accordingly, no software development costs have been capitalized to date. (g) CONCENTRATIONS OF CREDIT RISK Financial instruments that subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalents, marketable securities, notes receivable and trade accounts receivable. The Company's investments are in financial instruments of high quality. Concentration of credit risk with respect to accounts receivable is limited to customers to whom the Company makes significant sales. Two significant customers accounted for approximately 18% and 15%, respectively, of accounts receivable at December 27, 1997. Another significant customer accounted for approximately 12% of accounts receivable at December 31, 1998 (see Note 12). To control credit risk, the Company performs regular credit evaluations of its customers' financial condition and maintains allowances for potential credit losses. At December 31, 1998, the Company has a $5.0 million note receivable from a customer, secured by a first security interest in all the assets of the customer (see Note 6). F-7 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (h) FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of the Company's cash and cash equivalents, marketable securities, accounts receivable and accounts payable approximate fair value due to the short-term nature of these instruments. The Company has determined that the carrying amount of its note receivable from a customer approximates fair value based on the interest rate on the note and the value of the collateral that secures the note. Based on the borrowing rates currently available to the Company, the carrying amounts of debt issued during 1998 in connection with acquisitions approximate fair value. (i) EARNINGS PER SHARE Basic earnings per share was determined by dividing net income by the weighted average common shares outstanding during the period. Diluted earnings per share was determined by dividing net income by diluted weighted average shares outstanding. Diluted weighted shares outstanding reflects the dilutive effect, if any, of common stock options based on the treasury stock method. The calculations of diluted weighted average shares outstanding exclude 459,800 and 141,600 common stock options in 1997 and 1998, respectively, as their effect would be anti-dilutive. There were no anti-dilutive common stock options in 1996. The calculations of basic and diluted weighted average shares outstanding are as follows (in thousands):
1996 1997 1998 Basic weighted average common shares outstanding 28,090 28,756 33,216 Weighted average common equivalent shares 4,607 5,605 6,026 ------------ ------------ ------------ Diluted weighted average shares outstanding 32,697 34,361 39,242 ------------ ------------ ------------ ------------ ------------ ------------
(j) COMPREHENSIVE INCOME Comprehensive income represents the change in equity of a business enterprise resulting from transactions and other events and circumstances from nonowner sources. For 1997 and 1998, the only difference between comprehensive income and net income relates to unrealized gains and losses on marketable securities, net of the related tax effect. F-8 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (2) ACQUISITIONS On September 30, 1998, the Company acquired all of the outstanding capital stock of Quantum Telecom Solutions, Inc. (Quantum), a New Jersey based provider of switch-configuration software. The total consideration of $8.9 million consisted of approximately $5.4 million of cash plus the issuance of promissory notes totaling $3.5 million. On September 30, 1998, the Company also acquired all of the outstanding capital stock of XNT Systems, Inc.(XNT), a New Hampshire based supplier of intelligent switch control and comprehensive call-processing and control software. The total consideration of $8.8 million consisted of cash payments of approximately $2.3 million plus the issuance of promissory notes totaling $4.7 million and the assumption of certain liabilities of XNT totaling approximately $1.8 million. These acquisitions were accounted for under the purchase method of accounting, and accordingly, the results of operations from the date of acquisition are included in the Company's consolidated statements of income. The fair market value of assets acquired and liabilities assumed was based on an independent appraisal. The portion of the purchase price allocated to in-process research and development was based on a risk-adjusted cash flow appraisal method and represents projects that had not yet reached technological feasibility and had no alternative future use. This portion of the purchase price was expensed upon consummation of the acquisitions. Based on the independent appraisal, the Company has allocated a portion of the purchase price to certain intangible assets. Intangible assets consist of the following at December 31, 1998 (in thousands):
ESTIMATED USEFUL LIFE Developed technology 4 years $ 2,190 Assembled workforce 5 years 350 Goodwill 10 years 7,519 --------------- 10,059 Less--accumulated amortization 357 --------------- $ 9,702 --------------- ---------------
F-9 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) The Company periodically reviews the realizability of its intangible assets and has not recorded any impairment of these assets to date. The following unaudited pro forma summary information presents the combined results of operations of the Company, Quantum and XNT as if the acquisitions had occurred at the beginning of 1997. This unaudited pro forma financial information is presented for informational purposes only and may not be indicative of the results of operations as they would have been if the Company, Quantum and XNT had been a single entity, nor is it necessarily indicative of the results of operations that may be expected in the future. Anticipated efficiencies from the consolidation of the Company, Quantum and XNT and the effects of the acquired in process research and development have been excluded from the amounts presented below (in thousands, except per share data).
1997 1998 Revenues $ 93,474 $ 126,322 Net income 19,494 26,663 Earnings per share -Basic $ 0.68 $ 0.80 -Diluted 0.57 0.68
(3) CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES Cash equivalents are highly liquid investments with original maturities of three months or less. Marketable securities are highly liquid investment grade securities with original maturities of greater than three months. Investments purchased to be held for indefinite periods of time and not intended at the time of purchase to be held-to-maturity are classified as available-for-sale and reported at fair market value. At December 27, 1997 and December 31, 1998, the Company has classified all investments as available-for-sale. The unrealized gain on available-for-sale securities at December 31, 1998 was approximately $107,000, which has been recorded as other comprehensive income in stockholders' equity. During 1996, 1997 and 1998, the Company realized net gains of $0, 55,000 and $3,000, respectively, calculated using the specific identification method. The Company's investments include time deposits, commercial paper, bankers' acceptances and corporate, state municipality and U.S. government debt and equity securities. F-10 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) Cash, cash equivalents and marketable securities consist of the following (in thousands):
1997 1998 Cash and cash equivalents- Cash $ 1,655 $ 2,999 Time deposits 1,459 - Money markets 9,791 12,362 Commercial paper 32,071 38,156 Corporate debt securities - 4,000 Corporate equity securities - 5,000 Bankers' acceptance 2,992 - ------------- ------------- Total cash and cash equivalents $ 47,968 $ 62,517 ------------- ------------- ------------- -------------
1997 1998 Marketable securities- Time deposits $ 2,004 $ - U.S. government and agency debt securities 31,090 505 Municipality debt securities 2,000 27,134 Commercial paper 4,900 4,606 Corporate debt securities 26,935 23,334 ------------- ------------- Total marketable securities $ 66,929 $ 55,579 ------------- ------------- ------------- -------------
The following table summarizes the remaining maturity of the Company's investments in debt securities as of December 31, 1998 (in thousands): One year or less $ 46,761 One to five years 25,648 Variable maturity 25,326 ------------- $ 97,735 (4) INVENTORIES Inventories are valued at the lower of cost (first-in, first-out) or market. Work-in-process and finished goods consist of materials, labor and manufacturing overhead. Inventories at December 27, 1997 and December 31, 1998 consist of the following (in thousands):
1997 1998 Raw materials $ 396 $ 2,566 Work-in-process 3,713 2,030 Finished goods 631 808 ------------ ------------ $ 4,740 $ 5,404 ------------ ------------ ------------ ------------
F-11 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (5) PROPERTY AND EQUIPMENT The Company provides for depreciation and amortization using both straight-line and accelerated methods by charges to operations in amounts that allocate the cost of the assets over their estimated useful lives. Property and equipment consists of the following at December 27, 1997 and December 31, 1998 (in thousands):
ESTIMATED USEFUL 1997 1998 LIVES Test equipment $ 4,015 $ 7,540 2-5 years Buildings 3,991 7,763 40 years Office equipment, furniture and fixtures 3,460 7,064 2-7 years Land 576 1,250 N/A Building improvements 523 528 7-40 years Assets under capital lease 489 489 3 years Construction in progress (Note 13) 1,129 1,037 N/A --------------- --------------- 14,183 25,671 Less--Accumulated depreciation and amortization 4,015 7,233 --------------- --------------- $ 10,168 $ 18,438 --------------- --------------- --------------- ---------------
(6) OTHER ASSETS In October 1998, the Company entered into a promissory note receivable with a customer in the amount of $5.0 million. The note bears interest at the prime rate (7.75% at December 31, 1998) plus 3%. Interest is payable quarterly in arrears. Principal is payable in twelve equal quarterly installments beginning October 2000 through July 2003. Under certain circumstances, as defined, the principal amount may become due upon demand. This note is secured by a first security interest in all the assets of the customer. Revenues derived from this customer in 1998 were not material. F-12 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (7) LONG-TERM OBLIGATIONS Long-term obligations consist of the following at December 27, 1997 and December 31, 1998 (in thousands):
1997 1998 Promissory notes payable--XNT $ - $ 4,702 Promissory notes payable--Quantum - 3,456 Mortgage and Security Agreement 2,386 - Capital lease obligation--building 926 - Real Estate Promissory Note 460 - Promissory note payable to a bank 272 - Other 277 108 ------------ ------------ 4,321 8,266 Less--Current maturities 4,213 3,408 ------------ ------------ $ 108 $ 4,858 ------------ ------------ ------------ ------------
In connection with the 1998 acquisition of XNT (see Note 2), the Company issued promissory notes in the amount of $4.7 million. Interest at a rate of 10% per annum is payable annually in arrears. The notes mature as follows: $1.5 million in September 1999 and $1.6 million each in September 2000 and 2001. Upon the occurrence of certain events, as defined, the maturity of principal amounts outstanding under the notes may be accelerated or decelerated. In connection with the 1998 acquisition of Quantum (see Note 2), the Company issued promissory notes in the amount of $3.5 million. Interest at a rate of 10% per annum is payable quarterly in arrears. The notes mature as follows: $1.8 million in September 1999, $900,000 in March 2000 and $756,000 in September 2000. Upon the occurrence of certain events, as defined, the maturity of principal amounts outstanding under the notes may be accelerated or decelerated. In 1995, the Company entered into a building capital lease obligation that included a purchase option exercisable beginning in August 1998 for $875,000. During 1998, the Company exercised this option. In January 1998, the Company repaid all outstanding obligations under the Mortgage and Security Agreement, a promissory note payable and the Real Estate Promissory Note. Accordingly, all outstanding balances as of December 27, 1997 have been reflected as current liabilities in the accompanying December 27, 1997 consolidated balance sheet. F-13 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) Future maturities of the remaining long-term obligations are as follows (in thousands):
1999 $ 3,408 2000 3,257 2001 1,601 ------------ $ 8,266 ------------ ------------
(8) LINE-OF-CREDIT ARRANGEMENT The Company has an unsecured line-of-credit arrangement with a bank to provide up to $15.0 million in financing. Borrowings under this line bear interest at either the bank's base rate (7.75% at December 31, 1998) or the Eurodollar rate (5.07% at December 31, 1998) plus 1.75%. The Company is required to maintain certain restrictive covenants under this agreement. This agreement expires June 30, 1999. There have been no borrowings outstanding under this agreement in 1997 or 1998. (9) INCOME TAXES Deferred tax assets or liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, as measured by the enacted tax rates expected to be in effect when the differences reverse. The provision for income tax is based on pretax financial income. The components of the provision for income taxes are as follows (in thousands):
1996 1997 1998 Current- Federal $ 6,731 $ 11,249 $ 15,397 State 1,971 2,274 3,370 ------------ ------------ ------------ 8,702 13,523 18,767 ------------ ------------ ------------ Deferred (prepaid)- Federal (2,904) (1,036) (2,294) State (513) (310) (1,494) ------------ ------------ ------------ (3,417) (1,346) (3,788) ------------ ------------ ------------ Total provision $ 5,285 $ 12,177 $ 14,979 ------------ ------------ ------------ ------------ ------------ ------------
F-14 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) A reconciliation of the federal statutory rate to the Company's effective tax rate is as follows:
1996 1997 1998 Income tax provision at federal statutory rate 34 % 35 % 35 % Increase (decrease) in tax resulting from- State tax provision, net of federal benefit 6 5 3 Research and development tax credits - (2) (3) Nondeductible acquired in-process research and development - - 4 Other - 2 2 -------- ------- ------- Effective tax rate 40 % 40 % 41 % -------- ------- ------- -------- ------- -------
The approximate income tax effect of each type of temporary difference composing the net deferred tax asset (current and long-term) at December 27, 1997 and December 31, 1998 is as follows (in thousands):
1997 1998 Difference in inventory accounting method $ (778) $ (512) Nondeductible reserves 2,185 2,544 Nondeductible accruals 3,736 4,023 Depreciation and amortization - 1,392 Credit carryforwards - 869 Other temporary differences (36) 135 ------------ ------------ Net deferred tax asset $ 5,107 $ 8,451 ------------ ------------ ------------ ------------
