-----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, PJDbaNqw2VAj/AuoMSQFT0qDFhyVkXxuYO8W7U6hApTWlr5H5NvtVtmXqEuNr3y9 wGJj0X12YhxvyM4/xXeRJg== 0000927016-01-502499.txt : 20010815 0000927016-01-502499.hdr.sgml : 20010815 ACCESSION NUMBER: 0000927016-01-502499 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20010630 FILED AS OF DATE: 20010814 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NETWORK ENGINES INC CENTRAL INDEX KEY: 0001110903 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 043064173 STATE OF INCORPORATION: DE FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-30863 FILM NUMBER: 1713207 BUSINESS ADDRESS: STREET 1: 25 DAN ROAD CITY: CANTON STATE: MA ZIP: 02021 BUSINESS PHONE: 7813321000 MAIL ADDRESS: STREET 1: 25 DAN ROAD CITY: CANTON STATE: MA ZIP: 02021 10-Q 1 d10q.txt FORM 10-Q - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------- FORM 10-Q --------------------- (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________ to ___________ Commission file number: 0-30863 --------------------- NETWORK ENGINES, INC. (Exact name of registrant as specified in its charter) Delaware 04-3064173 (State or other jurisdiction of (I.R.S. Employer incorporation) Identification No.) 25 Dan Road, Canton, MA 02021 (Address of principal executive (Zip Code) offices) (781) 332-1000 (Registrant's telephone number, including area code) --------------------- 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 than 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 As of July 31, 2001, there were 35,132,226 shares of the registrant's Common Stock, par value $.01 per share, outstanding. - -------------------------------------------------------------------------------- NETWORK ENGINES, INC. INDEX PAGE NUMBER ------ PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONDENSED CONSOLIDATED BALANCE SHEETS ........................... 2 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ................. 3 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ................. 4 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ............ 5 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION ......................................... 10 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ............................................................ 27 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS ............................................... 28 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ....................... 28 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ............. 28 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ................................ 28 SIGNATURES .............................................................. 29 EXHIBIT INDEX ........................................................... 30 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS NETWORK ENGINES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
June 30, September 30, 2001 2000 ----------- ------------- ASSETS (unaudited) Current assets: Cash and cash equivalents ........................................ $ 81,672 $ 112,382 Restricted cash .................................................. 1,098 47 Accounts receivable, net of allowances ........................... 1,918 11,805 Inventories ...................................................... 733 6,600 Prepaid expenses and other current assets ....................... 464 1,031 Due from contract manufacturer ................................... 311 7,113 --------- --------- Total current assets .......................................... 86,196 138,978 Property and equipment, net ........................................... 6,221 7,098 Goodwill and intangible assets ........................................ 2,097 -- Other assets .......................................................... 106 136 --------- --------- Total assets .............................................. $ 94,620 $ 146,212 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ................................................. $ 3,306 $ 6,906 Due to contract manufacturer ..................................... 4,726 -- Accrued compensation and other related benefits .................. 905 1,773 Other accrued expenses ........................................... 806 1,077 Deferred revenue ................................................. 144 827 Current portion of capital lease obligations and notes payable ... 59 63 --------- --------- Total current liabilities ..................................... 9,946 10,646 Capital lease obligations and notes payable, net of current portion ... 30 90 Stockholders' equity: Preferred stock .................................................. -- -- Common stock ..................................................... 351 342 Additional paid-in capital ....................................... 178,630 171,314 Accumulated deficit .............................................. (82,219) (23,915) Notes receivable from stockholders ............................... (919) (94) Deferred stock compensation ...................................... (11,199) (12,171) --------- --------- Total stockholders' equity .................................... 84,644 135,476 --------- --------- Total liabilities and stockholders' equity ................ $ 94,620 $ 146,212 ========= =========
The accompanying notes are an integral part of the condensed consolidated financial statements. 2 NETWORK ENGINES, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited)
Three months ended June 30, Nine months ended June 30, --------------------------- -------------------------- 2001 2000 2001 2000 -------- -------- -------- -------- Net product revenues ..................................................... $ 2,130 $ 11,853 $ 11,129 $ 21,872 Net license revenues ..................................................... 250 2,666 661 3,113 -------- -------- -------- -------- Total net revenues ................................................... 2,380 14,519 11,790 24,985 Cost of revenues: Cost of product revenues (excluding stock compensation) .............. 2,158 8,916 10,804 15,714 Cost of license revenues (excluding stock compensation) .............. 2 17 4 24 Cost of revenues from stock compensation ............................. 80 84 251 159 Inventory write-down (recovery) ...................................... (2,837) -- 20,820 -- -------- -------- -------- -------- Total cost of revenues ............................................... (597) 9,017 31,879 15,897 -------- -------- -------- -------- Gross profit (loss) ................................................ 2,977 5,502 (20,089) 9,088 Operating expenses: Research and development ............................................. 3,067 2,063 10,909 5,147 Selling and marketing ................................................ 4,156 5,485 16,548 10,112 General and administrative ........................................... 1,238 1,120 5,691 2,311 Stock compensation ................................................... 2,217 954 4,844 1,755 Amortization of goodwill and intangible assets ....................... 225 -- 600 -- Restructuring and other charges ...................................... 2,812 -- 2,812 -- Loss on retirement of property and equipment ......................... -- -- 1,203 -- -------- -------- -------- -------- Total operating expenses ........................................... 13,715 9,622 42,607 19,325 -------- -------- -------- -------- Loss from operations ..................................................... (10,738) (4,120) (62,696) (10,237) Interest income, net ..................................................... 1,098 204 4,392 514 -------- -------- -------- -------- Net loss ................................................................. (9,640) (3,916) (58,304) (9,723) Accretion of redeemable convertible preferred stock ...................... -- (3,396) -- (7,655) -------- -------- -------- -------- Net loss attributable to common stockholders ............................. $ (9,640) $ (7,312) $(58,304) $(17,378) ======== ======== ======== ======== Net loss per common share - basic and diluted ............................ $ (0.28) $ (1.66) $ (1.71) $ (4.59) ======== ======== ======== ======== Shares used in computing net loss per common share - basic and diluted ... 34,436 4,413 34,159 3,784
The accompanying notes are an integral part of the condensed consolidated financial statements. 3 NETWORK ENGINES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
Nine months ended June 30, -------------------------- 2001 2000 --------- -------- Cash flows from operating activities: Net loss ................................................................................... $ (58,304) $ (9,723) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization .......................................................... 2,957 669 Provision for inventory reserve, net ................................................... 20,820 559 Provision for doubtful accounts ........................................................ 665 90 Stock compensation ..................................................................... 5,279 1,914 Interest on note receivable from stockholder ........................................... (13) (3) Loss on retirement of property and equipment ........................................... 1,203 -- Changes in operating assets and liabilities, net of effects of acquisition: Accounts receivable ................................................................ 9,222 (5,944) Inventories ........................................................................ (14,953) (8,026) Prepaid expenses and other current assets .......................................... 595 (1,013) Due from contract manufacturer ..................................................... 6,802 -- Accounts payable ................................................................... (3,804) 8,536 Due to contract manufacturer ....................................................... 4,726 -- Accrued expenses ................................................................... (1,145) 1,452 Deferred revenue ................................................................... (683) 1,216 --------- -------- Net cash used in operating activities ........................................... (26,633) (10,273) Cash flows from investing activities: Purchases of property and equipment ........................................................ (2,626) (5,239) Deposit of restricted cash ................................................................. (1,051) (279) Decrease (increase) in other assets ........................................................ 30 (50) Cash of business acquired, net of acquisition expenses ..................................... (30) -- --------- -------- Net cash used in investing activities ........................................... (3,677) (5,568) Cash flows from financing activities: Proceeds from notes payable ................................................................ -- 2,205 Payments on capital lease obligations and notes payable .................................... (64) (2,271) Issuance of stockholders' notes receivable ................................................. (812) -- Proceeds from issuance of common stock ..................................................... 476 379 Proceeds from issuance of redeemable convertible preferred stock, net of issuance costs .... -- 25,168 --------- -------- Net cash provided by (used in) financing activities ............................. (400) 25,481 --------- -------- Net increase (decrease) in cash and cash equivalents ............................................ (30,710) 9,640 Cash and cash equivalents, beginning of period .................................................. 112,382 1,435 --------- -------- Cash and cash equivalents, end of period ........................................................ $ 81,672 $ 11,075 ========= ========