(10) STOCKHOLDERS' EQUITY (a) COMMON STOCK The Company has authorized 100,000,000 shares of common stock, par value of $.01 per share. At December 31, 1998, there were 13,076,907 shares of common stock reserved for future issuance under the Company's stock plans. In November 1997, the Company completed an initial public offering of 4,500,000 shares of common stock at a per share price of $21. The Company received proceeds of approximately $87.1 million, net of underwriting discounts and commissions and offering expenses of approximately $7.4 million. F-15 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (b) PREFERRED STOCK The Company has 10,000,000 shares of $.01 par value preferred stock authorized. The Board of Directors has the authority to issue such shares in one or more series and to fix the relative rights and preferences without further vote or action by the stockholders. Currently, the Board of Directors has no plans to issue any shares of preferred stock. (11) STOCK OPTION PLANS Stock options are generally exercisable within 10 years of the original date of grant and vest over a period of up to five years from the date of grant. In some instances, options have been granted at exercise prices below the fair market value on the date of grant. The difference, if any, between the fair market value of shares of the Company's common stock and the exercise price of the option is recognized as compensation expense over the vesting term. During 1996, 1997 and 1998, the Company recognized net compensation expense of approximately $60,000, $125,000 and $189,000, respectively. The Company has the following stock option and stock purchase plans: (a) STOCK OPTION PROGRAM The Company has granted nonqualified stock options to purchase shares of its common stock at exercise prices generally determined to be at fair market value by the Company's Board of Directors on the date of grant. In November 1997, this program was terminated. There are 9,472,545 options outstanding under this program as of December 31, 1998. (b) 1997 STOCK OPTION PLAN Under the terms of the 1997 Stock Option Plan (1997 Plan), incentive and nonqualified stock options may be granted to employees and consultants to purchase an aggregate of 3,000,000 shares of common stock. During 1998, the Company granted 1,567,200 options under the 1997 Plan, of which 1,557,800 options were outstanding at December 31, 1998. (c) DIRECTOR OPTION PLAN The Company's Non-Employee Director Stock Option Plan (Director Option Plan) provides for the grant of options to purchase an aggregate 225,000 shares of common stock to nonemployee directors of the Company. Each such director will be granted an option to purchase 30,000 shares upon election to the Board of Directors. In addition, each such director will be automatically granted an option to purchase 15,000 shares in each of the two years following the date such person becomes a director. These options will vest 1/3 on grant date, 1/3 one year from grant date and 1/3 two years from grant date. During 1997 and 1998, the Company granted F-16 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) a total of 120,000 options under the Director Option Plan, of which 100,000 options were outstanding at December 31, 1998. (d) STOCK OPTION ACTIVITY Stock option activity under all option plans for the three years in the period ended December 31, 1998 is as follows:
WEIGHTED AVERAGE NUMBER OF SHARES EXERCISE PRICE Outstanding, December 31, 1995 7,890,840 $ 0.084 Granted 1,997,500 4.250 Forfeited (30,000) 0.333 -------------- ------------- Outstanding, December 28, 1996 9,858,340 0.927 Granted 1,574,100 9.471 Exercised (2,400) 1.000 Forfeited (124,200) 4.035 -------------- ------------- Outstanding, December 27, 1997 11,305,840 2.083 Granted 1,597,200 19.821 Exercised (1,407,805) 1.089 Forfeited (364,890) 8.409 -------------- ------------- Outstanding, December 31, 1998 11,130,345 $ 4.546 -------------- ------------- -------------- -------------
F-17 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) The following table summarizes information about stock options outstanding at December 31, 1998:
WEIGHTED AVERAGE WEIGHTED REMAINING NUMBER AVERAGE RANGE OF EXERCISE PRICES NUMBER OUTSTANDING CONTRACTUAL LIFE EXERCISABLE EXERCISE PRICE $ 0.002 - $0.002 4,814,005 5.2 4,814,005 $ 0.002 0.167 - 0.167 562,770 5.9 471,570 0.167 0.333 - 0.333 1,201,250 6.7 795,050 0.333 1.000 - 2.340 314,000 7.5 114,800 2.333 4.500 - 6.000 1,927,933 7.8 400,373 5.003 7.000 - 10.500 372,927 8.3 61,647 7.351 11.500 - 17.250 314,760 8.8 55,980 14.192 18.000 - 27.000 1,598,000 9.7 54,440 20.986 38.000 - 38.000 24,700 10.0 - - -------------- ------------- ----------- 11,130,345 6,767,865 $ 0.741 -------------- ------------- ----------- -------------- ------------- ----------- Exercisable, December 27, 1997 7,179,990 $ 0.307 ------------- ----------- ------------- ----------- Exercisable, December 28, 1996 6,356,940 $ 0.046 ------------- ----------- ------------- -----------
(e) FAIR VALUE OF STOCK OPTIONS Statement of Financial Accounting Standards (SFAS) No. 123, ACCOUNTING FOR STOCK-BASED Compensation, requires the measurement of the fair value of stock options to be included in the statement of income or disclosed in the notes to financial statements. The Company has determined that it will continue to account for stock-based compensation for employees under Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and elect the disclosure-only alternative under SFAS No. 123. F-18 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) Had compensation cost for the Company's option plans been determined based on the fair value at the grant dates, as prescribed in SFAS No. 123, the Company's net income would have been as follows:
1996 1997 1998 Net income (in thousands)- As reported $ 7,901 $ 18,616 $ 21,690 Pro forma 7,456 16,712 19,157 Diluted earnings per share- As reported $ .24 $ .54 $ .55 Pro forma .23 .49 .50
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants during the applicable period:
1996 1997 1998 Dividend yield - - - Volatility 56.6% 56.6% 70.5% Risk-free interest rate 5.9%-6.8% 5.0%-6.6% 4.5%-5.6% Expected option term 7.5 years 5.0 years 5.0 years Weighted average fair value per share of options granted $ 5.64 $ 5.28 $12.55
(f) 1997 EMPLOYEE STOCK PURCHASE PLAN The 1997 Employee Stock Purchase Plan provides for the sale of up to 400,000 shares of common stock to participating employees semiannually. The purchase price is equal to 85% of the fair market value at either the beginning or the end of the semiannual period, as defined. During 1998, 20,238 shares of common stock were issued under this plan. F-19 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) (12) SEGMENT AND ENTERPRISE-WIDE REPORTING The Company currently operates in one operating segment as a provider of programmable switches. This segment derives its revenues from the sale and support of a family of open, programmable, carrier-class switches that address the complex enhanced services and wireless and wireline infrastructure needs of network providers. The Company derives substantially all of its revenue from the sale and support of one group of similar products and services. Substantially all of the Company's assets are located within the United States. During 1996, 1997 and 1998, the Company derived its revenues from the following geographic regions (in thousands):
1996 1997 1998 United States $ 81,524 $ 81,524 $ 109,493 Other 1,842 7,203 13,765 ------------- ------------- ------------- $ 62,050 $ 88,727 $ 123,258 ------------- ------------- ------------- ------------- ------------- -------------
During 1996, 1997 and 1998, the Company derived a portion of its revenues from sales to single customers that exceeded 10 percent of total revenues, as follows:
1996 1997 1998 Significant customer A * 10% 20% Significant customer B 37% 26% *
*Revenue derived from this customer was less than 10% of the Company's total revenue during the period (13) COMMITMENTS The Company leases certain equipment and office facilities under noncancelable operating leases, which expire at various dates through November 2001. Future minimum lease payments required under these leases at December 31, 1998 are approximately as follows (in thousands):
FISCAL YEAR AMOUNT 1999 $ 1,098 2000 477 2001 367 ------------ $ 1,942 ------------ ------------
F-20 EXCEL SWITCHING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998 (Continued) Total rent expense under these agreements for 1996, 1997 and 1998 was approximately $1.1 million, $1.2 million and $1.1 million, respectively. During 1998, the Company began construction of a $7.0 million building addition. As of December 31, 1998, the Company had incurred approximately $1.0 million of land acquisition and construction costs related to this building addition. (14) EMPLOYEE BENEFIT PLAN The Company has a qualified 401(k) retirement savings plan covering all employees. Under this plan, participants may elect to defer a portion of their compensation, subject to certain limitations. In addition, the Company, at the discretion of the Board of Directors, may make profit sharing contributions into the plan. For fiscal years 1996, 1997 and 1998, the Company made contributions of approximately $534,000, $898,000 and $1,180,000, respectively. (15) ACCRUED EXPENSES Accrued expenses at December 27, 1997 and December 31, 1998 consist of the following (in thousands):
1997 1998 Accrued sales returns and allowances $ 4,397 $ 4,708 Accrued payroll and benefits 2,297 6,889 Accrued post-sales support and warranty 1,690 2,470 Accrued marketing 1,166 703 Accrued professional fees 737 923 Accrued other 869 1,181 ------------ ------------ $ 11,156 $ 16,874 ------------ ------------ ------------ ------------
F-21 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Excel Switching Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of Excel Switching Corporation and subsidiaries included in this Form 10-K and have issued our report thereon dated January 26, 1999. Our audit was made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed in Item 14(a)(2) is the responsibility of the Company's management and is presented for the purpose of complying with Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states, in all material respects, the financial data required to be set forth therein, in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN LLP Boston, Massachusetts January 26, 1999 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
Balance Beginning of Charged to Cost Deductions Balance Period Or Expense (Write-offs) Recoveries End of Period ------ ---------- ------------ ---------- -------------- Allowance for Doubtful Accounts - ----------------------------- 1996 653,000 497,000 (171,000) 0 979,000 1997 979,000 555,000 (184,000) 0 1,350,000 1998 1,350,000 650,000 (0) 0 2,000,000 Accrued Sales Returns and Allowances - ----------------------------- 1996 578,000 3,094,000 (2,429,000) 0 1,243,000 1997 1,243,000 5,053,000 (2,046,000) 147,000 4,397,000 1998 4,397,000 3,623,000 (3,312,000) 0 4,708,000
S-1 EX-3.2 2 EX-99.1 Exhibit 3.2 EXCEL SWITCHING CORPORATION **************** AMENDED AND RESTATED BY-LAWS **************** ARTICLE I Stockholders 1. Annual Meeting. The annual meeting of stockholders shall be held on the second Friday in May of each year (or if that be a legal holiday in the place where the meeting is to be held, on the next succeeding full business day) at 10:00 A.M., or such other time, place and date as may be fixed by the Directors and stated in the notice of the meeting. The purposes for which the annual meeting is to be held, in addition to those prescribed by law, by the Articles of Organization of the corporation (the "Articles of Organization") or by these By-laws, may be specified by the Directors or the President. In the event an annual meeting has not been held on the date fixed in these By-laws, a special meeting in lieu of the annual meeting may be held with all the force and effect of an annual meeting. 2. Special Meetings. Special meetings of stockholders may be called by the President or by the Directors. Upon written application of one or more stockholders who hold at least 10% in interest of the capital stock entitled to vote at a meeting, a special meeting shall be called by the Clerk, or in the case of the death, absence, incapacity or refusal of the Clerk, by another officer. Notwithstanding the immediately preceding sentence, if the corporation has a class of voting stock registered under the Securities Exchange Act of 1934, as amended, upon written application of one or more stockholders who hold at least 40% in interest of the capital stock entitled to vote at a meeting, a special meeting shall be called by the Clerk, or in case of the death, absence, incapacity or refusal of the Clerk, by any other officer. 3. Place of Meetings. All meetings of stockholders shall be held at the principal office of the corporation unless a different place (within or without Massachusetts, but within the United States) is fixed by the Directors or the President and stated in the notice of the meeting. 4. Notice of Meetings. A written notice of the place, date and hour of all meetings of stockholders stating the purpose of the meeting shall be given by the Clerk or an Assistant Clerk or by the person calling the meeting at least seven days before the meeting or such longer period as is required by law to each stockholder entitled to vote thereat and to each stockholder who under the law, under the Articles of Organization or under these By-laws, is entitled to such notice, by leaving such notice with such stockholder or at his or her residence or usual place of business, or by mailing it, postage prepaid, and addressed to such stockholder at his or her address as it appears in the records of the corporation. Whenever notice of a meeting is required to be given a stockholder under any provision of the Massachusetts Business Corporation Law or of the Articles of Organization or these By-laws, a written waiver thereof, executed before or after the meeting by such stockholder or his or her attorney thereunto authorized and filed with the records of the meeting, shall be deemed equivalent to such notice. -2- 5. Notice of Stockholder Business. The following provisions of this Section 5 shall apply to the conduct of business at any meeting of the stockholders. (As used in this Section 5, the term annual meeting shall include a special meeting in lieu of annual meeting.) (a) At any meeting of the stockholders, only such business shall be conducted as shall have been brought before the meeting (i) pursuant to the corporation's notice of meeting, (ii) by or at the direction of the Board of Directors or (iii) by any stockholder of the corporation who is a stockholder of record at the time of giving of the notice provided for in paragraph (b) of this Section 5, who shall be entitled to vote at such meeting and who complies with the notice procedures set forth in paragraph (b) of this Section 5. (b) For business to be properly brought before any meeting of the stockholders by a stockholder pursuant to clause (iii) of paragraph (a) of this By-law, the stockholder must have given timely notice thereof in writing to the Clerk of the corporation. To be timely, a stockholder's notice must be delivered to or mailed and received at the principal executive offices of the corporation (i) in the case of any annual meeting, not less than ninety (90) days nor more than 120 days prior to the date specified in Section 1 above for such annual meeting, regardless of any postponements, deferrals or adjournments of that meeting to a later date; provided, however, that if a special meeting in lieu of annual meeting of stockholders is to be held on a date prior to the date specified in Section 1 above, and if less than seventy (70) days' notice or prior public disclosure of the date of such special meeting in lieu of annual meeting is given or made, notice by the stockholder to be timely must be so delivered or received not later than the close of business on the tenth day following the earlier of the date on which notice of the date of such special meeting in lieu of annual meeting was mailed or the day on which public disclosure was made of the date of such special meeting in lieu of annual meeting; and (ii) in the case of a special meeting (other than a special meeting in lieu of an annual meeting), not later than the tenth day following the earlier of the day on which notice of the date of the scheduled meeting was mailed or the day on which public disclosure was made of the date of the scheduled meeting. A stockholder's notice to the Clerk shall set forth as to each matter the stockholder proposes to bring before the meeting, (i) a brief description of the business desired to be brought before the meeting and the reasons for conducting such business at the meeting, (ii) the name and address, as they appear on the corporation's books, of the stockholder proposing such business, the name and address of the beneficial owner, if any, on whose behalf the proposal is made, and the name and address of any other stockholders or beneficial owners known by such stockholder to be supporting such proposal, (iii) the class and number of shares of the corporation which are owned beneficially and of record by the stockholder proposing such business, by the beneficial owner, if any, on whose behalf the proposal is made, and by any other stockholders or beneficial owners known by such stockholder to be supporting such proposal and (iv) any material interest in such proposed business of the stockholder proposing such business, any material interest in such proposed business of the beneficial owner, if any, on whose behalf the proposal is made, and any material interest of any other stockholders or beneficial owners known by such stockholder to be supporting such proposal in such proposed business, to the extent known by such stockholder. (c) Notwithstanding anything in these By-laws to the contrary, no business shall be conducted at a meeting except in accordance with the procedures set forth in these By-laws. The person presiding at the meeting shall, if the facts warrant, determine that business was not properly brought before the meeting and in accordance with the procedures prescribed by these By-laws, and if he should so determine, he shall so declare at the meeting and any such business not properly brought before the meeting shall not be transacted. Notwithstanding the foregoing provision of this By-law, a stockholder shall also comply with all applicable requirements of the Securities Exchange Act of 1934, as amended -3- (or any successor provision), and the rules and regulations thereunder with respect to the matters set forth in this By-law. (d) This provision shall not prevent the consideration and approval or disapproval at the meeting of reports of officers, Directors and committees of the Board of Directors, but, in connection with such reports, no new business shall be acted upon at such meeting unless properly brought before the meeting as herein provided. 6. Quorum. The holders of a majority in interest of all stock issued, outstanding and entitled to vote at a meeting shall constitute a quorum, but a lesser number may adjourn any meeting from time to time without further notice; except that, if two or more classes of stock are outstanding and entitled to vote as separate classes, then in the case of each such class, a quorum shall consist of the holders of a majority in interest of the stock of that class issued, outstanding and entitled to vote. 7. Voting and Proxies. Each stockholder shall have one vote for each share of stock entitled to vote owned by him or her and a proportionate vote for a fractional share, unless otherwise provided by the Articles of Organization in the case that the corporation has two or more classes or series of stock. Capital stock shall not be voted if any installment of the subscription therefor has been duly demanded in accordance with the law of the Commonwealth of Massachusetts and is overdue and unpaid. Stockholders may vote either in person or by written proxy. Proxies shall be filed with the clerk of the meeting, or of any adjournment thereof, before being voted. No proxy dated more than six months before the date named therein shall be valid and no proxy shall be valid after the final adjournment of such meeting. Notwithstanding the provisions of the preceding sentence, a proxy coupled with an interest sufficient in law to support an irrevocable power, including, without limitation, an interest in shares or in the corporation generally, may be made irrevocable if it so provides, need not specify the meeting to which it relates, and shall be valid and enforceable until the interest terminates, or for such shorter period as may be specified in the proxy. Except as otherwise limited therein, proxies shall entitle the persons named therein to vote at any adjournment of such meeting but shall not be valid after final adjournment of such meeting. A proxy with respect to stock held in the name of two or more persons shall be valid if executed by any one of them unless at or prior to exercise of the proxy the corporation receives a specific written notice to the contrary from any one of them. A proxy purporting to be executed by or on behalf of a stockholder shall be deemed valid unless challenged at or prior to its exercise and the burden of proving invalidity shall rest on the challenger. 8. Action at Meeting. When a quorum is present, the holders of a majority of the stock present or represented and voting on a matter (or if there are two or more classes of stock entitled to vote as separate classes, then in the case of each such class, the holders of a majority of the stock of that class present or represented and voting on a matter), except where a larger or different vote is required by law, the Articles of Organization or these By-laws, shall decide any matter to be voted on by the stockholders. Broker non-votes will be counted for purposes of determining whether a quorum is present on any matter, but will not be counted as having been voted on any matter for which voting authority is withheld. Any election of Directors or officers by the stockholders shall be determined by a plurality of the votes cast by stockholders entitled to vote at the election. Any such elections shall be by ballot if so requested by any stockholder entitled to vote thereon. The corporation shall not directly or indirectly vote any share of its own stock. -4- ARTICLE II Directors 1. Powers. The business of the corporation shall be managed by a Board of Directors who may exercise all the powers of the corporation except as otherwise provided by law, by the Articles of Organization or by these By-laws. In the event of vacancy in the Board of Directors, the remaining Directors, except as otherwise provided by law, may exercise the powers of the full Board until the vacancy is filled. 2. Number, Election and Qualification. A Board of Directors (the "Board") shall be elected by the stockholders at the annual meeting. The number of Directors shall be fixed by the stockholders (except as that number may be enlarged by the Board of Directors acting pursuant to Section 4 of this Article), but shall be not less than three, except that whenever there shall be only two stockholders the number of directors shall be not less than two and whenever there shall be only one stockholder or prior to the issuance of any stock, there shall be at least one director, and shall be not more than nine. 3. Vacancies. Any vacancy in the Board of Directors, however occurring, including a vacancy resulting from the enlargement of the Board, may be filled by the stockholders or, in the absence of stockholder action, by the Directors. Each such successor shall hold office for the unexpired term of his or her predecessor and until his or her successor is chosen and qualified or until his or her earlier death, resignation or removal. 4. Enlargement of the Board. The Board of Directors may be enlarged by the stockholders at any meeting or by vote of a majority of the Directors then in office. 5. Tenure. Except as otherwise provided by law, by the Articles of Organization or by these By-laws, Directors shall hold office until the next annual meeting of stockholders and until their successors are chosen and qualified. Any Director may resign by delivering his or her written resignation to the corporation at its principal office or to the President, Clerk or Secretary. Such resignation shall be effective upon receipt unless it is specified to be effective at some other time or upon the happening of some other event. 6. Removal. A Director may be removed from office (a) with or without cause by the vote of the holders of a majority of the shares entitled to vote in the election of Directors, provided that the Directors of a class elected by a particular class of stockholders may be removed only by the vote of the holders of a majority of the shares of the particular class of stockholders entitled to vote for the election of such Directors; or (b) for cause by vote of a majority of the Directors then in office. A Director may be removed for cause only after a reasonable notice and opportunity to be heard before the body proposing to remove him or her. 7. Meetings. Regular meetings of the Directors may be held without call or notice at such places and at such times as the Directors may from time to time determine, provided that any Director who is absent when such determination is made shall be given notice of the determination. A regular meeting of the Directors may be held without a call or notice at the same place as the annual meeting of stockholders. Special meetings of the Directors may be held at any time and place designated in a call by the President or two or more Directors. 8. Telephone Conference Meetings. Members of the Board of Directors may participate in a meeting of the board by means of a conference telephone or similar communications equipment by -5- means of which all persons participating in the meeting can hear each other at the same time and participation by such means shall constitute presence in person at a meeting. 9. Notice of Meetings. Notice of all special meetings of the Directors shall be given to each Director by the President, Secretary, or Assistant Secretary, or if there is no Secretary or Assistant Secretary, by the Clerk, or Assistant Clerk, or in case of the death, absence, incapacity or refusal of such persons, by the officer or one of the Directors calling the meeting. Notice shall be given to each Director in person or by e-mail or by telephone, telegram or facsimile sent to his or her business or home address at least twenty-four hours in advance of the meeting, or by written notice mailed to his or her business or home address at least forty-eight hours in advance of the meeting. Notice of a meeting need not be given to any Director if a written waiver of notice, executed by such Director before or after the meeting, is filed with the records of the meeting, or to any Director who attends the meeting without protesting prior thereto or at its commencement the lack of notice to him or her. A notice or waiver of notice of a Directors' meeting need not specify the purposes of the meeting. 10. Quorum. At any meeting of the Directors, a majority of the Directors then in office shall constitute a quorum. Less than a quorum may adjourn any meeting from time to time without further notice. 11. Action at Meeting. At any meeting of the Directors at which a quorum is present, a majority of the Directors present may take any action on behalf of the Board except to the extent that a larger number is required by law or the Articles of Organization or these By-laws. 12. Action by Consent. Any action required or permitted to be taken at any meeting of the Directors may be taken without a meeting, if all the Directors consent to the action in writing and the written consents are filed with the records of the meetings of Directors. Such consents shall be treated for all purposes as a vote at a meeting. 13. Committees. The Directors may, by vote of a majority of the Directors then in office, elect from their number an executive or other committees and may by like vote delegate thereto some or all of their powers except those which by law, the Articles of Organization or these By-laws they are prohibited from delegating to such committee. Except as the Directors may otherwise determine, any such committee may make rules for the conduct of its business, but unless otherwise provided by the Directors or in such rules, its business shall be conducted as nearly as may be in the same manner as is provided by these By-laws for the Directors. ARTICLE III Officers 1. Enumeration. The officers of the corporation shall consist of a President, a Treasurer, a Clerk, and such other officers, including a Chairman of the Board of Directors, one or more Vice-Presidents, Assistant Treasurers, Assistant Clerks, Secretary and Assistant Secretaries as the Directors may determine. 2. Election. The President, Treasurer and Clerk shall be elected annually by the Directors at their first meeting following the annual meeting of stockholders. Other officers may be chosen by the Directors at such meeting or at any other meeting. -6- 3. Qualification. The President may, but need not be, a Director. No officer need be a stockholder. Any two or more offices may be held by the same person. The Clerk shall be a resident of Massachusetts unless the corporation has a resident agent appointed for the purpose of service of process. Any officer may be required by the Directors to give bond for the faithful performance of his or her duties to the corporation in such amount and with such sureties as the Directors may determine. 4. Tenure. Except as otherwise provided by law, by the Articles of Organization or by these By-laws, the President, Treasurer and Clerk shall hold office until the first meeting of the Directors following the next annual meeting of stockholders and until their successors are chosen and qualified; and all other officers shall hold office until the first meeting of the Directors following the next annual meeting of stockholders and until their successors are chosen and qualified, unless a shorter term is specified in the vote choosing or appointing them. Any officer may resign by delivering his or her written resignation to the corporation at its principal office or to the President, Clerk or Secretary, and such resignation shall be effective upon receipt unless it is specified to be effective at some other time or upon the happening of some other event. 