The accompanying notes are an integral part of the condensed consolidated financial statements. 4 NETWORK ENGINES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying condensed consolidated financial statements have been prepared by Network Engines, Inc. ("Network Engines" or the "Company") in accordance with generally accepted accounting principles and pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the audited financial statements and the accompanying notes included in the Company's 2000 Annual Report on Form 10-K/A filed by the Company with the Securities and Exchange Commission. The information furnished reflects all adjustments, which, in the opinion of management, are of a normal recurring nature and are considered necessary for a fair presentation of results for the interim periods. It should also be noted that results for the interim periods are not necessarily indicative of the results expected for the full year or any future period. The preparation of these condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates included in the financial statements are inventory valuation, accounts receivable and sales allowances and the recoverability of intangible assets. Actual results could differ from those estimates. 2. SIGNIFICANT ACCOUNTING POLICIES Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission released Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). This bulletin summarizes certain views of the staff of the Securities and Exchange Commission (the "Staff") on applying generally accepted accounting principles to revenue recognition in financial statements. The Staff believes that revenue is realized or realizable and earned when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the seller's price to the buyer is fixed or determinable; and collectibility is reasonably assured. In June 2000, the Staff issued Staff Accounting Bulletin No. 101B, "Second Amendment: Revenue Recognition in Financial Statements," ("SAB 101B"). SAB 101B delays the implementation of SAB 101 until the fourth quarter of the Company's fiscal year 2001. The Company does not expect the application of SAB 101 to have a material impact on the Company's financial position or results of operations. In June 2001, the Financial Accounting Standards Board issued SFAS No. 141 ("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets." SFAS 141 requires that all business combinations be accounted for under the purchase method only and that certain acquired intangible assets in a business combination be recognized as assets apart from goodwill. SFAS 142 requires, among other things, the cessation of the amortization of goodwill. In addition, the standard includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS 142 also requires the completion of a transitional goodwill impairment test six months from the date of adoption. SFAS 141 is effective for all business combinations initiated after June 30, 2001. SFAS 142 is effective for the Company's fiscal quarters beginning on October 1, 2002; early adoption is not permitted. The Company is currently assessing the impact of adopting SFAS 142 on its financial position and results of operations. 5 NETWORK ENGINES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Comprehensive Loss During each period presented, comprehensive loss was equal to net loss. Segment Reporting During each period presented, the Company operated in a single business segment, primarily in the United States. 3. NET LOSS PER SHARE Basic net loss per share is computed by dividing the net loss attributable to common stockholders for the period by the weighted average number of shares of common stock outstanding during the period, excluding shares of common stock subject to repurchase by the Company ("restricted shares"). Diluted net loss per share is computed by dividing the net loss attributable to common stockholders for the period by the weighted average number of shares of common stock and potential common stock outstanding during the period, if dilutive. Potential common stock includes restricted shares and incremental shares of common stock issuable upon the exercise of stock options and warrants and upon conversion of redeemable convertible preferred stock. Because the inclusion of potential common stock would be anti-dilutive for all periods presented, diluted net loss per share is the same as basic net loss per share. The following table sets forth the potential common stock excluded from the calculation of net loss per common share because their inclusion would be anti-dilutive (in thousands): As of June 30, -------------------- 2001 2000 ------ ------ Options to purchase common stock .................... 6,034 3,729 Warrants to purchase common stock ................... 1,625 1,869 Unvested restricted common stock .................... 458 594 Redeemable convertible preferred stock .............. -- 21,448 ------ ------ 8,117 27,640 ====== ====== 4. INVENTORIES Inventories consisted of the following (in thousands): June 30, September 30, 2001 2000 -------- ------------- Raw materials ............................ $ 248 $3,524 Work in process .......................... 86 847 Finished goods ........................... 399 2,229 ------ ------ $ 733 $6,600 ====== ====== 5. CONTINGENCIES 6 NETWORK ENGINES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) On December 29, 1999, a former employee, George Flate, commenced a lawsuit against the Company, former officers and a current director in Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he was unlawfully terminated as Vice President of OEM Sales in an effort to deprive him of commission payments. Mr. Flate is seeking undisclosed damages based on two contractual claims relating to his employment, although the Company anticipates that Mr. Flate will claim damages in the multi-million dollar range. Specifically, Mr. Flate is alleging a breach of the implied covenant of good faith and fair dealing against the Company and a claim of intentional interference with contractual relations against the former officers of the company named in the lawsuit. Both of these claims are based on Mr. Flate's allegations that he is entitled to commissions from several transactions that were negotiated after Mr. Flate was no longer with the Company. Mr. Flate was employed by the Company for approximately one year. Currently, the matter is in the early stages of discovery. Although the Company believes that these claims are without merit and the Company intends to vigorously defend against each claim asserted in the complaint, an adverse resolution of either of these claims could require the payment of substantial monetary damages. Moreover, the Company's defense against these claims might result in the expenditure of significant financial and managerial resources. 6. ACQUISITION OF IP PERFORMANCE On November 8, 2000, the Company completed its acquisition of IP Performance, Inc. ("IP Performance"), a developer of network acceleration technology, through the exchange of 128,693 shares of Network Engines common stock for all outstanding shares of IP Performance capital stock. The acquisition was accounted for using the purchase method of accounting. Accordingly, the fair market value of the acquired assets and assumed liabilities have been included in the Company's financial statements as of the acquisition date and the results of IP Performance operations have been included in the Company's financial statements thereafter. The purchase price of approximately $2,540,000, assumed net liabilities of approximately $94,000 and acquisition expenses of approximately $63,000, resulted in goodwill and intangible assets of approximately $2,697,000. The Company is amortizing the goodwill and intangible assets over a three-year period. Through June 30, 2001, the Company amortized approximately $600,000 of goodwill and intangible assets. The Company's pro forma statements of operations prior to the acquisition would not differ materially from reported results. The Company also issued 321,756 shares of restricted common stock to key employee shareholders of IP Performance. These shares are restricted as to sale and such restrictions lapse in three equal annual installments beginning on November 8, 2001, contingent upon continued employment of the holder. In connection with the issuance of these restricted shares, the Company recorded approximately $6,351,000 of deferred compensation, which is being recognized as stock compensation expense ratably over the vesting period. Through June 30, 2001, the Company recognized approximately $2,474,000 of stock compensation expense. The amount of stock compensation expense to be recorded in future periods could change if holders of unvested restricted stock cease to be employees of the Company prior to the lapse of the vesting period. 7. INVENTORY WRITE-DOWN (RECOVERY) During the nine months ended June 30, 2001, the Company recorded a net inventory write-down of approximately $20,820,000 for excess and obsolete inventory related to the Company's WebEngine Blazer, WebEngine Sierra and StorageEngine Voyager products. This excess and obsolete inventory was due to an unanticipated shortfall in sales of these products and the resulting reduction in expected future sales of these products. The net write-down included inventory held at the Company's contract manufacturer, inventory on-hand and firm purchase commitments as of June 30, 2001. During the three months ended June 30, 2001, the Company reversed approximately $2,837,000 of inventory reserves recorded during the six months ended March 31, 2001. The reversal was the result of the Company's better-than-expected sales of products and components during the quarter ended June 30, 2001, as well as more favorable negotiations with vendors on inventory commitments, which had been included in the previously recorded inventory write-down. 7 NETWORK ENGINES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 8. RESTRUCTURING AND OTHER CHARGES In April 2001, as a result of the effect that the recent economic down-turn has had on the Company and its customers' information technology spending, the Company announced and implemented a restructuring plan to align the Company's operating expenses and cash requirements with current market conditions. This plan included a reduction in the Company's workforce from 243 employees to 170 employees, the curtailment of a planned expansion into currently leased facilities, the consolidation of international operations, a reduction of marketing programs and other items. The Company recorded a charge in the amount of approximately $951,000 for employee related costs including severance payments to terminated employees and stock option compensation expense related to modifications of certain stock options held by terminated employees. In addition, the Company recorded a charge of approximately $1,331,000 to write off certain assets related to facilities that the Company will not be occupying. The Company also recorded an additional charge of approximately $530,000 primarily related to non-refundable deposits on tradeshows the Company will not be attending as well as certain other sales and marketing commitments. The following table sets forth restructuring reserve activity during the three months ended June 30, 2001:
Employee Facility Related Related Other Total ------- ------- -------- ------- Restructuring charge $ 951 $ 1,331 $ 530 $ 2,812 Cash payments (678) (99) (119) (896) Non-cash utilization (184) (1,194) (277) (1,655) ------- ------- ------- ------- Restructuring reserve balance at June 30, 2001 $ 89 $ 38 $ 134 $ 261 ======= ======= ======= =======
The Company expects the remaining restructuring accrual balance to be fully utilized by December 31, 2001, which will include cash payments of approximately $261,000. 9. RETIREMENT OF PROPERTY AND EQUIPMENT During the nine months ended June 30, 2001, the Company retired fixed assets related to its WebEngine Blazer product line. These fixed assets had a total net book value of approximately $1,203,000 and consisted primarily of computer equipment previously utilized in the production and sales of the WebEngine Blazer, the Company's previous generation web content appliance server product. 10. RELATED PARTY TRANSACTIONS In January 2001, the Company entered into a series of related agreements with Lawrence A. Genovesi, the Company's current Chairman and former Chief Technology Officer and Chief Executive Officer. These agreements were entered into in order to avoid significant sales of the Company's stock by Mr. Genovesi as a result of a margin call on a personal loan that was collateralized by Mr. Genovesi's holdings of the Company's common stock. The Company agreed to guarantee a personal loan obtained by Mr. Genovesi from a financial institution (the "Bank") through a deposit of $1,051,850 of the Company's cash with the Bank (the "Guarantee"). The Guarantee period ends on January 9, 2002 and the balance of the amount deposited with the Bank will be returned to the Company. Mr. Genovesi and the Company also entered into an agreement whereby Mr. Genovesi has agreed to reimburse the Company for any obligations incurred by the Company under the Guarantee (the "Reimbursement Agreement"). Any unpaid balances under the 8 NETWORK ENGINES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Reimbursement Agreement bear interest at a rate of 10% per annum. In the event of a default of the Reimbursement Agreement by Mr. Genovesi, the Company has the right to apply any and all compensation due to Mr. Genovesi against all of Mr. Genovesi's obligations outstanding under the Reimbursement Agreement. In addition, the Company and Mr. Genovesi entered into a revolving promissory note of up to $210,000 (the "Note"). The Note bears interest at a rate of 5.9% per annum and is due and payable in full upon the earlier of January 9, 2002 or 30 days following the date Mr. Genovesi ceases to be an employee of the Company. In conjunction with the Guarantee, the Reimbursement Agreement and the Note, the Company and Mr. Genovesi entered into a pledge agreement whereby Mr. Genovesi pledged to the Company all shares of the Company's common stock owned by Mr. Genovesi as of the date of the agreement or subsequently acquired, and all options and other rights to acquire shares of the Company's common stock owned by Mr. Genovesi as of the date of the agreement or