5. Removal. The Directors may remove any officer with or without cause by vote of a majority of the Directors then in office; provided, that an officer may be removed for cause only after a reasonable notice and opportunity to be heard before the Board of Directors. 6. President, Chairman of the Board, and Vice-President. The President shall, unless otherwise provided by the Directors, be the chief executive officer of the corporation and shall, subject to the direction of the Directors, have general supervision and control of its business. Unless otherwise provided by the Directors he or she shall preside, when present, at all meetings of stockholders and, unless a Chairman of the Board has been elected and is present, of the Directors. If a Chairman of the Board of Directors is elected he or she shall preside at all meetings of the Board of Directors at which he or she is present. The Chairman shall have such other powers as the Directors may from time to time designate. Any Vice-President shall have such powers as the Directors may from time to time designate. 7. Treasurer and Assistant Treasurers. The Treasurer shall, subject to the direction of the Directors, have general charge of the financial affairs of the corporation and shall cause accurate books of account to be kept. He or she shall have custody of all funds, securities, and valuable documents of the corporation, except as the Directors may otherwise provide. Any Assistant Treasurer shall have such powers as the Directors may from time to time designate. 8. Clerk and Assistant Clerks. The Clerk shall record all proceedings of the stockholders in a book to be kept therefor. Unless a transfer agent is appointed, the Clerk shall keep or cause to be kept in Massachusetts, at the principal office of the corporation or at his or her office, the stock and transfer records of the corporation, in which are contained the names of all stockholders and the record address and the amount of stock held by each. In case a Secretary is not elected, the Clerk shall record all proceedings of the Directors in a book to be kept therefor. In the absence of the Clerk from any meeting of the stockholders, an Assistant Clerk, if one be elected, otherwise a Temporary Clerk designated by the person presiding at the meeting, shall perform the duties of the Clerk. Any Assistant Clerk shall have such additional powers as the Directors may from time to time designate. 9. Secretary and Assistant Secretaries. If a Secretary is elected, he or she shall keep a record of the meetings of the Directors and in his or her absence, an Assistant Secretary, if one be elected, otherwise a Temporary Secretary designated by the person presiding at the meeting, shall keep a record -7- of the meetings of the Directors. Any Assistant Secretary shall have such additional powers as the Directors may from time to time designate. 10. Other Powers and Duties. Each officer shall, subject to these By-laws, have in addition to the duties and powers specifically set forth in these By-laws, such duties and powers as are customarily incident to his or her office, and such duties and powers as the Directors may from time to time designate. ARTICLE IV Capital Stock 1. Certificates of Stock. Subject to the provisions of Section 2 below, each stockholder shall be entitled to a certificate of the capital stock of the corporation in such form as may be prescribed from time to time by the Directors. The certificate shall be signed by the President or a Vice-President, and by the Treasurer or an Assistant Treasurer; provided, however, such signatures may be facsimiles if the certificate is signed by a transfer agent, or by a registrar, other than a Director, officer or employee of the corporation. In case any officer who has signed or whose facsimile signature has been placed on such certificate shall have ceased to be such officer before such certificate is issued, it may be issued by the corporation with the same effect as if he or she were such officer at the time of its issue. Every certificate issued for shares of stock at a time when such shares are subject to any restriction on transfer pursuant to the Articles of Organization, these By-laws or any agreement to which the corporation is a party shall have the restriction noted conspicuously on the certificate and shall also set forth on the face or back of the certificate either the full text of the restriction or a statement of the existence of such restriction and a statement that the corporation will furnish a copy thereof to the holder of such certificate upon written request and without charge. Every stock certificate issued by the corporation at a time when it is authorized to issue more than one class or series of stock shall set forth upon the face or back of the certificate either the full text of the preferences, voting powers, qualifications and special and relative rights of the shares of each class and series, if any, authorized to be issued, as set forth in the Articles of Organization, or a statement of the existence of such preferences, powers, qualifications, and rights, and a statement that the corporation will furnish a copy thereof to the holder of such certificate upon written request and without charge. 2. Stockholder Open Accounts. The corporation may maintain or caused to be maintained stockholder open accounts in which may be recorded all stockholders' ownership of stock and all changes therein. Certificates need not be issued for shares so recorded in a stockholder open account unless requested by the stockholder. 3. Transfers. Subject to the restrictions, if any, stated or noted on the stock certificates, shares of stock may be transferred in the records of the corporation by the surrender to the corporation or its transfer agent of the certificate therefor, properly endorsed or accompanied by a written assignment and power of attorney properly executed, with necessary transfer stamps affixed, and with such proof of the authenticity of signature as the corporation or its transfer agent may reasonably require. When such stock certificates are thus properly surrendered to the corporation or its transfer agent, the corporation or transfer agent shall cause the records of the corporation to reflect the transfer of the shares of stock. Except as may be otherwise required by law, by the Articles of Organization or by these By-laws, the corporation shall be entitled to treat the record holder of stock as shown in its records as the owner of such stock for all purposes, including the payment of dividends and the right to vote with respect thereof, -8- regardless of any transfer, pledge or other disposition of such stock, until the shares have been transferred on the books of the corporation in accordance with the requirements of these By-laws. It shall be the duty of each stockholder to notify the corporation of his or her post office address. 4. Record Date. The Directors may fix in advance a time which shall be not more than sixty (60) days before the date of any meeting of stockholders or the date for the payment of any dividend or the making of any distribution to stockholders or the last day on which the consent or dissent of stockholders may be effectively expressed for any purpose, as the record date for determining the stockholders having the right to notice of and to vote at such meeting and any adjournment thereof or the right to receive such dividend or distribution or the right to give such consent or dissent. In such case only stockholders of record on such record date shall have such right, notwithstanding any transfer of stock on the books of the corporation after the record date. Without fixing such record date the Directors may for any of such purposes close the transfer books for all or any part of such period. If no record date is fixed and the transfer books are not closed, the record date for determining stockholders having the right to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, and the record date for determining stockholders for any other purpose shall be at the close of business on the day on which the Board of Directors acts with respect thereto. 5. Replacement of Certificates. In case of the alleged loss, mutilation or destruction of a certificate of stock, a duplicate certificate may be issued in place thereof, upon such terms and conditions as the Directors may prescribe. 6. Issue of Capital Stock. The whole or any part of the then authorized but unissued shares of each class of stock may be issued at any time or from time to time by the Board of Directors without action by the stockholders. 7. Reacquisition of Stock. Shares of stock previously issued which have been reacquired by the corporation, may be restored to the status of authorized but unissued shares by vote of the Board of Directors, without amendment of the Articles of Organization. ARTICLE V Provisions Relative to Directors, Officers, Stockholders and Employees 1. Certain Contracts and Transactions. In the absence of fraud or bad faith, no contract or transaction by this corporation shall be void, voidable or in any way affected by reason of the fact that the contract or transaction is (a) with one or more of its officers, Directors, stockholders or employees, (b) with a person who is in any way interested in this corporation or (c) with a corporation, organization or other concern in which an officer, Director, stockholder or employee of this corporation is an officer, director, stockholder, employee or in any way interested. The provisions of this section shall apply notwithstanding the fact that the presence of a Director or stockholder, with whom a contract or transaction is made or entered into or who is an officer, director, stockholder or employee of a corporation, organization or other concern with which a contract or transaction is made or entered into or who is in any way interested in such contract or transaction, was necessary to constitute a quorum at the -9- meeting of the Directors (or any authorized committee thereof) or stockholders at which such contract or transaction was authorized and/or that the vote of such Director or stockholder was necessary for the adoption of such contract or transaction, provided that if said interest was material, it shall have been known or disclosed to the Directors or stockholders voting at said meeting on said contract or transaction. A general notice to any person voting on said contract or transaction that an officer, Director, stockholder or employee has a material interest in any corporation, organization or other concern shall be sufficient disclosure as to such officer, Director, stockholder or employee with respect to all contracts and transactions with such corporation, organization or other concern. This section shall be subject to amendment or repeal only by action of the stockholders. 2. Indemnification. Each Director and officer of the corporation, and any person who, at the request of the corporation, serves as a director or officer of another organization shall be indemnified by the corporation against any cost, expense (including attorneys' fees), judgment, liability and/or amount paid in settlement reasonably incurred by or imposed upon him or her in connection with any action, suit or proceeding (including any proceeding before any administrative or legislative body or agency), to which he or she may be made a party or otherwise involved or with which he or she shall be threatened, by reason of his or her being, or related to his or her status as, a Director or officer of the corporation or of any other organization, which other organization he or she serves or has served as director or officer at the request of the corporation (whether or not he or she continues to be an officer or Director of the corporation or such other organization at the time such action, suit or proceeding is brought or threatened), unless such indemnification is prohibited by the Business Corporation Law of the Commonwealth of Massachusetts. The foregoing right of indemnification shall be in addition to any rights to which any such person may otherwise be entitled and shall inure to the benefit of the executors or administrators of each such person. The corporation may pay the expenses incurred by any such person in defending a civil or criminal action, suit or proceeding in advance of the final disposition of such action, suit, or proceeding, upon receipt of an undertaking by such person to repay such payment if it is determined that such person is not entitled to indemnification hereunder. This section shall not affect any rights to indemnification to which corporate personnel other than Directors and officers may be entitled by contract or otherwise under law. This section shall be subject to amendment or repeal only by action of the stockholders, and any such amendment or repeal shall not affect the rights arising hereunder prior to the effective date of the amendment or repeal. ARTICLE VI Miscellaneous Provisions 1. Fiscal Year. Except as from time to time otherwise determined by the Directors, the fiscal year of the corporation shall be the twelve month period ending on the 31st day of December of each year or as otherwise selected by the Board of Directors from time to time. Following any change in the fiscal year previously adopted, a certificate of such change, signed under the penalties of perjury by the Clerk or an Assistant Clerk, shall be filed forthwith with the state secretary. 2. Seal. The seal of this corporation shall, subject to alteration by the Directors, bear its name, the word "Massachusetts", and the year of its incorporation. 3. Execution of Instruments. All deeds, leases, transfers, contracts, bonds, notes and other obligations authorized to be executed by an officer of the corporation in its behalf shall be signed by the President, any Vice President or the Treasurer except as the Directors may generally or in particular cases otherwise determine. -10- 4. Voting of Securities. Except as the Directors may otherwise designate, the President or Treasurer may waive notice of, and appoint any person or persons to act as proxy or attorney in fact for this corporation (with or without power of substitution) at any meeting of stockholders or shareholders of any other corporation or organization, the securities of which may be held by the corporation. 5. Corporate Records. The original, or attested copies, of the Articles of Organization, By-laws and records of all meetings of incorporators and stockholders, and the stock and transfer records, which shall contain the names of all stockholders and the record address and the amount of stock held by each, shall be kept in Massachusetts at the principal office of the corporation or at an office of its transfer agent or of the Clerk or of its resident agent. Said copies and records need not all be kept in the same office. They shall be available at all reasonable times to the inspection of any stockholder for any proper purpose but not to secure a list of stockholders or other information for the purpose of selling said list or information or copies thereof or of using the same for a purpose other than in the interest of the applicant, as a stockholder, relative to the affairs of the corporation. 6. Articles of Organization. All references in these By-laws to the Articles of Organization shall be deemed to refer to the Restated Articles of Organization of the corporation, as amended and in effect from time to time. 7. Amendments. These By-laws, to the extent provided in these By-laws, may be amended or repealed, in whole or in part, and new By-laws adopted either (a) by the stockholders at any meeting of the stockholders by the affirmative vote of the holders of at least a majority in interest of the capital stock present and entitled to vote, provided that notice of the proposed amendment or repeal or of the proposed making of new By-laws shall have been given in the notice of such meeting, or (b) if so authorized by the Restated Articles of Organization, by the Board of Directors at any meeting of the Board by the affirmative vote of a majority of the Directors then in office, but no amendment or repeal of a By-law shall be voted by the Board of Directors and no new By-law shall be made by the Board of Directors which alters the provisions of these By-laws with respect to removal of Directors, or the election of committees by Directors and the delegation of powers thereto, nor shall the Board of Directors make, amend or repeal any provision of the By-laws which by law, the Restated Articles of Organization or the By-laws requires action by the stockholders. Not later than the time of giving notice of the meeting of stockholders next following the making, amending, or repealing by the Directors of any By-law, notice thereof stating the substance of such change shall be given to all stockholders entitled to vote on amending the By-laws. Any By-law or amendment of a By-law made the Board of Directors may be amended or repealed by the stockholders by affirmative vote as above provided in this Section 7. 8. 1987 Massachusetts Control Share Acquisition Act. The 1987 Massachusetts Control Share Acquisition Act, Chapter 110D of the Massachusetts General Laws, as it may be amended from time to time, shall not apply to the corporation. 9. Massachusetts General Laws, Chapter 110F. Chapter 110F of the Massachusetts General Laws, as it may be amended from time to time, shall not apply to the corporation. EX-10.1 3 EX-10.1 EXHIBIT 10.1 EXCEL SWITCHING CORPORATION AMENDED AND RESTATED 1997 STOCK OPTION PLAN 1. PURPOSE. This Amended and Restated 1997 Stock Option Plan (the "Plan") is intended to provide incentives: (a) to the officers and other employees of Excel Switching Corporation (the "Company"), any present or future parent and any present or future subsidiaries of the Company (collectively, "Related Corporations") by providing them with opportunities to purchase stock in the Company pursuant to options granted hereunder which qualify as "incentive stock options" ("ISO" or "ISOs") under Section 422(b) of the Internal Revenue Code of 1986, as amended (the "Code"); (b) to directors, officers, employees and consultants of the Company and Related Corporations by providing them with opportunities to purchase stock in the Company pursuant to options granted hereunder which do not qualify as ISOs ("Non-Qualified Option" or "Non-Qualified Options"); (c) to directors, officers, employees and consultants of the Company and Related Corporations by providing them with awards of stock in the Company ("Awards"); and (d) to directors, officers, employees and consultants of the Company and Related Corporations by providing them with opportunities to make direct purchases of stock in the Company ("Purchases"). Both ISOs and Non-Qualified Options are referred to hereafter individually as an "Option" and collectively as "Options". Options, Awards and authorizations to make Purchases are referred to hereafter collectively as "Stock Rights". As used herein, the terms "parent" and "subsidiary" mean "parent corporation" and "subsidiary corporation", respectively, as those terms are defined in Section 424 of the Code. 2. ADMINISTRATION OF THE PLAN. A. BOARD OR COMMITTEE ADMINISTRATION. The Plan shall be administered by the Board of Directors of the Company (the "Board") or, subject to paragraph 2(d) (relating to compliance with Section 162(m) of the Code), by a committee appointed by the Board (the "Committee"). Hereinafter, all references in this Plan to the "Committee" shall mean the Board if no Committee has been appointed. Subject to ratification of the grant or authorization of each Stock Right by the Board (if so required by applicable state law), and subject to the terms of the Plan, the Committee shall have the authority to (i) determine the employees of the Company and Related Corporations (from among the class of employees eligible under paragraph 3 to receive ISOs) to whom ISOs may be granted, and to determine (from among the class of individuals and entities eligible under paragraph 3 to receive Non-Qualified Options and Awards and to make Purchases) to whom Non-Qualified Options, Awards and authorizations to make Purchases may be granted; (ii) determine the time or times at which Options or Awards may be granted or Purchases made; (iii) determine the exercise price per share subject to each Option, which price shall not be less than the minimum price specified in paragraph 6, and the purchase price of shares subject to each Purchase; (iv) determine whether each Option granted shall be an ISO or a Non-Qualified Option; (v) determine (subject to paragraph 7) the time or times when each Option shall become exercisable and the duration of the exercise period; (vi) extend the period -2- during which outstanding Options may be exercised; (vii) determine whether restrictions such as repurchase options are to be imposed on shares subject to Options, Awards and Purchases and the nature of such restrictions, if any; (viii) interpret the Plan and prescribe and rescind rules and regulations relating to it; and (ix) authorize executive officers of the Company to (a) execute option agreements with individuals hired as employees of the Company during the periods between Committee meetings, not including individuals hired as executive officers, and (b) determine the number of Options to be issued to such employee, subject to the specific limitations set forth by the Committee in its grant of authority to such executive officer. If the Committee determines to issue a Non-Qualified Option, it shall take whatever actions it deems necessary, under Section 422 of the Code and the regulations promulgated thereunder, to ensure that such Option is not treated as an ISO. The interpretation and construction by the Committee of any provisions of the Plan or of any Stock Right granted under it shall be final unless otherwise determined by the Board. The Committee may from time to time adopt such rules and regulations for carrying out the Plan as it may deem best. No member of the Board or the Committee shall be liable for any action or determination made in good faith with respect to the Plan or any Stock Right granted under it. B. COMMITTEE ACTION. The Committee may select one of its members as its chairman, and shall hold meetings at such time and places as it may determine. Acts by a majority of the Committee, or acts reduced to or approved in writing by a majority of the members of the Committee, shall be the valid acts of the Committee. From time to time the Board may increase the size of the Committee and appoint additional members thereof, remove members (with or without cause) and appoint new members in substitution therefor, fill vacancies however caused, or remove all members of the Committee and thereafter directly administer the Plan. C. GRANT OF STOCK RIGHTS TO BOARD MEMBERS. Stock Rights may be granted to members of the Board. All grants of Stock Rights to members of the Board shall in all other respects be made in accordance with the provisions of this Plan applicable to other eligible persons. Members of the Board who are either (i) eligible for Stock Rights pursuant to the Plan or (ii) have been granted Stock Rights may vote on any matters affecting the administration of the Plan or the grant of any Stock Rights pursuant to the Plan, except that no such member shall act upon the granting to himself of Stock Rights, but any such member may be counted in determining the existence of a quorum at any meeting of the Board during which action is taken with respect to the granting to him of Stock Rights. D. PERFORMANCE-BASED COMPENSATION. The Board, in its discretion, may take such action as may be necessary to ensure that Stock Rights granted under the Plan qualify as "qualified performance-based compensation" within the meaning of Section 162(m) of the Code and applicable regulations promulgated thereunder ("Performance-Based Compensation"). Such action may include, in the Board's discretion, some or all of the following (i) if the Board determines that Stock Rights granted under the Plan generally shall constitute Performance-Based Compensation, by a committee consisting solely of two or more "outside directors (as defined in applicable regulations promulgated under Section 162(m) of the Code), (ii) if any Non-Qualified Options with an exercise price less than the fair market value per share of -3- Common Stock are granted under the Plan and the Board determines that such Options should constitute Performance-Based Compensation, such options shall be made exercisable only upon the attainment of a pre-established, objective performance goal established by the Committee, and such grant shall be submitted for, and shall be contingent upon shareholder approval and (iii) Stock Rights granted under the Plan may be subject to such other terms and conditions as are necessary for compensation recognized in connection with the exercise or disposition of such Stock Right or the disposition of Common Stock acquired pursuant to such Stock Right, to constitute Performance-Based Compensation. 3. ELIGIBLE EMPLOYEES AND OTHERS. ISOs may be granted only to employees of the Company or any Related Corporation. Non-Qualified Options, Awards and authorizations to make Purchases may be granted to any director (whether or not an employee), officer, employee or consultant of the Company or any Related Corporation. The Committee may take into consideration a recipient's individual circumstances in determining whether to grant an ISO, a Non-Qualified Option or an authorization to make a Purchase. Granting of any Stock Right to any individual or entity shall neither entitle that individual or entity to, nor disqualify him from, participation in any other grant of Stock Rights. 4. STOCK. The stock subject to Options, Awards and Purchases shall be authorized but unissued shares of Common Stock of the Company, par value $.01 per share (the "Common Stock"), or shares of Common Stock reacquired by the Company in any manner. The aggregate number of shares which may be issued pursuant to the Plan is 5,000,000 shares, subject to adjustment as provided in paragraph 13. If any Option granted under the Plan shall expire or terminate for any reason without having been exercised in full or shall cease for any reason to be exercisable in whole or in part, the shares subject to such Options shall again be available for grants of Stock Rights under the Plan. No employee of the Company or any Related Corporation may be granted Options to acquire, in the aggregate, more than 3,500,000 shares of Common Stock under the Plan during any fiscal year of the Company, subject to adjustment as provided in paragraph 13. The following provision shall be effective only on and after the date of the initial public offering of shares of Common Stock of the Company pursuant to the Securities Act of 1933, as amended. If any Option granted under the Plan shall expire or terminate for any reason without having been exercised in full or shall cease for any reason to be exercisable in whole or in part or shall be repurchased by the Company, the shares subject to such Option shall be included in the determination of the aggregate number of shares of Common Stock deemed to have been granted to such employee under the Plan. 5. GRANTING OF STOCK RIGHTS. Stock Rights may be granted under the Plan at any time on or after September 16, 1997 and prior to September 15, 2007. The date of grant of a Stock Right under the Plan will be the date specified by the Committee at the time it grants the Stock Right; provided, however, that such date shall not be prior to the date on which the Committee acts to approve the grant. 6. MINIMUM OPTION PRICE; ISO LIMITATIONS. -4- A. PRICE FOR NON-QUALIFIED OPTIONS, AWARDS, AND PURCHASES. Subject to paragraph 2(d) (relating to compliance with Section 162(m) of the Code), the exercise price per share specified in the agreement relating to each Non-Qualified Option granted and the purchase price per share of stock granted in any Award or authorized as a Purchase under the Plan shall in no event be less than the minimum legal consideration required therefor under the laws of any jurisdiction in which the Company or its successors in interest may be organized. B. PRICE FOR ISOS. The exercise price per share specified in the agreement relating to each ISO granted under the Plan shall not be less than the fair market value per share of Common Stock on the date of such grant. In the case of an ISO to be granted to an employee owning stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any Related Corporation, the price per share specified in the agreement relating to such ISO shall not be less than one hundred ten percent (110%) of the fair market value per share of Common Stock on the date of grant. For purposes of determining stock ownership under this paragraph, the rules of Section 424(d) of the Code shall apply. C. $100,000 ANNUAL LIMITATION ON ISO VESTING. Each eligible employee may be granted options treated as ISOs only to the extent that, in the aggregate under this Plan and all incentive stock option plans of the Company and any Related Corporation, such ISOs do not become exercisable for the first time by such employee during any calendar year in a manner which would entitle the employee to purchase more than $100,000 in fair market value (determined at the time the ISOs were granted) of Common Stock in that year. Any options granted to an employee in excess of such amount will be granted as Non-Qualified Options, and the Company shall issue separate certificates to the optionee with respect to options that are Non-Qualified Options and Options that are ISOs. D. DETERMINATION OF FAIR MARKET VALUE. If, at the time an Option is granted under the Plan, the Company's Common Stock is publicly traded, "fair market value" shall be determined as of the date of grant or, if the prices or quotes discussed in this sentence are unavailable for such date, the last business day for which such prices or quotes are available prior to the date such Option is granted and shall mean (i) the average (on that date) of the high and low prices of the Common Stock on the principal national securities exchange on which the Common Stock is traded, if the Common Stock is then traded on a national securities exchange; or (ii) the last reported sale price (on that date) of the Common Stock on the Nasdaq National Market, if the Common Stock is not then traded on a national securities exchange; or (iii) the average of the closing bid and asked prices last quoted (on that date) by an established quotation service for over-the-counter securities, if the Common Stock is not reported on the Nasdaq National Market. However, if the Common Stock is not publicly traded at the time an Option is granted under the Plan, "fair market value" shall be deemed to be the fair value of the Common Stock as determined by the Committee after taking into consideration all factors which it deems appropriate, including, without limitation, recent sale and offer prices of the Common Stock in private transactions negotiated at arm's length. -5- 7. OPTION DURATION. Subject to earlier termination as provided in paragraphs 9 and 10 or in the agreement relating to such Option, each Option shall expire on the date specified by the Committee, but not more than (i) ten years and one day from the date of grant in the case of Non-Qualified Options, (ii) ten years from the date of grant in the case of ISOs generally, and (iii) five years from the date of grant in the case of ISOs granted to an employee owning stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or any Related Corporation, as determined under paragraph 6(B). Subject to earlier termination as provided in paragraphs 9 and 10, the term of each ISO shall be the term set forth in the original instrument granting such ISO, except with respect to any part of such ISO that is converted into a Non-Qualified Option pursuant to paragraph 16. 