subsequently acquired (collectively the "Pledged Securities"). Additionally, Mr. Genovesi pledged to the Company all additional securities or other consideration from time to time acquired by Mr. Genovesi in substitution for, or in respect of, the Pledged Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during the term of the agreement, all proceeds of such sale will be applied first to any outstanding obligations related to the Note and then to any amounts payable under the Reimbursement Agreement. In addition to the Pledged Securities, the Note is collateralized by a second mortgage on certain real property owned by Mr. Genovesi. As of June 30, 2001, approximately $75,000 was outstanding under the Note (included in the balance sheet as notes receivable from stockholders) and no amounts were required to be reimbursed to the Company under the Reimbursement Agreement. In April 2001, the Company entered into full recourse loan agreements with certain current and former employees and certain current and former executive officers of the Company (the "Loan Agreements"). These loan agreements were entered into to avoid substantial sales of the Company's common stock by these employees and executive officers as a result of alternative minimum tax obligations incurred by these employees and executive officers. The total amount loaned to these employees and executive officers under the Loan Agreements was approximately $737,000. Outstanding amounts under the Loan Agreements accrue interest at a rate of 4.63% per annum and are due and payable in full upon the earlier of one year from the date of each individual agreement or thirty days after termination of employment with the Company, unless termination is involuntary and without cause. In conjunction with the Loan Agreements, each employee and executive officer pledged all shares of capital stock of the Company now owned, or acquired in the future, (the "Pledged Stock"), and any distributions on the Pledged Stock or proceeds from their sale. Amounts due under these Loan Agreements have been included in the balance sheet as notes receivable from stockholders. 11. SUBSEQUENT EVENTS In July 2001, the Company announced a restructuring plan to realign its organization and change its business strategy and approach to the appliance server market. As a result of this plan, the Company is de-emphasizing much of its customized hardware and software and transitioning from primarily direct sales channels to indirect sales channels and expects to reduce its workforce from approximately 160 employees to 95 employees. The Company expects to record a restructuring charge to operations of approximately $7,000,000 in the three months ended September 30, 2001. The Company expects this restructuring charge to be comprised of approximately $2.5 million of cash payments, primarily severance and employee related, and approximately $4.5 million of write-offs of impaired assets. On August 14, 2001, the Company announced that its board of directors had approved a $5 million stock repurchase program. The stock repurchase program will be carried out over time in open market transactions at prevailing market prices, or in non-solicited privately negotiated transactions, beginning on or about August 17, 2001. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Special Note Regarding Forward-looking Statements This form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain information about financial results, economic conditions, trends and known uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements as a result of a number of factors, which include those discussed in this section and elsewhere in this report and the risks discussed in our other filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly reissue these forward-looking statements to reflect events or circumstances that arise after the date hereof. The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 in this Quarterly Report on Form 10-Q and our 2000 Annual Report on Form 10-K/A filed by the Company with the Securities and Exchange Commission. Overview When we first entered the market for dense scalable web appliance servers, we focused our business primarily on providing our scalable web content servers to Internet-based organizations, content infrastructure providers and larger enterprises. It was necessary for us to design many of the hardware components, which went into the server and, as a result, we invested significant resources in the development of our products. In June 1999, we introduced our first generation of web servers, the WebEngine Blazer. Since the introduction of our WebEngine Blazer product, we experienced significant growth as we invested in the development of our technology and products, the recruitment and training of personnel for our engineering, sales and marketing and technical support departments, and the establishment of an administrative organization. As a result, our employee base grew from 39 as of June 30, 1999 to 244 as of March 31, 2001, and our operating expenses grew significantly. Over time, much of the hardware components of appliance servers have become commoditized and a significant number of companies have entered the appliance server marketplace. In response to competitive pressures and the effects of the recent downturn in the economy, we commenced a restructuring plan in the quarter ended June 30, 2001, to better align our operating expenses with our reduced revenues. This restructuring plan resulted in a $2.8 million charge to operations in the April 2001, and included a reduction in our work force to 170 employees, as well as the curtailment of planned facility expansion and other cost cutting measures. As part of this restructuring plan, we undertook an extensive review of our business strategy and in July 2001, we announced a second restructuring of our business to better position us to compete within the appliance server marketplace. As a result of our July 2001 restructuring, we will de-emphasize much of our customized software and hardware development and focus our resources on what we believe to be our core competencies of hardware packaging and software integration. In addition, this restructuring of our business includes a transition from primarily direct sales channels to partnerships with independent software vendors (ISVs) and OEMs in order to offer "turn-key" appliance server solutions to enterprise customers. The July 2001 restructuring plan includes a reduction in our work force from approximately 160 employees to approximately 95 employees. We expect to incur a charge to operations of approximately $7 million in the quarter ended September 30, 2001 as we execute our July 2001 restructuring plan. We expect this restructuring charge to be comprised of approximately $2.5 million of cash payments, primarily severance and employee related, and approximately $4.5 million of write-offs of impaired assets. At June 30, 2001, we had an accumulated deficit of approximately $82.2 million. Our revenues are derived from sales of our appliance servers. We recognize revenues when title to the goods has passed, provided evidence of an arrangement has been received, no obligations remain 10 outstanding and collectibility is reasonably assured. The majority of our sales to date have been to customers in the United States. In the past, we generated a portion of our net revenues from license arrangements, which allowed certain customers to sell our WebEngine Blazer product under their name in exchange for per unit fees. We recognized license revenues upon the licensee's sale to its customers. During the nine months ended June 30, 2001, we recorded approximately $661,000 in license revenues; however, we do not anticipate future revenues from existing license revenue arrangements. Gross profit (loss) represents net revenues recognized less the cost of revenues. Cost of revenues includes cost of materials, manufacturing costs, manufacturing personnel expenses, obsolescence charges, packaging, license fees and shipping and warranty costs. Our gross profit (loss) will be affected primarily by the mix of product revenues, product pricing, the timing, size and configuration of customer orders, and new product introductions by us and our competitors. Research and development expenses consist primarily of salaries and related expenses for personnel engaged in research and development, fees paid to consultants and outside service providers, material costs for prototype and test units and other expenses related to the design, development, testing and enhancements of our products. We expense all of our research and development costs as they are incurred. We believe that a significant level of investment in product research and development is required to remain competitive. We expect to continue to devote substantial resources to product research and development. However, as a result of our July 2001 restructuring plan, we expect research and development expenses to decrease in absolute dollars over the remainder of fiscal 2001 but continue to fluctuate as a percentage of net revenues. After our July 2001 restructuring, there were 36 employees in research and development compared to 81 employees at June 30, 2001. Selling and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales, marketing and customer support functions, as well as costs associated with advertising, trade shows, public relations and marketing materials. As a result of our July 2001 restructuring plan, we expect selling and marketing expenses to decrease in absolute dollars over the remainder of fiscal 2001 but continue to fluctuate as a percentage of net revenues. After our July 2001 restructuring, there were 25 employees in sales, marketing and customer support compared to 49 employees at June 30, 2001. General and administrative expenses consist primarily of salaries and other related costs for executive, finance, accounting, information technology, facilities and human resources personnel, as well as accounting, legal, other professional fees and allowance for doubtful accounts. As a result of our July 2001 restructuring plan, we expect these expenses to increase in absolute dollars over the remainder of fiscal 2001 as we complete the transition of our organization to our new business strategy, but continue to fluctuate as a percentage of net revenues. After our July 2001 restructuring, there were 14 general and administrative employees compared to 19 employees at June 30, 2001. We have recorded deferred stock compensation on our balance sheet of $15.5 million in connection with stock option and restricted stock grants to our employees and directors that were granted between February 1, 1999 and June 30, 2000. This amount represents the difference between the exercise price and the deemed fair value of our common stock for financial reporting purposes at the date of grant. We are amortizing this stock compensation over the vesting period of the related options. All options granted subsequent to June 30, 2000 have been issued with exercise prices equal to the deemed fair market value of the common stock and, accordingly, no additional deferred compensation has been recorded. Through June 30, 2001, we amortized $5.6 million to stock compensation expense and $2.5 million of deferred stock compensation has been reversed due to the cancellation of options for terminated employees. We recorded $6.4 million of deferred compensation on our balance sheet as a result of restricted stock issued to the employees of IP Performance, Inc. ("IP Performance") retained as our employees in connection with our acquisition of IP Performance in November 2000. The restricted stock vests annually through November 2003 and is contingent upon continued employment. Through June 30, 2001, we amortized $2.5 million to stock compensation expense. 11 During the next twelve months, after reversing deferred compensation to employees terminated in the July 2001 restructuring plan, we expect to amortize stock compensation of: Expected Amortization of Stock Fiscal Quarter Ending Compensation - --------------------- ------------ (in thousands) September 30, 2001 ....................................... $1,040 December 31, 2001 ........................................ 1,027 March 31, 2002 ........................................... 1,021 June 30, 2002 ............................................ 1,021 We expect aggregate per quarter stock compensation amortization of approximately $1.0 million during the remainder of fiscal 2002 and fiscal 2003 and an aggregate of approximately $1.0 million thereafter. The amount of stock compensation expense to be recorded in future periods could change if restricted common stock, or options, for accrued but unvested compensation are forfeited. Results of Operations The following table sets forth financial data for the periods indicated as a percentage of net revenues:
Three months ended Nine months ended June 30, June 30, ------------------ ----------------- 2001 2000 2001 2000 ---- ---- ---- ---- Net revenues ................................................................ 100% 100% 100% 100% Cost of revenues: Cost of product revenues (excluding stock compensation) ................ 91 61 92 63 Cost of license revenues (excluding stock compensation) ................ -- -- -- -- Cost of revenues stock compensation .................................... 3 1 2 1 Inventory write-down (recovery) ....................................... (119) -- 176 -- ---- ---- ---- ---- Total cost of revenues ................................................. (25) 62 270 64 ---- ---- ---- ---- Gross profit (loss) ................................................. 125 38 (170) 36 Operating expenses: Research and development ............................................... 129 14 93 21 Selling and marketing .................................................. 175 38 140 40 General and administrative ............................................. 52 8 48 9 Stock compensation ..................................................... 93 6 41 7 Amortization of goodwill and intangible assets ......................... 9 -- 5 -- Restructuring and other charges ........................................ 118 -- 24 -- Loss on retirement of property and equipment ........................... -- -- 10 -- ---- ---- ---- ---- Total operating expenses ............................................ 576 66 361 77 ---- ---- ---- ---- Loss from operations ........................................................ (451) (28) (531) (41) Interest income, net ........................................................ 46 1 37 2 ---- ---- ---- ---- Net loss .................................................................... (405%) (27%) (494%) (39%) ==== ==== ==== ====
Three Months Ended June 30, 2001 and June 30, 2000 12 Net Revenues Net revenues decreased to $2.4 million in the three months ended June 30, 2001 from $14.5 million in the three months ended June 30, 2000. The decrease is due primarily to a decrease in product sales volumes as a result of the general economic slowdown, which significantly impacted the information technology spending of our traditional "new economy" customer base. To a lesser extent, the decline in net revenues is the result of a decrease in license revenues and to a lower average selling price of our products due to increased competitive pricing pressure. We do not expect significant future license revenues. Gross Profit (Loss) Gross profit (loss) decreased to a profit of $3.0 million for the three months ended June 30, 2001 from a profit of $5.5 million in the three months ended June 30, 2000. This decrease is primarily due to the decrease in license revenues and, to a lesser extent, lower average selling prices and lower sales volumes. The decline in gross profit (loss) was offset by a reversal of $2.8 million of inventory reserves recognized during the three months ended June 30, 2001. This inventory reversal was due primarily to better-than-expected sales of products and components as well as favorable negotiations with vendors regarding inventory commitments previously reserved for. Excluding this inventory reserve reversal, gross profit (loss), in the three months ended June 30, 2001, was a profit of $140,000, which is attributable to license revenues of $250,000. Operating Expenses Research and Development. Research and development expenses increased to $3.1 million in the three months ended June 30, 2001 from $2.1 million in the three months ended June 30, 2000. This increase was due primarily to increased compensation costs as research and development personnel increased from 49 employees at June 30, 2000 to 81 employees at June 30, 2001. The increase in research and development expenses was offset by a decrease in prototype and test unit costs as well as decreases in consulting and recruiting. Selling and Marketing. Selling and marketing expenses decreased to $4.2 million in the three months ended June 30, 2001 from $5.5 million in the three months ended June 30, 2000. This decrease was due primarily to decreased compensation costs as sales, marketing and customer support personnel decreased from 60 employees at June 30, 2000 to 49 employees at June 30, 2001. To a lesser extent, the decrease in selling and marketing expenses is also attributable to decreased advertising costs and a decrease in recruiting costs. General and Administrative. General and administrative expenses increased to $1.2 million in the three months ended June 30, 2001 from $1.1 million in the three months ended June 30, 2000. This increase was due primarily to increased insurance costs as a result of the Company's July 2000 initial public offering. To a lesser extent, the increase in general and administrative expenses was due to increased facilities costs as a result of the Company's move into its Canton, MA headquarters in May 2000, which were somewhat offset by decreases in recruiting costs. Stock Compensation. We recognized stock compensation expense of $705,000 and $1.0 million in the three months ended June 30, 2001 and 2000, respectively, related to the grant of options and restricted stock to employees and directors during fiscal 1999 and prior to our initial public offering in fiscal 2000. In connection with restricted stock issued to employees as a result of our acquisition of IP Performance, Inc., we recorded deferred stock compensation of $6.4 million, of which we recognized $1.6 million as stock compensation expense during the three months ended June 30, 2001. 13 Amortization of Goodwill and Intangible Assets. In connection with our acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and intangible assets of $2.7 million, of which we amortized $225,000 in the three months ended June, 2001. Restructuring and Other Charges. As a result of our April 2001 restructuring, we recorded a charge to operations of $2.8 million. This charge was due to a reduction in our workforce from 243 employees to 170 employees, the curtailment of a planned expansion into leased facilities and other items. This restructuring was to better align our operating expenses with reduced revenues. This charge included approximately $951,000 for employee related costs including severance payments to terminated employees and stock option compensation expense related to modifications of certain stock options held by terminated employees, approximately $1,331,000 to write off certain assets related to facilities that we will not be occupying and approximately $530,000 primarily related to non-refundable deposits on tradeshows the Company will not be attending as well as certain other sales and marketing commitments. In July 2001, we announced a second restructuring and expect to record a charge to operations of approximately $7.0 million. Our July 2001 restructuring is the result of an intensive review of our business and includes a re-focus of our resources on hardware packaging and software integration and away from the custom hardware and software development that we had done in the past. Interest income, net Interest income, net increased to $1.1 million in the three months ended June 30, 2001 from $204,000 in the three months ended June 30, 2000. This increase was due to the investment of the net proceeds from our initial public offering in July 2000. Nine Months Ended June 30, 2001 and June 30, 2000 Net Revenues Net revenues decreased to $11.8 million in the nine months ended June 30, 2001 from $25.0 million in the nine months ended June 30, 2000. The decrease is due primarily to a decrease in product sales volumes as a result of the general economic slowdown and its impact on the information technology spending of our traditional "new economy" customer base. To a lesser extent, the decline in net revenues during the nine months ended June 30, 2001 is the result of a decrease in license revenues recognized as well as a lower average selling price of our products due to increased competitive pricing pressure. Gross Profit (Loss) Gross profit (loss) decreased to a loss of ($20.1) million for the nine months ended June 30, 2001 from a profit of $9.1 million in the nine months ended June 30, 2000. This decrease is primarily attributable to a charge of approximately $20.8 million to write-down excess and obsolete inventory in the nine months ended June 30, 2001, for which there was no comparable charge in the nine months ended June 30, 2000. The inventory write-down resulted from an unanticipated decline in sales during the nine months ended June 30, 2001 as well as a high level of inventory, and firm inventory commitments, compared to the Company's reduced expectations for future product sales. Excluding the inventory write-down, and stock compensation, gross profit (loss) decreased to a profit of $982,000, or 8% of net revenues, in the nine months ended June 30, 2001 from a profit of $9.2 million, or 37% of net revenues, in the nine months ended June 30, 2000. This decrease was primarily due to the decrease in product sales volumes and a decrease in license revenues recognized during the nine months ended June 30, 2001. To a lesser extent, the decrease in gross profit (loss) is the result of a lower average selling price of our products due to competitive pricing pressure in the nine months ended June 30, 2001. Operating Expenses Research and Development. Research and development expenses increased to $10.9 million in the nine months ended June 30, 2001 from $5.1 million in the nine months ended June 30, 2000. This increase was due primarily to increased compensation costs as research and development personnel increased from 49 employees at June 30, 2000 to 81 employees at June 30, 2001. To a lesser extent, the increase in research 14 and development expenses was due to increased prototype and test unit costs and higher consulting costs related to development efforts associated with the development of new products released during the nine months ended June 30, 2001. Selling and Marketing. Selling and marketing expenses increased to $16.5 million in the nine months ended June 30, 2001 from $10.1 million in the nine months ended June 30, 2000. This increase was due primarily to increased compensation costs as we increased our sales, marketing and customer support personnel to a peak of 98 employees during the nine months ended June 30, 2001 from 60 employees at June 30, 2000. As of June 30, 2001, we had approximately 49 employees in our sales, marketing and customer support organization. To a lesser extent, the increase in selling and marketing expenses is also attributable to increased travel costs associated with the increase in sales, marketing and customer support personnel as well as increased advertising costs. General and Administrative. General and administrative expenses increased to $5.7 million in the nine months ended June 30, 2001 from $2.3 million in the nine months ended June 30, 2000. This increase was due primarily to increased compensation costs as general and administrative personnel increased from 24 employees at June 30, 2000 to a peak of 34 employees during the nine months ended June 30, 2001 and ended at 19 employees as of June 30, 2001. In addition, this increase was due to increased professional service fees and insurance costs associated with our operation as a public company and increased bad debt expense. To a lesser extent, the increase was due to increase consulting costs associated with the expansion of our information technology infrastructure. Stock Compensation. We recognized stock compensation expense of $2.6 million and $1.9 million in the nine months ended June 30, 2001 and 2000, respectively, related to the grant of options and restricted stock to employees and directors during fiscal 1999 and prior to our initial public offering in fiscal 2000. In connection with restricted stock issued to employees as a result of our acquisition of IP Performance, Inc., we recorded deferred stock compensation of $6.4 million, of which we recognized $2.5 million as stock compensation expense during the nine months ended June 30, 2001. Amortization of Goodwill and Intangible Assets. In connection with our acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and intangible assets of $2.7 million, of which we amortized $600,000 in the nine months ended June 30, 2001. Loss on Retirement of Property and Equipment. In the nine months ended June 30, 2001, we retired fixed assets related to our WebEngine Blazer product line. These fixed assets had a total net book value of approximately $1,203,000 and consisted primarily of computer equipment previously utilized in the production and sales of the WebEngine Blazer, our previous generation web content appliance server product. Interest income, net Interest income, net increased to $4.4 million in the nine months ended June 30, 2001 from $514,000 in the nine months ended June 30, 2000. This increase was due to the investment of the net proceeds from our initial public offering in July 2000. Liquidity and Capital Resources Since fiscal 1997, we have financed our operations primarily through the sale of equity securities, borrowings and the sale of our products. On July 18, 2000, we completed our initial public offering by selling 7,475,000 shares of our common stock, including the exercise of the underwriters' overallotment option of 975,000 shares, at $17 per share and raised approximately $116.9 million, net of offering costs and underwriting fees totaling approximately $10.2 million. Prior to our initial public offering, we raised approximately $37.3 million, net of offering costs, from the issuance of preferred stock. As of June 30, 2001, we had $81.7 million in cash and cash equivalents, excluding restricted cash of $1.1 million. 