8. EXERCISE OF OPTION. Subject to the provisions of paragraphs 9 through 12, 21 and 22 each Option granted under the Plan shall be exercisable as follows: A. FULL VESTING OR PARTIAL VESTING. The Option shall either be fully exercisable on the date of grant or shall become exercisable thereafter in such installments as the Committee may specify. B. FULL VESTING OF INSTALLMENTS. Once an installment becomes exercisable it shall remain exercisable until expiration or termination of the Option, unless otherwise specified by the Committee or as otherwise provided in this Plan. C. PARTIAL EXERCISE. Each Option or installment may be exercised at any time or from time to time, in whole or in part, for up to the total number of shares with respect to which it is then exercisable. D. ACCELERATION OF VESTING. Subject to any accounting considerations with respect to "Accounting for Business Combinations" pursuant to Accounting Principles Board Opinion No. 16, The Committee shall have the right to accelerate the date of exercise of any installment of any Option; provided that the Committee shall not accelerate the exercise date of any installment of any Option granted to any employee as an ISO (and not previously converted into a Non-Qualified Option pursuant to paragraph 16) if such acceleration would violate the annual vesting limitation contained in Section 422(d) of the Code, as described in paragraph 6(C). 9. TERMINATION OF EMPLOYMENT. Unless otherwise specified in the Agreement relating to such ISO, if an ISO Optionee ceases to be employed by the Company and all Related Corporations other than by reason of death or disability as defined in paragraph 10, no further installments of his ISOs shall become exercisable, and his ISOs shall terminate after the passage of ninety (90) days from the date of termination of his employment, but in no event later than on their specified expiration dates, except to the extent that such ISOs (or unexercised installments thereof) have been converted into Non-Qualified Options pursuant to paragraph 16. Employment shall be considered as continuing uninterrupted during any bona fide leave of absence (such as those attributable to illness, military obligations or governmental service) provided that the period of such leave does not exceed ninety (90) days or, if longer, any period -6- during which such Optionee's right to re-employment is guaranteed by statute or by contract. A bona fide leave of absence with the written approval of the Committee shall not be considered an interruption of employment under the Plan, provided that such written approval contractually obligates the Company or any Related Corporation to continue the employment of the Optionee after the approved period of absence. ISOs granted under the Plan shall not be affected by any change of employment within or among the Company and Related Corporations, so long as the Optionee continues to be an employee of the Company or any Related Corporation. Nothing in the Plan shall be deemed to give any grantee of any Stock Right the right to be retained in employment or other service by the Company or any Related Corporation for any period of time. 10. DEATH; DISABILITY. A. DEATH. If an ISO Optionee ceases to be employed by the Company and all Related Corporations by reason of his or her death, any ISO owned by such Optionee may be exercised, to the extent of the number of shares with respect to which he or she could have exercised it on the date of his or her death, by the estate, personal representative or beneficiary who has acquired the ISO by will or by the laws of descent and distribution, at any time prior to the earlier of (i) the specified expiration date of the ISO or (ii) 180 days from the date of the Optionee's death. B. DISABILITY. If an ISO Optionee ceases to be employed by the Company and all Related Corporations by reason of his or her disability, such Optionee shall have the right to exercise any ISO held by him or her on the date of termination of employment, to the extent of the number of shares with respect to which he or she could have exercised it on that date, until the earlier of (i) the specified expiration date of the ISO or (ii) 180 days from the date of the termination of the Optionee's employment. For the purposes of the Plan, the term "disability" shall mean "permanent and total disability" as defined in Section 22(e)(3) of the Code or successor statute. 11. ASSIGNABILITY. During the lifetime of the optionee, each Option shall be exercisable only by him or her and no Option shall be assignable or transferable by the optionee EXCEPT by will or by the laws of descent and distribution or, in the case of Non-Qualified Options, pursuant to a valid domestic relations order or in accordance with the terms of the Optionee's option agreement and in compliance with the provisions of the Securities Act of 1933, as amended. 12. TERMS AND CONDITIONS OF OPTIONS. Options shall be evidenced by instruments (which need not be identical) in such forms as the Committee may from time to time approve. Such instruments shall conform to the terms and conditions set forth in paragraphs 6 through 11 hereof and may contain such other provisions as the Committee deems advisable which are not inconsistent with the Plan, including restrictions applicable to shares of Common Stock issuable upon exercise of Options. In granting any Non-Qualified Option, the Committee may specify that such Non-Qualified Option shall be subject to the restrictions set forth herein with respect to ISOs, or to such other termination and cancellation provisions as the Committee may determine. The Committee may from time to time confer authority and responsibility on one or more of its -7- own members and/or one or more officers of the Company to execute and deliver such instruments. The proper officers of the Company are authorized and directed to take any and all action necessary or advisable from time to time to carry out the terms of such instruments. 13. ADJUSTMENTS. Upon the occurrence of any of the following events, an Optionee's rights with respect to Options granted to him hereunder shall be adjusted as hereinafter provided, unless otherwise specifically provided in the written agreement between the Optionee and the Company relating to such Option: A. STOCK DIVIDENDS AND STOCK SPLITS. If the shares of Common Stock shall be subdivided or combined into a greater or smaller number of shares or if the Company shall issue any shares of Common Stock as a stock dividend on its outstanding Common Stock, the number of shares of Common Stock deliverable upon the exercise of Options shall be appropriately increased or decreased proportionately, and appropriate adjustments shall be made in the purchase price per share to reflect such subdivision, combination or stock dividend. B. CONSOLIDATIONS OR MERGERS. If the Company is to be consolidated with or acquired by another entity in a merger or other reorganization in which the holders of the outstanding voting stock of the Company immediately preceding the consummation of such event, shall, immediately following such event, hold as a group, less than a majority of the voting securities of the surviving or successor entity, or in the event of a sale of all or substantially all of the Company's assets or otherwise (an "Acquisition"), the Committee or the board of directors of any entity assuming the obligations of the Company hereunder (the "Successor Board"), shall, as to outstanding Options, take one or more of the following actions: (i) make appropriate provision for the continuation of such Options by substituting on an equitable basis for the shares then subject to such Options the consideration payable with respect to the outstanding shares of Common Stock in connection with the Acquisition; or (ii) make appropriate provision for the continuation of such Options by substituting on an equitable basis for the shares then subject to such Options any equity securities of the successor corporation or such other securities as the Successor Board deems appropriate, the fair market value of which shall not materially exceed the fair market value of the shares of Common Stock subject to such Options immediately preceding the Acquisition; or (iii) upon written notice to the Optionees, provide that all Options must be exercised, to the extent then exercisable, within a specified number of days of the date of such notice, at the end of which period the Options shall terminate; or (iv) terminate all Options in exchange for a cash payment equal to the excess of the fair market value of the shares subject to such Options (to the extent then exercisable) over the exercise price thereof; or (v) accelerate the date of exercise of such Options or of any installment of any such Options; or (vi) terminate all Options in exchange for the right to participate in any stock option or other employee benefit plan of any successor corporation. The foregoing actions are subject in all instances to the approval of the Board of Directors and any accounting considerations for any acquisition which is treated as a "pooling of interests" transaction pursuant to the Accounting Principles Board (APB) Opinion No. 16, if any discretionary action by the Board of Directors would otherwise violate the accounting rules for treatment of the Acquisition as a "pooling of interests" under APB No. 16. -8- C. RECAPITALIZATION OR REORGANIZATION. In the event of a recapitalization or reorganization of the Company (other than a transaction described in subparagraph B above) pursuant to which securities of the Company or of another corporation are issued with respect to the outstanding shares of Common Stock, an Optionee upon exercising an Option shall be entitled to receive for the purchase price paid upon such exercise the securities he or she would have received if he or she had exercised his or her Option prior to such recapitalization or reorganization. D. MODIFICATION OF ISOS. Notwithstanding the foregoing, any adjustments made pursuant to subparagraphs A, B or C with respect to ISOs shall be made only after the Committee, after consulting with counsel for the Company, determines whether such adjustments would constitute a "modification" of such ISOs (as that term is defined in Section 424 of the Code) or would cause any adverse tax consequences for the holders of such ISOs. If the Committee determines that such adjustments made with respect to ISOs would constitute a modification of such ISOs, or would cause adverse tax consequences to the holders, it may refrain from making such adjustments. E. DISSOLUTION OR LIQUIDATION. In the event of the proposed dissolution or liquidation of the Company, each Option will terminate immediately prior to the consummation of such proposed action or at such other time and subject to such other conditions as shall be determined by the Committee. F. ISSUANCES OF SECURITIES. Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of shares subject to Options. No adjustments shall be made for dividends paid in cash or in property other than securities of the Company. G. FRACTIONAL SHARES. No fractional shares shall be issued under the Plan and the Optionee shall receive from the Company cash in lieu of such fractional shares. H. ADJUSTMENTS. Upon the happening of any of the foregoing events described in subparagraphs A, B or C above, the class and aggregate number of shares set forth in paragraph 4 hereof that are subject to Stock Rights which previously have been or subsequently may be granted under the Plan shall also be appropriately adjusted to reflect the events described in such subparagraphs. The Committee or the Successor Board shall determine the specific adjustments to be made under this paragraph 13 and, subject to paragraph 2, its determination shall be conclusive. If any person or entity owning restricted Common Stock obtained by exercise of a Stock Right made hereunder receives shares or securities or cash in connection with a corporate transaction described in subparagraphs A, B or C above as a result of owning such restricted Common Stock, such shares or securities or cash shall be subject to all of the conditions and restrictions applicable to the restricted Common Stock with respect to which such shares or securities or cash were issued, unless otherwise determined by the Committee or the Successor Board. -9- 14. MEANS OF EXERCISING STOCK RIGHTS. A Stock Right (or any part or installment thereof) shall be exercised by giving written notice to the Company at its principal office address. Such notice shall identify the Stock Right being exercised and specify the number of shares as to which such Stock Right is being exercised, accompanied by full payment of the purchase price therefor either (a) in United States dollars in cash or by check, or (b) at the discretion of the Committee, through delivery of shares of Common Stock having a fair market value equal as of the date of the exercise to the cash exercise price of the Stock Right, or (c) at the discretion of the Committee, by delivery of the grantee's personal recourse note bearing interest payable not less than annually at no less than 100% of the lowest applicable Federal rate, as defined in Section 1274(d) of the Code, or (d) at the discretion of the Committee and consistent with applicable law, through the delivery of an assignment to the Company of a sufficient amount of the proceeds from the sale of the Common Stock acquired upon exercise of the Option and an authorization to the broker or selling agent to pay that amount to the Company, which sale shall be at the participant's direction at the time of exercise, or (e) at the discretion of the Committee, by any combination of (a), (b), (c) and (d) above. If the Committee exercises its discretion to permit payment of the exercise price of an ISO by means of the methods set forth in clauses (b), (c), (d) or (e) of the preceding sentence, such discretion shall be exercised in writing at the time of the grant of the ISO in question. The holder of a Stock Right shall not have the rights of a shareholder with respect to the shares covered by his Stock Right until the date of issuance of a stock certificate to him for such shares. Except as expressly provided above in paragraph 13 with respect to changes in capitalization and stock dividends, no adjustment shall be made for dividends or similar rights for which the record date is before the date such stock certificate is issued. 