15 Cash used in operating activities was $26.6 million and $10.3 million in the nine months ended June 30, 2001 and 2000, respectively. Cash used in operating activities during the nine months ended June 30, 2001 was primarily due to a net loss of $58.3 million, an increase in inventories and decreases in accounts payable and accrued expenses, offset in part by a decrease in accounts receivable and a net increase in the amount due to our contract manufacturer and adjusted for non-cash charges for inventory reserves, stock compensation, depreciation and amortization and a loss on the retirement of property and equipment. Cash used in operations during the six months ended June 30, 2000 was primarily due to a net loss of $9.7 million and increases in inventories, accounts receivable and prepaid expenses, offset in part by increases in accounts payable, accrued expenses and deferred revenue and adjusted for charges for depreciation, inventory reserves and stock-based compensation. Cash used in investing activities was $3.7 million and $5.6 million in the nine months ended June 30, 2001 and 2000, respectively. Cash used in investing activities was primarily for purchases of property and equipment, deposits of restricted cash for an executive loan guarantee and an increase in other assets during the nine months ended June 30, 2001. For the nine months ended June 30, 2000, cash used in investing activities was primarily for purchases of property and equipment and leasehold improvements to our headquarters in Canton, Massachusetts. Cash used in financing activities was $400,000 during the nine months ended June 30 2001 and cash provided by financing activities was $25.5 million in the nine months ended June 30, 2001. Cash used in financing activities in the nine months ended June 30, 2001 was primarily through the issuance of notes to stockholders, offset in part by cash provided by the issuance of common stock from the exercise of stock options and through our employee stock purchase plan. Cash provided by financing activities in the nine months ended June 30, 2000 was primarily from the sale of our series D preferred stock through which we raised net proceeds of approximately $25.2 million. In connection with our April 2001 restructuring, we are obligated to make additional cash payments of approximately $261,000 over the next two quarters. In connection with the July 2001 restructuring, we have committed to actions which will require cash payments of approximately $2.5 million, the majority of which will be made over the next two quarters. We anticipate that funds required to make all restructuring payments will be available from its current working capital. Our future liquidity and capital requirements will depend upon numerous factors, including: o the successful transition of our sales distribution focus from direct sales to strategic partnerships with independent software vendors and OEM's; o the costs and timing of product engineering efforts and the success of these efforts; o the costs involved in maintaining and enforcing intellectual property rights; o market developments; and o other factors. We believe that our available cash resources, including cash and cash equivalents, together with cash we expect to generate from sales of our products will be sufficient to meet our debt service, operating and capital requirements through at least the next 12 months. After that, we may need to raise additional funds. We may seek to raise additional funds through borrowings, public or private equity financings or from other sources. There can be no assurance that additional financing will be available at all or, if available, will be on terms acceptable to us. If additional financing is needed and is not available on acceptable terms, we would need to reduce our operating expenses. 16 Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission released Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). This bulletin summarizes certain views of the staff of the Securities and Exchange Commission (the "Staff") on applying generally accepted accounting principles to revenue recognition in financial statements. The Staff believes that revenue is realized or realizable and earned when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the seller's price to the buyer is fixed or determinable; and collectibility is reasonably assured. In June 2000, the Staff issued Staff Accounting Bulletin No. 101B, "Second Amendment: Revenue Recognition in Financial Statements," ("SAB 101B"). SAB 101B delays the implementation of SAB 101 until the fourth quarter of the Company's fiscal year 2001. The Company does not expect the application of SAB 101 to have a material impact on the Company's financial position or results of operations. In June 2001, the Financial Accounting Standards Board issued SFAS No. 141 ("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets." SFAS 141 requires that all business combinations be accounted for under the purchase method only and that certain acquired intangible assets in a business combination be recognized as assets apart from goodwill. SFAS 142 requires, among other things, the cessation of the amortization of goodwill. In addition, the standard includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS 142 also requires the completion of a transitional goodwill impairment test six months from the date of adoption. SFAS 141 is effective for all business combinations initiated after June 30, 2001. SFAS 142 is effective for the Company's fiscal quarters beginning on October 1, 2002; early adoption is not permitted. The Company is currently assessing the impact of adopting SFAS 142 on its financial position and results of operations. 17 FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS The risks and uncertainties described below are not the only ones we are faced with. Additional risks and uncertainties not presently known to us, or that are currently deemed immaterial, may also impair our business operations. If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected. Risks Related to Restructuring We have recently announced plans to restructure our business. There can be no assurance that these plans will have the intended effect on our business. On July 31, 2001, we announced plans to restructure our business. These plans include a considerable reduction in our workforce and our future operating expenses and an adjustment to our business plan to concentrate our resources on our core competencies, which include hardware platform packaging and integration and the ability to integrate our hardware platforms with various operating systems, management systems and application software systems. Our restructuring plans also include a transition from primarily direct sales channels to partnerships with independent software vendors and OEMs in order to offer "turn-key" solutions for enterprise customers. There can be no assurance that these restructuring plans will have a positive effect on our financial results, our market share, the market price of our common stock or public perception of us in the appliance server marketplace, or that we will ever achieve substantial revenues, each of which could cause further decline in the market price of our common stock. Risks Related to Competition Within Our Industry If we are not able to effectively compete against providers of general-purpose servers or specific-purpose servers, our revenues will not increase and may decrease further. In the market for appliance servers, we face significant competition from larger companies who market general-purpose or specific-purpose servers and have greater financial resources and name recognition than we do. Many of these companies have larger and more established service organizations to support these products. These and other large competitors may be able to leverage their existing resources, including their service organizations, and provide a wider offering of products and higher levels of support on a more cost-effective basis than we can. In addition, competing companies may be able to undertake more extensive promotional activities, adopt more aggressive pricing policies and offer more attractive terms to their customers than we can. If these large competitors provide lower cost appliance servers with greater functionality or support than our products, or if some of their products are comparable to ours and are offered as part of a range of products that is broader than ours, our products could become undesirable. Even if the functionality of competing products is equivalent to ours, we face a substantial risk that a significant number of customers would elect to pay a premium for similar functionality rather than purchase products from a less-established vendor. Increased competition may continue to negatively affect our business and future operating results by leading to price reductions, higher selling expenses or a reduction in our market share. Our revenues could be reduced if general-purpose server, or specific-purpose server, manufacturers make acquisitions in order to join their extensive distribution capabilities with our smaller competitors' products. Compaq, Dell, Hewlett-Packard, IBM, Sun Microsystems, Network Appliance and other server manufacturers may not only develop their own appliance server solutions, but they may also acquire or establish cooperative relationships with our other current competitors, including smaller private companies. Because general-purpose server, and certain specific-purpose server, manufacturers have significant financial and organizational resources available, they may be able to quickly penetrate the appliance server market by leveraging the technology and expertise of smaller companies and utilizing their own extensive distribution channels. For example, Cobalt, an appliance server company was acquired by Sun 18 Microsystems in December 2000. We expect that the appliance server industry will experience further consolidation. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share through consolidation. We may sell fewer products if other vendors' products are no longer compatible with ours or other vendors bundle their products with those of our competitors and sell them at lower prices. Our ability to sell our products depends in part on the compatibility of our products with other vendors' software and hardware products. Developers of these products may change their products so that they will no longer be compatible with our products. These other vendors may also decide to bundle their products with other appliance servers for promotional purposes and discount the sales price of the bundle. If that were to happen, our business and future operating results could suffer if we were no longer able to offer commercially viable products. If we fail to successfully transition our customer base to strategic partnerships with independent software vendors and OEM's, our operations could be materially adversely affected. To date, our revenues have been principally derived from smaller companies in the Internet marketplace, otherwise known as "new economy" customers. As a component of our July 2001 announced restructuring plans, we will focus our sales and marketing efforts on strategic partnerships with independent software vendors and OEM's. This strategy may fail to generate sufficient revenues to offset the demands that this strategy will place on our business. A failure to successfully transition our revenues to strategic partnerships could materially adversely affect our operations. Appliance server products are subject to rapid technological change due to changing operating system software and network hardware and software configurations, and our sales will suffer if our products are rendered obsolete by new technologies. The appliance server market is characterized by rapid technological change, frequent new product introductions and enhancements, potentially short product life cycles, changes in customer demands and evolving industry standards. Our products could be rendered obsolete if products based on new technologies are introduced or new industry standards emerge. New products and product enhancements can require long development and testing periods, which requires us to hire and retain scarce, technically competent personnel. Significant delays in new product releases or significant problems in installing or implementing new products could seriously damage our business. We have on occasion experienced delays in the scheduled introduction of new and enhanced products and cannot be certain that we will avoid similar delays in the future. Our future success depends upon our ability to utilize our creative packaging and hardware and software integration skills to combine industry standard hardware and software to produce low-cost, high-performance products that satisfy our strategic partners' requirements and achieve market acceptance. We cannot be certain that we will successfully identify new product opportunities and develop and bring new products to market in a timely and cost-effective manner. Risks Related to Our Financial Results We are an early-stage company in the evolving market for appliance servers. Because of our limited operating history in the appliance server market, it is difficult to discern trends that may emerge and affect our business. We may experience negative trends associated with seasonality that, due to our limited operating history, we have not experienced in the past. In the past, it was necessary for us to custom design almost all of the hardware in our appliance servers. To date, these products have not obtained significant market acceptance and, as the appliance server market has evolved, much of the hardware, and software, has become standardized. As a result, we have decided to de-emphasize our focus on customized hardware and software and to develop appliance servers using more standardized hardware and software. We can not be sure whether our future product offerings 19 will obtain market acceptance, whether they will capture adequate market share or whether we will be able to recognize significant revenue from them. Our limited historical financial performance may make it difficult for you to evaluate the success of our business to date and to assess its future viability. If our customers do not purchase our future products, our revenues and operating results will be adversely affected. Factors that may affect the market acceptance of our products, some of which are beyond our control, include the following: o the growth and changing requirements of the appliance server market; o the performance, quality, price and total cost of ownership of our products; o the availability, price, quality and performance of competing products and technologies; and o the successful development of our relationships with existing and potential channel partners. We have a history of losses and expect to experience losses in the future, which could result in the market price of our common stock declining. Since our inception, we have incurred significant net losses, including net losses of $4.2 million, $5.8 million and $12.5 million in fiscal 1998, 1999 and 2000, respectively, as well as net losses of $9.6 million and $58.3 million in the three and nine-month periods ended June 30 2001, respectively. We expect to have net losses in the future. In addition, we had an accumulated deficit of $82.2 million as of June 30, 2001. We believe that our future growth depends upon the success of our new product development and selling and marketing efforts, which will require us to incur significant product development, selling and marketing and administrative expenses. As a result, we will need to generate significant revenues to achieve profitability. We cannot be certain that we will achieve profitability in the future or, if we achieve profitability, that we will be able to sustain it. If we do not achieve and maintain profitability, the market price for our common stock may continue to decline. We anticipate that our expenses will decrease through at least the remainder of the current fiscal year as a result of our recently announced restructuring plans as we curtail discretionary selling, general and administrative expenses, consolidate our international operations, defer our expansion into Asia, implement new business strategies to efficiently maximize our resources and utilize other cost saving methods. If these, or other cost control measures that we may employ, are unsuccessful, our expenses could increase and our losses could be greater than expected, which could negatively impact the market price for our common stock. Our revenues have fallen sharply recently and we may not be able to return to our historical revenue growth rates, which could cause our stock price to decline even further. Our revenues grew rapidly in fiscal 1999 and fiscal 2000 and fell sharply in the nine months ended June 30, 2001. We are unable to predict whether or not we will be able to return to the rate of revenue growth achieved in fiscal 1999 and fiscal 2000 because of uncertain economic conditions, growing competition, the incremental manner in which customers implement appliance servers and our recently announced transition from primarily direct sales channels to indirect channels. If we are unable to return to the rate of revenue growth we experienced in fiscal 1999 and fiscal 2000, our stock price could experience further declines. If the commodification of products and competition in the appliance server market increases, then the average unit price of our products may decrease and our operating results may suffer. Products in the appliance server market may be subject to further commodification as the industry matures and other businesses introduce more competing products. The average unit price of some of our products 20 has already decreased, and may continue to decrease, in response to changes in product mix, competitive pricing pressures, or new product introductions by us or our competitors. If we are unable to offset decreases in our average selling prices by increasing our sales volumes, our revenues will decline. Changes in the mix of sales of our products, including the mix of higher margin sales of products sold in smaller quantities and somewhat lower margin sales of products sold in larger quantities, could adversely affect our operating results for future quarters. To improve our gross margins, we also must reduce the manufacturing cost of our products. Our efforts to produce higher margin products, continue to improve our products and produce new products may make it difficult to reduce our manufacturing cost per product. Further, our current reliance on our single manufacturer, SCI Systems, may not allow us to reduce our cost per product. Our quarterly revenues and operating results may fluctuate due to a lack of growth of the appliance server market in general or failure of our products to achieve market acceptance. Our quarterly revenues and operating results are difficult to predict and may fluctuate significantly from quarter to quarter because appliance servers generally, and our current products in particular, are relatively new and the future growth of the market for our products is uncertain. In addition, we expect to rely on additional new products for growth in our net revenues in the future. If the appliance server market in general fails to grow as expected or our products fail to achieve market acceptance, our quarterly net revenues and operating results may fall below the expectations of investors and public market research analysts. In this event, the price of our common stock could decline. We expect to continue to derive a substantial portion of our revenues from a small number of customers, and our financial results may suffer significantly if major customers do not purchase of our products. A relatively small number of customers accounted for a significant portion of our net revenues. In fiscal 1999, sales to three customers accounted for 46%, 28% and 14% of net revenues. In fiscal 2000, sales to two customers accounted for 16% and 12% of net revenues. In the three months ended June 30, 2001, sales to two customers accounted for 11% each of net revenues. None of our customers is obligated to purchase any quantity of our products in the future. As a result of our recently announced restructuring, we will focus primarily on partnerships with independent software vendors and OEMs and we will significantly de- emphasize our sales to end-user customers. Accordingly, we expect to derive a substantial portion of our future revenues from a small number of independent software vendors and OEMs. If we are unsuccessful in partnering with substantial independent software vendors and OEMs, our financial results may be adversely affected, our reputation in the industry may suffer and our ability to predict cash flow accurately may decrease. Risks Related to the Growth of the Appliance Server Market and the Internet. If appliance servers are not increasingly adopted as a means to deliver on and conduct commerce over the Internet, the market for our products may not grow and the market price for our common stock could decline as a result of lower revenues or reduced investor expectations. We expect that substantially all of our revenues will come from sales of our newest and future appliance server products. As a result, we depend on the growing use of appliance servers as a means to deliver information and conduct commerce over the Internet. The market for appliance server products, particularly those using the Internet to deliver information and process commercial transactions, has only recently begun to develop and is evolving rapidly. Because this market is new, we cannot predict its potential size or future growth rate. Our revenues may not grow and the market price for our common stock could decline if the appliance server market does not grow rapidly. We believe that our expectations for the growth of the appliance server market may not be fulfilled if customers continue to use general-purpose servers. The role of our appliance servers could, for example, be limited if general-purpose servers become better at performing functions currently being performed by our appliance servers or are offered at a lower cost. This could force us to further lower the prices of our products or result in fewer sales of our products. 21 If the market for appliance server products does not grow because medium to large Internet service providers and application service providers in our target market are not receptive to them, our revenues may not grow. Large Internet service providers and application service providers that offer hosting services may not be as receptive to our products as other organizations because they currently rely on, and their buying programs are more likely to be based on, established, proprietary operating systems and general-purpose servers. In addition, we expect that Internet service providers that specialize in providing Internet access and non-hosting services to consumers will not be substantial purchasers of our products. Consolidation has begun to occur in the Internet service provider and application service provider market, with many large Internet service providers and application service providers acquiring smaller and regional companies. Continued consolidation in this market could result in some of our customers being absorbed into larger organizations. This consolidation may increase the number of larger corporations that may not be as receptive to our products and, as a result, our revenues would not grow and may even decrease. Potential increases or changes in governmental regulation of Internet communication and commerce could discourage the growth of the Internet, which could decrease the demand for our products. Due to concerns arising from the increasing use of the Internet, a number of laws and regulations have been, and may be, adopted covering issues including user privacy, taxation, pricing, acceptable content and quality of products and services. Legislative changes could dampen the growth in use of the Internet generally and decrease the acceptance of the Internet as a communications and commercial medium. Further, due to the global nature of the Internet, it is possible that multiple federal, state or foreign jurisdictions might attempt to regulate Internet transmissions or levy sales or other taxes relating to Internet-based activities. Moreover, the applicability to the Internet of existing laws, including laws governing property ownership, libel and personal privacy, is uncertain. We cannot assess the possible negative impact of any future regulation of the Internet on our business. Risks Related to Our Marketing and Sales Efforts We need to effectively manage our sales and marketing operations to continue to increase market awareness and sales of our products. If we fail to do so, our growth, if any, will be limited. Through our recent restructuring plans, we significantly reduced our selling and marketing personnel in an attempt to reduce operating expenses and to conserve cash. Although we have fewer selling and marketing personnel, we must continue to increase market awareness and sales of our products. If we fail in this endeavor, our growth, if any, will be limited. Our efforts to promote our brand may not result in the desired brand recognition by customers or in increased sales. In the fast growing market for appliance servers, we believe we need a strong brand to compete successfully. In order to attract and retain customers, we believe that our brand must be recognized and viewed favorably by our customers and end users. As part of our recent restructuring plans, we reduced our marketing programs. If we are unable to design and implement effective marketing campaigns or otherwise fail to promote and