15. TERM AND AMENDMENT OF PLAN. This Plan was adopted by the Board as of September 16, 1997 and approved by the stockholders of the Company on September 16, 1997. The Plan shall expire at the end of the day on September 15, 2007 (except as to Options outstanding on that date). Subject to the provisions of paragraph 5 above, Stock Rights may be granted under the Plan prior to the date of stockholder approval of the Plan. The Board may terminate or amend the Plan in any respect at any time, except that, without the approval of the stockholders obtained within 12 months before or after the Board adopts a resolution authorizing any of the following actions: (a) the total number of shares that may be issued under the Plan may not be increased (except by adjustment pursuant to paragraph 13); (b) the benefits accruing to participants under the Plan may not be materially increased; (c) the requirements as to eligibility for participation in the Plan may not be materially modified; (d) the provisions of paragraph 3 regarding eligibility for grants of ISOs may not be modified; (e) the provisions of paragraph 6(B) regarding the exercise price at which shares may be offered pursuant to ISOs may not be modified (except by adjustment pursuant to paragraph 13); (f) the expiration date of the Plan may not be extended; and (g) the Board may not take any action which would cause the Plan to fail to comply with Rule 16b-3. Except as otherwise provided in this paragraph 15 or in paragraph 23, in no event may action of the Board or stockholders alter or impair the rights of a grantee, without his consent, under any Stock Right previously granted to him. -10- 16. CONVERSION OF ISOS INTO NON-QUALIFIED OPTIONS; TERMINATION OF ISOS. Subject to paragraph 13(d), without the prior written consent of the holder of an ISO, the Committee shall not alter the terms of such ISO (including the means of exercising such ISO) if such alteration would constitute a modification (within the meaning of Section 424(h)(3) of the Code). The Committee, at the written request or with the written consent of any Optionee, may in its discretion take such actions as may be necessary to convert such Optionee's ISOs (or any installments or portions of installments thereof) that have not been exercised on the date of conversion into Non-Qualified Options at any time prior to the expiration of such ISOs, regardless of whether the Optionee is an employee of the Company or a Related Corporation at the time of such conversion. Such actions may include, but shall not be limited to, extending the exercise period or reducing the exercise price of the appropriate installments of such ISOs. At the time of such conversion, the Committee (with the consent of the Optionee) may impose such conditions on the exercise of the resulting Non-Qualified Options as the Committee in its discretion may determine, provided that such conditions shall not be inconsistent with this Plan. Nothing in the Plan shall be deemed to give any Optionee the right to have such Optionee's ISOs converted into Non-Qualified Options, and no such conversion shall occur until and unless the Committee takes appropriate action. Upon the taking of such action, the Company shall issue separate certificates to the Optionee with respect to Options that are Non-Qualified Options and Options that are ISOs. 17. APPLICATION OF FUNDS. The proceeds received by the Company from the sale of shares pursuant to Options granted and Purchases authorized under the Plan shall be used for general corporate purposes. 18. GOVERNMENTAL REGULATION. The Company's obligation to sell and deliver shares of the Common Stock under this Plan is subject to the approval of any governmental authority required in connection with the authorization, issuance or sale of such shares. 19. WITHHOLDING OF ADDITIONAL INCOME TAXES. Upon the exercise of a Non-Qualified Option, the grant of an Award, the making of a Purchase of Common Stock for less than its fair market value, the making of a Disqualifying Disposition (as defined in paragraph 20), the making of a distribution or other payment with respect to such stock or securities, or the vesting or transfer of restricted Common Stock acquired on the exercise of a Stock Right hereunder, the Company may withhold income and/or employment taxes in respect of amounts that constitute compensation includible in gross income, or otherwise treated by law as wages for withholding for income or employment tax purposes. The Committee in its discretion may condition (i) the exercise of an Option, (ii) the grant of an Award, (iii) the making of a Purchase of Common Stock for less than its fair market value, or (iv) the vesting or transferability of restricted Common Stock acquired by exercising a Stock Right, on the grantee's making satisfactory arrangement for such withholding. Such arrangement may include payment by the grantee in cash or by check of the amount of the withholding taxes or, at the discretion of the Company, by the grantee's delivery of previously held shares of Common Stock or the withholding from the shares of Common Stock otherwise deliverable upon exercise of Option shares having an aggregate fair market value equal to the amount of such withholding taxes. The -11- use of any method of payment other than by cash or check in some cases may require or cause additional withholding obligations. 20. NOTICE TO COMPANY OF DISQUALIFYING DISPOSITION. By accepting an ISO granted under the Plan, each ISO Optionee thereby agrees to notify the Company in writing immediately after such Optionee makes a Disqualifying Disposition of any Common Stock acquired pursuant to the exercise of an ISO. Generally, a Disqualifying Disposition is any disposition (including any sale) of such Common Stock occurring on or before the later of the date (a) two years after the date the employee was granted the ISO, or (b) one year after the date the employee acquired Common Stock by exercising the ISO. 21. NO EXERCISE OF OPTION IF ENGAGEMENT OR EMPLOYMENT TERMINATED FOR CAUSE. If the employment of an Optionee that is an employee or consultant of the Company or any Related Corporation is terminated for "Cause," such Optionee's options shall terminate on the date of such termination and the Option shall thereupon not be exercisable to any extent whatsoever. "Cause" is conduct, as determined by the Board of Directors, involving one or more of the following: (i) gross misconduct by the employee or consultant which is materially injurious to the Company; or (ii) the commission of an act of embezzlement, fraud or deliberate disregard of the rules or policies of the Company; or (iii) the unauthorized disclosure or misappropriation of any trade secret or confidential information of the Company or any third party who has a business relationship with the Company or the violation of any noncompetition covenant or assignment of inventions obligation with the Company; or (iv) the commission of an act which induces any customer or prospective customer of the Company to break a contract with the Company or to decline to do business with the Company; or (v) the conviction of the employee or consultant of a felony involving any financial impropriety or which would materially interfere with such Optionee's ability to perform his or her services or otherwise be injurious to the Company; or (vi) the failure of the employee or consultant to perform in a material respect his or her employment obligations without proper cause. In making such determination, the Board shall act fairly and in utmost good faith. For the purposes of this Section 21, termination of employment shall be deemed to occur when the employee receives notice that his employment is terminated. 22. ACCELERATION AND VESTING OF OPTION FOR BUSINESS COMBINATIONS. Unless otherwise specifically provided in the written agreement between the Optionee and the Company relating to such Option, upon any merger, consolidation, sale of all (or substantially all) of the assets of the Company, or other business combination involving the sale or transfer of all (or substantially all) of the capital stock or assets of the Company in which the Company is not the surviving entity, or, if it is the surviving entity, does not survive as an operating going concern in substantially the same line of business (an "Acquisition"), then the remaining unvested portions of any Option outstanding to any Optionee shall, immediately prior to the consummation of any of the foregoing events, become vested and immediately exercisable by the Optionee according to the following formula and dependent upon the length of the Optionee's continuous months of employment or engagement by the Company prior to the consummation of the Acquisition, PROVIDED, HOWEVER, that this Section shall not apply to any reincorporation of the Company in a different State pursuant to a migratory merger: -12- (i) If the Optionee has been employed by the Company for 36 months or more, then the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. (ii) If the Optionee has been employed by the Company for more than 30 but less than 36 months, then 80% of the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. (iii) If the Optionee has been employed by the Company for more than 24 but less than 30 months, then 50% of the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. (iv) If the Optionee has been employed by the Company for more than 18 but less than 24 months, then 40% of the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. (v) If the Optionee has been employed by the Company for more than 12 but less than 18 months, then 30% of the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. (vi) If the Optionee has been employed by the Company for more than 6 but less than 12 months, then 20% of the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. (vii) If the Optionee has been employed by the Company for more than 1 but less than 6 months, then 10% of the remaining unvested portion of any Option held by such Optionee shall become fully vested and exercisable. 23. POOLING-OF INTERESTS-ACCOUNTING. If the Company proposes to engage in an Acquisition intended to be accounted for as a pooling-of-interests, and in the event that the provisions of this Plan or of any Stock Right granted hereunder, or any actions of the Board taken in connection with such Acquisition, are determined by either the Company's Board, or by both the acquiring company's board and the Company's Board, to cause such Acquisition to fail to be accounted for as a pooling-of-interests, then such provisions or actions shall be amended or rescinded by the Board, without the consent of any Optionee, to be consistent with pooling-of-interests accounting treatment for such Acquisition. 24. GOVERNING LAW; CONSTRUCTION. The validity and construction of the Plan and the instruments evidencing Stock Rights shall be governed by the laws of the Commonwealth of Massachusetts or the laws of any jurisdiction in which the Company or its successors in interest may be organized. In construing this Plan, the singular shall include the plural and the masculine gender shall include the feminine and neuter, unless the context otherwise requires. EX-10.2 4 EX-10.2 AMENDED AND RESTATED 1997 NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN EXHIBIT 10.2 EXCEL SWITCHING CORPORATION AMENDED AND RESTATED 1997 NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN 1. PURPOSE. This Non-Qualified Stock Option Plan, to be known as the Amended and Restated 1997 Non-Employee Director Stock Option Plan (hereinafter, the "Plan") is intended to promote the interests of Excel Switching Corporation (hereinafter, the "Company") by providing an inducement to obtain and retain the services of qualified persons who are not employees or officers of the Company to serve as members of its Board of Directors (the "Board"). 2. AVAILABLE SHARES. The total number of shares of Common Stock, par value $.01 per share, of the Company (the "Common Stock") for which options may be granted under this Plan shall not exceed 225,000 shares, subject to adjustment in accordance with paragraph 10 of this Plan. Shares subject to this Plan are authorized but unissued shares or shares that were once issued and subsequently reacquired by the Company. If any options granted under this Plan are surrendered before exercise or lapse without exercise, in whole or in part, the shares reserved therefor shall continue to be available under this Plan. 3. ADMINISTRATION. This Plan shall be administered by the Board or by a committee appointed by the Board (the "Committee"). In the event the Board fails to appoint or refrains from appointing a Committee, the Board shall have all power and authority to administer this Plan. In such event, the word "Committee" wherever used herein shall be deemed to mean the Board. The Committee shall, subject to the provisions of the Plan, have the power to construe this Plan, to determine all questions hereunder, and to adopt and amend such rules and regulations for the administration of this Plan as it may deem desirable. No member of the Board or the Committee shall be liable for any action or determination made in good faith with respect to this Plan or any option granted under it. 4. AUTOMATIC GRANT OF OPTIONS. Subject to the availability of shares under this Plan and commencing on January 1, 2000, each person who is or becomes a member of the Board and who is not an employee or officer of the Company (a "Non-Employee Director") shall be automatically granted an option to purchase 1,250 shares of Common Stock of the Company on the first business day of January, April, July and October of each fiscal year of the Company, provided that such individual continues to be a Non-Employee Director on such date and provided that as of such date, such individual has been a member of the Board for at least one (1) year. 2 The options to be granted under this paragraph 4 shall be the only options ever to be granted at any time to such member under this Plan. 5. OPTION PRICE. The purchase price of the stock covered by an option granted pursuant to this Plan shall be 100% of the fair market value of such shares on the day the option is granted. The option price will be subject to adjustment in accordance with the provisions of paragraph 10 of this Plan. For purposes of this Plan, if, at the time an option is granted under the Plan, the Company's Common Stock is publicly traded, "fair market value" shall be determined as of the last business day for which the prices or quotes discussed in this sentence are available prior to the date such option is granted and shall mean (i) the average (on that date) of the high and low prices of the Common Stock on the principal national securities exchange on which the Common Stock is traded, if the Common Stock is then traded on a national securities exchange; or (ii) the last reported sale price (on that date) of the Common Stock on the Nasdaq National Market, if the Common Stock is not then traded on a national securities exchange; or (iii) the closing bid price (or average of bid prices) last quoted (on that date) by an established quotation service for over-the-counter securities, if the Common Stock is not reported on the Nasdaq National Market List. If the Common Stock is not publicly traded at the time an option is granted under the Plan, "fair market value" shall be deemed to be the fair value of the Common Stock as determined by the Committee after taking into consideration all factors which it deems appropriate, including, without limitation, recent sale and offer prices of the Common Stock in private transactions negotiated at arm's length. Notwithstanding the foregoing the fair market value of the Common Stock for the grant of an option on the date of the Company's Prospectus in connection with its initial public offering (the "Offering") shall be equal to the price per share at which the Common Stock is sold to the underwriters upon the Offering, without regard to any applicable discounts or commissions provided to such underwriters. 