maintain our brand, our sales may not increase and our business may be adversely affected. Our business may also suffer if we incur excessive expenses promoting and maintaining our brand but fail to achieve the expected or desired increase in revenues. If we are unable to effectively manage our customer service and support activities, we may not be able to retain our existing customers and attract new customers. We have a small customer service and support organization. We need to effectively manage our customer support operations to ensure that we maintain good relationships with our customers. If our customer support organization is unsuccessful in maintaining good customer relationships, we may lose customers to 22 our competitors and our reputation in the market could be damaged. As a result, we may lose revenue and incur losses greater than expected. Risks Related to Our Product Manufacturing We rely on a single contract manufacturer to produce our products, which could have an adverse affect on our operations. Our agreement with SCI Systems does not guarantee production levels, manufacturing line space or manufacturing prices. In addition, our agreement with SCI renews annually and allows either party to elect not to renew the agreement. If we are required to, or if we choose to, change outside manufacturers, we may experience transitional difficulties and we may lose sales and customer relationships may suffer. In addition, in the event that we require additional manufacturing capacity, SCI Systems may not have additional facilities available when we need them. Commencing volume production or expanding production to another facility owned by SCI Systems may be expensive and time-consuming. In addition, commencement of the manufacturing of our products at additional SCI Systems manufacturing sites we may need in the future may cause transitional problems, including delays and quality control issues, which could cause us to lose sales and impair our ability to achieve profitability. We may need to find new outside manufacturers to manufacture our products in higher volume and at lower costs to meet increased demand and competition. In addition, Sanmina Corporation and SCI Systems have recently announced their plans to merge. There can be no assurance as to the effect, positive or negative, that this merger will have on the operation of SCI as it relates to our agreement with them. If we do not accurately forecast our component requirements, our business and operating results could be adversely affected. We use rolling forecasts based on anticipated product orders to determine our component requirements. Lead times for materials and components that we order vary significantly and depend on factors including specific supplier requirements, contract terms and current market demand for those components. In addition, a variety of factors, including the timing of product releases, potential delays or cancellations of orders and the timing of large orders, make it difficult to predict product orders. As a result, our component requirement forecasts may not be accurate. If we overestimate our component requirements, we may have excess inventory, which would increase our costs. If we underestimate our component requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our products to our customers. Any of these occurrences would negatively impact our business and operating results. Our dependence on sole source and limited source suppliers for key components makes us susceptible to supply shortages that could prevent us from shipping customer orders on time, if at all, and could result in lost sales or customers. We depend upon single source and limited source suppliers for our industry-standard processors and power supplies and our printed circuit boards, chassis and sheet metal parts. We also depend on limited sources to supply several other industry-standard components. We have in the past experienced, and may in the future experience, shortages of, or difficulties in acquiring, components needed to produce our products. Shortages have been of limited duration and have not yet caused delays in production of our products. However, shortages in supply of these key components for an extended time would cause delays in the production of our products, prevent us from satisfying our contractual obligations and meeting customer expectations, and result in lost sales or customers. If we are unable to buy components we need or if we are unable to buy components at acceptable prices, we will not be able to manufacture and deliver our products on a timely or cost-effective basis to our customers. 23 Risks Related to Our Products' Dependence on Intellectual Property and Our Use of Our Brand Our reliance upon contractual provisions and domestic trademark laws to protect our proprietary rights may not be sufficient to protect our intellectual property from others who may sell similar products. Our products are differentiated from those of our competitors by our internally developed software and hardware and the manner in which they are integrated into our products. If we fail to protect our intellectual property, other vendors could sell products with features similar to ours, and this could reduce demand for our products. We believe that the steps we have taken to safeguard our intellectual property afford only limited protection. Others may develop technologies that are similar or superior to our technology or design around the copyrights and trade secrets we own. Despite the precautions we have taken, laws and contractual restrictions may not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies. In addition, the laws of the countries in which we decide to market our services and solutions may offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third-parties to benefit from our technology without paying us for it, which would significantly harm our business. We have invested substantial resources in developing our products and our brand, and our operating results would suffer if we were subject to a protracted infringement claim or one with a significant damages award. Substantial litigation regarding intellectual property rights and brand names exists in our industry. We expect that appliance server products may be increasingly subject to third-party infringement claims as the number of competitors in our industry segment grows and the functionality of products in different industry segments overlaps. We are not aware that our products employ technology that infringes any proprietary rights of third parties. However, third parties may claim that we infringe their intellectual property rights. Any claims, with or without merit, could: o be time-consuming to defend; o result in costly litigation; o divert our management's attention and resources; o cause product shipment delays; or o require us to enter into royalty or licensing agreements. Royalty or licensing agreements may not be available on terms acceptable to us, if at all. A successful claim of product infringement against us or our failure or inability to license the infringed or similar technology could adversely affect our business because we would not be able to sell the impacted product without redeveloping it or incurring significant additional expenses. Other Risks Related to Our Business If we do not retain our senior management, we may not be able to successfully execute our business plan. As a result of our recent restructurings, we have lost members of our management team. The loss of key members of our current management team could harm us. Our success is substantially dependent on the ability, experience and performance of these members of our senior management team. Because of their ability and experience, we may not be able to implement successfully our business strategy, if we lose one or more of these members. 24 If we fail to retain a significant number of qualified technical personnel, we may not be able to develop and introduce our products on a timely basis. We require the services of a substantial number of qualified technical personnel. The market for qualified personnel is characterized by intense competition, as well as a high level of employee mobility, which makes it particularly difficult to attract and retain the qualified technical personnel we require. We have experienced the negative effects of an economic slowdown. Our revenues have declined significantly during the past six months and the market price of our common stock has decreased significantly. As a result, we have undertaken plans to substantially reduce our operating expenditures, including a reduction in the number of personnel in our organization. This reduction in personnel places added pressure on the remaining employees and management of the Company. These and other factors may make it difficult for us to retain the qualified employees and management that we need to effectively manage our business operations, including key research and development activities. If we are unable to retain a sufficient number of technical personnel we may not be able to complete development of, or upgrade or enhance, our products in a timely manner, which could negatively impact our business and could hinder any future growth. If the market price of our common stock is not quoted on a national exchange, our ability to raise future capital may be hindered and the market price of our common stock may be negatively impacted. The market price for our common stock has significantly declined recently and our common stock failed to achieve a closing bid price of one dollar for a period of thirty days. As a result, we received notification from the NASDAQ stock market that, if our common stock failed to maintain a closing bid price of one dollar or greater for a period of ten trading days prior to and including October 29, 2001, then there is the potential that our common stock could be de-listed from the NASDAQ National Market. If our common stock is de-listed from the NASDAQ National Market, we may experience difficulties in raising future capital, if needed, to continue our business operations. In addition, in the event that the market price of our common stock is not quoted on the NASDAQ National Market, our stock price may be further negatively impacted. If we cannot manage our international operations profitably, our revenues may not increase and our business and results of operations would be adversely affected. We have limited experience managing an international sales operation. There are risks and complexities inherent in conducting international operations, including, for example, longer payment cycles, local labor laws and practices and the complexity of complying with additional regulatory requirements. Any of these factors, and our inexperience, may limit our ability to profitably manage our international operations and, consequently, our business and results of operations may suffer. If our products fail to perform properly and conform to our specifications, our customers may demand refunds or assert claims for damages and our reputation and operating results may suffer. Because our appliance server products are complex, they could contain errors or bugs that can be detected at any point in a product's life cycle. In the past we have discovered errors in some of our products and have experienced delays in the shipment of our products during the period required to correct these errors or we have had to replace defective products that were already shipped. These delays and replacements have principally related to new product releases. Errors in our products may be found in the future and any of these errors could be significant. Detection of any significant errors may result in: o the loss of or delay in market acceptance and sales of our products; o diversion of development resources; o injury to our reputation; or o increased maintenance and warranty costs. These problems could harm our business and future operating results. Product errors or delays could be material, including any product errors or delays associated with the introduction of new products or the versions of our products that support Windows or UNIX-based operating systems. If our products fail to conform to warranted specifications, customers could demand a refund for the purchase price or assert claims for damages. Moreover, because our products are used in connection with critical distributed computing systems services, we may receive significant liability claims if our products do not work properly. Our agreements with customers typically contain provisions intended to limit our exposure to liability claims. However, these limitations may not preclude all potential claims. Liability claims could exceed our insurance coverage and require us to spend significant time and money in litigation or to pay significant damages. 