6. PERIOD OF OPTION. Unless sooner terminated in accordance with the provisions of paragraph 8 of this Plan, an option granted hereunder shall expire on the date which is ten (10) years after the date of grant of the option. 7. VESTING OF SHARES AND NON-TRANSFERABILITY OF OPTIONS. (a) Options granted under paragraph 4 of this Plan shall be fully vested and immediately exercisable on the date such options are granted to the optionee. The number of shares as to which options may be exercised shall be cumulative, so that once the option shall become exercisable as to any shares it shall continue to be exercisable as to said shares, until expiration or termination of the option as provided in this Plan. (b) Notwithstanding subsection (a) of this paragraph 7, if an optionee attends less than 75% of the Board meetings held in any fiscal year (a "Default Year"), then the optionee shall forfeit his right to receive options in the next fiscal year in 3 proportion to the percentage of Board meetings which the optionee actually attended in the Default Year. If the optionee is required to forfeit his right to receive future options, each successive quarterly option grant shall be forfeited, in whole or in part, until the requisite number of options have been forfeited. By way of illustration, if an optionee attends only 25% of the actual meetings of the Board of Directors (whether regular or special) held in any fiscal year, then the optionee shall forfeit the right to receive 75% of the options to be granted in the next fiscal year (i.e., the grant of options on January 1, April 1 and July 1 of the next fiscal year). (c) TRANSFERABILITY. Any option granted pursuant to this Plan shall be assignable or transferable by will, the laws of descent and distribution, pursuant to a domestic relations order or in accordance with the terms of the optionee's option agreement and only in compliance with the provisions of the Securities Act of 1933, as amended. 8. TERMINATION OF OPTION RIGHTS. (a) Subject to paragraph 8(c) below and except as may otherwise be specified in the agreement relating to an option, in the event an optionee ceases to be a member of the Board for any reason other than death or permanent disability, any portion of an option which is then vested but has not been exercised at the time the optionee so ceases to be a member of the Board may be exercised, to the extent it is then vested, by the optionee at any time prior to the scheduled expiration date of the option. (b) Except as may otherwise be specified in the agreement relating to an option, in the event that an optionee ceases to be a member of the Board by reason of his or her death or permanent disability, any unexercised options shall be exercisable by the optionee (or by the optionee's personal representative, heir or legatee, in the event of death) at any time prior to the scheduled expiration date of the option. (c) Except as may otherwise be specified in the agreement relating to an option, no portion of an option may be exercised if the optionee is removed from the Board of Directors for any one of the following reasons: (i) disloyalty, gross negligence, dishonesty or breach of fiduciary duty to the Company; or (ii) the commission of an act of embezzlement, fraud or deliberate disregard of the rules or policies of the Company; or (iii) the unauthorized disclosure or misappropriation of any trade secret or confidential information of the Company; or (iv) the commission of an act which constitutes unfair competition with the Company or which induces any customer of the Company to break a contract with the Company; or (v) the conduct of any activity on behalf of any organization or entity which is a competitor of the Company (unless such conduct is approved by a majority of the members of the Board of Directors). 9. EXERCISE OF OPTION. Subject to the terms and conditions of this Plan and the option agreements, an option granted hereunder shall, to the extent then exercisable, 4 be exercisable in whole or in part by giving written notice to the Company by mail, facsimile or in person addressed to Excel Switching Corporation, at its principal executive offices, stating the number of shares with respect to which the option is being exercised, accompanied by payment in full for such shares. Payment may be (a) in United States dollars in cash or by check, (b) in whole or in part in shares of the Common Stock of the Company already owned by the person or persons exercising the option or shares subject to the option being exercised (subject to such restrictions and guidelines as the Board may adopt from time to time), valued at fair market value determined in accordance with the provisions of paragraph 5 or (c) consistent with applicable law, through the delivery of an assignment to the Company of a sufficient amount of the proceeds from the sale of the Common Stock acquired upon exercise of the option and an authorization to the broker or selling agent to pay that amount to the Company, which sale shall be at the participant's direction at the time of exercise. There shall be no such exercise at any one time as to fewer than one hundred (100) shares or all of the remaining shares then purchasable by the person or persons exercising the option if fewer than one hundred (100) shares. The Company's transfer agent shall, on behalf of the Company, prepare a certificate or certificates representing such shares acquired pursuant to exercise of the option, shall register the optionee as the owner of such shares on the books of the Company and shall cause the fully executed certificate(s) representing such shares to be delivered to the optionee as soon as practicable after payment of the option price in full. The holder of an option shall not have any rights of a stockholder with respect to the shares covered by the option, except to the extent that one or more certificates for such shares shall be delivered to him or her upon the due exercise of the option. 10. ADJUSTMENTS UPON CHANGES IN CAPITALIZATION AND OTHER EVENTS. Upon the occurrence of any of the following events, an optionee's rights with respect to options granted to him or her hereunder shall be adjusted as hereinafter provided: (a) STOCK DIVIDENDS AND STOCK SPLITS. If the shares of Common Stock shall be subdivided or combined into a greater or smaller number of shares or if the Company shall issue any shares of Common Stock as a stock dividend on its outstanding Common Stock, the number of shares of Common Stock deliverable upon the exercise of options shall be appropriately increased or decreased proportionately, and appropriate adjustments shall be made in the purchase price per share to reflect such subdivision, combination or stock dividend. (b) RECAPITALIZATION ADJUSTMENTS. In the event of a reorganization, recapitalization, merger, consolidation, or any other change in the corporate structure or shares of the Company, to the extent permitted by Rule 16b-3 under the Securities Exchange Act of 1934, adjustments in the number and kind of shares authorized by this Plan and in the number and kind of shares covered by, and in the option price of outstanding options under this Plan necessary to maintain the proportionate interest of the optionee and preserve, without exceeding, the value of such option, shall be made. Notwithstanding the foregoing, no such adjustment shall be made which would, within the meaning of any applicable provisions of the Internal Revenue 5 Code of 1986, as amended, constitute a modification, extension or renewal of any Option or a grant of additional benefits to the holder of an Option. (c) ISSUANCES OF SECURITIES. Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of shares subject to options. No adjustments shall be made for dividends paid in cash or in property other than securities of the Company. (d) ADJUSTMENTS. Upon the happening of any of the foregoing events, the class and aggregate number of shares set forth in paragraph 2 of this Plan that are subject to options which previously have been or subsequently may be granted under this Plan shall also be appropriately adjusted to reflect such events. The Board shall determine the specific adjustments to be made under this paragraph 10 and its determination shall be conclusive. 11. RESTRICTIONS ON ISSUANCE OF SHARES. Notwithstanding the provisions of paragraphs 4 and 9 of this Plan, the Company shall have no obligation to deliver any certificate or certificates upon exercise of an option until one of the following conditions shall be satisfied: (i) The issuance of shares with respect to which the option has been exercised is at the time of the issue of such shares effectively registered under applicable Federal and state securities laws as now in force or hereafter amended; or (ii) Counsel for the Company shall have given an opinion that the issuance of such shares is exempt from registration under Federal and state securities laws as now in force or hereafter amended; and the Company has complied with all applicable laws and regulations with respect thereto, including without limitation all regulations required by any stock exchange upon which the Company's outstanding Common Stock is then listed. 12. LEGEND ON CERTIFICATES. The certificates representing shares issued pursuant to the exercise of an option granted hereunder shall carry such appropriate legend, and such written instructions shall be given to the Company's transfer agent, as may be deemed necessary or advisable by counsel to the Company in order to comply with the requirements of the Securities Act of 1933, as amended, or any state securities laws. 13. REPRESENTATION OF OPTIONEE. If requested by the Company, the optionee shall deliver to the Company written representations and warranties upon exercise of the option that are necessary to show compliance with Federal and state securities laws, including representations and warranties to the effect that a purchase of shares under the 6 option is made for investment and not with a view to their distribution (as that term is used in the Securities Act of 1933, as amended). 14. OPTION AGREEMENT. Each option granted under the provisions of this Plan shall be evidenced by an option agreement, which agreement shall be duly executed and delivered on behalf of the Company and by the optionee to whom such option is granted. The option agreement shall contain such terms, provisions and conditions not inconsistent with this Plan as may be determined by the officer executing it. 15. TERMINATION AND AMENDMENT OF PLAN. Options may no longer be granted under this Plan after September 15, 2007, and this Plan shall terminate when all options granted or to be granted hereunder are no longer outstanding. The Board may at any time terminate this Plan or make such modification or amendment thereof as it deems advisable; PROVIDED, HOWEVER, that the Board may not, without approval by the affirmative vote of the holders of a majority of the shares of Common Stock present in person or by proxy and voting on such matter at a meeting, (a) increase the maximum number of shares for which options may be granted under this Plan (except by adjustment pursuant to Section 10), (b) materially modify the requirements as to eligibility to participate in this Plan, or (c) materially increase benefits accruing to option holders under this Plan. Termination or any modification or amendment of this Plan shall not, without consent of a participant, affect his or her rights under an option previously granted to him or her. 16. WITHHOLDING OF INCOME TAXES. Upon the exercise of an option, the Company, in accordance with Section 3402(a) of the Internal Revenue Code, may require the optionee to pay withholding taxes in respect of amounts considered to be compensation includible in the optionee's gross income. 17. COMPLIANCE WITH REGULATIONS. It is the Company's intent that the Plan comply in all respects with Rule 16b-3 under the Securities Exchange Act of 1934 (or any successor or amended provision thereof) and any applicable Securities and Exchange Commission interpretations thereof. If any provision of this Plan is deemed not to be in compliance with Rule 16b-3, the provision shall be null and void. 18. GOVERNING LAW. The validity and construction of this Plan and the instruments evidencing options shall be governed by the laws of the Commonwealth of Massachusetts, without giving effect to the principles of conflicts of law thereof. EX-21.1 5 EXHIBIT 21.1 EXHIBIT 21.1 EXCEL SWITCHING CORPORATION SUBSIDIARIES OF THE COMPANY 1. Excel Securities Corp. a Massachusetts Corporation Excel Switching Corporation ownership 100% 2. Excel Switching Japan KK a Japanese corporation Excel Switching Corporation ownership 100% 3. Excel Switching Europe a Belgian corporation Excel Switching Corporation ownership 100% EX-23.2 6 EX-23.2 EXHIBIT 23.2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statement on Form S-8 No. 333-51711. ARTHUR ANDERSEN LLP Boston, Massachusetts March 26, 1999 EX-27 7 EX-27
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM EXCEL SWITCHING CORPORATIONS 1998 CONSOLIDATED FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1998 DEC-28-1997 DEC-31-1998 62,517 55,579 30,912 (2,000) 5,404 163,886 25,671 (7,233) 198,782 32,483 4,858 0 0 340 161,101 198,782 123,258 123,258 35,603 35,603 57,113 0 (295) 36,669 14,979 21,690 0 0 0 21,690 .65 .55
-----END PRIVACY-ENHANCED MESSAGE-----