25 Any claims for damages, whether or not successful, could seriously damage our reputation and our business. Our stock may be subject to substantial price and volume fluctuations due to a number of factors, many of which will be beyond our control that may prevent our stockholders from reselling our common stock at a profit. The securities markets have experienced significant price and volume fluctuations in the past and the market prices of the securities of technology companies have been especially volatile. This market volatility, as well as general economic, market or political conditions, could reduce the market price of our common stock in spite of our operating performance. In addition, our operating results could be below the expectations of public market analysts and investors, and in response the market price of our common stock could decrease significantly. Investors may be unable to resell their shares of our common stock for a profit. In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of management's attention and resources. The recent decline in the market price of our common stock and market conditions generally could adversely affect our ability to raise additional capital, to complete future acquisitions of or investments in other businesses and to attract and retain qualified technical and sales and marketing personnel. We have anti-takeover defenses that could delay or prevent an acquisition and could adversely affect the price of our common stock. Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and, without any further vote or action on the part of the stockholders, will have the authority to determine the price, rights, preferences, privileges and restrictions of the preferred stock. This preferred stock, if issued, might have preference over the rights of the holders of common stock and could adversely affect the price of our common stock. The issuance of this preferred stock may make it more difficult for a third party to acquire us or to acquire a majority of our outstanding voting stock. We currently have no plans to issue preferred stock. In addition, provisions of our second amended and restated certificate of incorporation, second amended and restated by-laws and equity compensation plans may deter an unsolicited offer to purchase Network Engines. These provisions, coupled with the provisions of the Delaware General Corporation Law, may delay or impede a merger, tender offer or proxy contest involving Network Engines. For example, our board of directors will be divided into three classes, only one of which will be elected at each annual meeting. These factors may further delay or prevent a change of control of our business. Future sales by existing stockholders could depress the market price of our common stock. Sales of a substantial number of shares of our common stock by existing stockholders could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity securities. 26 We may need additional capital that may not be available to us and, if raised, may dilute our existing investors' ownership interest in us. We may need to raise additional funds to develop or enhance our services and solutions, to fund expansion, to respond to competitive pressures or to acquire complementary products, businesses or technologies. Additional financing may not be available on terms that are acceptable to us. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and these securities might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds are not available on acceptable terms, our ability to fund our expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We do not engage in any foreign currency hedging transactions and therefore, do not believe we are subject to material exchange rate risk. We are exposed to market risk related to changes in interest rates. We invest excess cash balances in cash equivalents. We believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows will not be material. 27 PART II--OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On December 29, 1999, a former employee, George Flate, commenced a lawsuit against us, a current officer and director and a former officer and director in Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he was unlawfully terminated as Vice President of OEM Sales in an effort to deprive him of commission payments. He is seeking undisclosed damages based on two contractual claims relating to his employment, although we anticipate he will claim damages in the multi-million dollar range. Specifically, he is alleging a breach of the implied covenant of good faith and fair dealing against Network Engines and a claim of intentional interference with contractual relations against the current and former officers of the company named in the lawsuit. Both of these claims are based on Mr. Flate's allegations that he is entitled to commissions from several transactions that were negotiated after Mr. Flate was no longer with the company. Mr. Flate was employed by Network Engines for approximately one year. Currently, the matter is in the early stages of discovery. Although we believe these claims are without merit and we intend to vigorously defend against each claim asserted in the complaint, an adverse resolution of either of these claims could require the payment of substantial monetary damages. Moreover, our defense against these claims might result in the expenditure of significant financial and managerial resources. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (d) Use of Proceeds from Sales of Registered Securities On July 18, 2000, we sold 7,475,000 shares of our common stock in an initial public offering at a price of $17.00 per share pursuant to a Registration Statement on Form S-1 (the "Registration Statement") (Registration No. 333-34286), which was declared effective by the Securities and Exchange Commission on July 12, 2000. The aggregate proceeds to us from the offering were approximately $116.9 million reflecting gross proceeds of $127.0 million net of underwriting fees of approximately $8.9 million and other offering costs of approximately $1.3 million. None of the proceeds of the offering was paid by us, directly or indirectly, to any director, officer or general partner of ours or any of their associates, to any persons owning ten percent or more of our outstanding stock, or to any of our affiliates. During the period from the offering to June 30, 2001, we have used the proceeds as follows: approximately $31.9 million was used to fund the operations of the Company and approximately $4.1 million was used for capital acquisitions. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the three months ended June 30, 2001. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The exhibits which are filed with this report or which are incorporated by reference are set forth in the Exhibit Index hereto. (b) Reports on Form 8-K We did not file any reports on Form 8-K during the period covered by this report. 28 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NETWORK ENGINES, INC. Date: August 14, 2001 /s/ John H. Curtis -------------------------------------------- John H. Curtis President and Chief Executive Officer (Principal Executive Officer) /s/ Douglas G. Bryant -------------------------------------------- Douglas G. Bryant Vice President of Administration, Chief Financial Officer, Treasurer and Secretary (Principal Financial Officer and Principal Accounting Officer) 29 EXHIBIT INDEX Exhibit No. Exhibit 10.31 Sub-lease agreement dated June 21, 2001, with Techmar Communications, Inc. for 45 Dan Road, Canton, Massachusetts. 10.32 Consent to Sub-lease from Dan Road Buildings, LLC regarding sub-lease agreement for 45 Dan Road, Canton, Massachusetts. 30 EX-10.31 3 dex1031.txt SUB-LEASE AGREEMENT DATED 6/21/2001 EXHIBIT 10.31 SUBLEASE THIS SUBLEASE ("Sublease") is made as of June 21, 2001 , by Network Engines, Inc. ("Sublandlord"), a Delaware corporation with principal offices at 25 Dan Road, Canton MA 02021 and Techmar Communications, Inc., a Delaware corporation ("Subtenant"). BACKGROUND: A. New Boston Battery March Limited Partnership, predecessor in interest to Dan Road Building LLC, as Landlord ("Prime Landlord"), and Sublandlord, as Tenant, entered into a Lease dated 19 October 1999 (the "Original Lease"), as amended by a First Amendment to Lease Agreement, dated February 1, 2000 (the "First Amendment"), as further amended by a Second Amendment to Lease Agreement, dated June 1, 2000, (the "Second Amendment,") and as further amended by a Third Amendment to Lease Agreement, dated September 14 , 2000, (the "Third Amendment," and together with the Original Lease, the First Amendment and the Second Amendment, the "Prime Lease," a copy of which Prime Lease, not including the First Amendment or the Third Amendment, is attached hereto as Exhibit B), regarding certain premises ("Prime Lease Premises") in the buildings described in the Prime Lease as being located at 15 and 45 Dan Road, Canton Massachusetts, all as described in the Prime Lease. (15 Dan Road has subsequently been renumbered by the USPS as 25 Dan Road.) B. Sublandlord and Subtenant wish to enter into a sublease for a portion of the Prime Lease Premises located at 45 Dan Road, and consisting of approximately 23,159 rentable square feet as depicted on Exhibit A attached hereto, (the "Sublease Premises"), all upon the terms and conditions set forth below. AGREEMENT: 1. Sublease. Subtenant subleases from Sublandlord, and Sublandlord subleases to Subtenant, the Sublease Premises upon the terms and conditions set forth below. 2. Sublease Term. The term of this Sublease ("Sublease Term") will commence on the latter to occur of (a) August 15, 2001, (b) delivery of the Sublease Premises to Subtenant or (c) delivery of written notice from the Prime Landlord of Prime Landlord's consent to this Sublease ("Commencement Date"), and will expire on March 30, 2005. 3. Use. Subtenant shall use the Sublease Premises only as allowed in Section II ("Use") of the Prime Lease, and for no other purpose without the written consent of both Prime Landlord and Sublandlord, which consent, with regard to the Prime Landlord, may be withheld at its discretion and with regard to the Sublandlord, will not be unreasonably withheld. 4. "As Is" Sublease; Alterations. Subtenant accepts the Sublease Premises, in "as is" condition, on the date of this Sublease, "with all faults". Subtenant will pay for the installation and cost of any and all improvements, alterations or other work required on or to the Sublease Premises or on or to any other portion of the property and/or building of which the Sublease Premises are a part as a result of Subtenant's use of the Sublease Premises. Subtenant shall make or install no structural improvements, alterations or work on or to the Sublease Premises or on or to the property and/or building of which the Sublease Premises are a part without the prior written consent of Sublandlord (which consent shall not be unreasonably withheld) and Prime Landlord (to the extent such consent is required under the Prime Lease). Subtenant shall be permitted to make cosmetic, decorative improvements to the Sublease Premises that do not affect the building's structure or its systems, if and as allowed under the Prime Lease. 5. Rent; Late Charges. Subtenant will pay to Sublandlord monthly base rent ("Base Rent") for the Sublease Premises in advance, without abatement, deduction or setoff, on the Commencement Date and on the first day of each calendar month thereafter during the Sublease Term, as follows: - --------------------------------------------------------------------------- Period Annually Per Monthly Annual Square Foot - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- Commencement date -- $12.50 $24,123.96 $289,487.50 3/31/02 - --------------------------------------------------------------------------- 4/01/02 - 3/31/03 $12.50 $24,123.96 $289,487.50 - --------------------------------------------------------------------------- 4/01/03 - 3/31/04 $13.00 $25,088.92 $301,067.00 - --------------------------------------------------------------------------- 4/01/04 - 3/31/05 $13.00 $25,088.92 $301,067.00 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- Subtenant will also pay Sublandlord, as additional rent ("Additional Rent") and in the manner set forth in the Prime Lease, that portion of "Tenant's Taxes and Operating Cost Excess" (as set forth in the Prime Lease) attributable to the Subleased Premises. Sublandlord represents and warrants to Subtenant that for purposes of this Sublease, "Tenant's Building Proportionate Share" (as defined in the Prime Lease) for the Sublease Premises is 17.26%, and "Tenant's Property Proportionate Share" (as defined in the Prime Lease) for the Subleased Premises is 8.43%, each percentage calculated as provided in the Prime Lease. Sublandlord shall promptly forward to Subtenant any notice from Landlord under Section XI of the Prime Lease. Sublandlord shall, upon reasonable request and at Subtenant's cost and expense, exercise Sublandlord's audit rights under Section XI(i) of the Prime Lease with respect to the Subleased Premises, for the benefit of Subtenant. In the event that the Rent is not paid within ten (10) days after the due date, Sublandlord shall assess and Subtenant shall pay a late charge in an amount equal to interest at the rate of prime rate plus two percent (2%) on the unpaid balance from the date said Rent became due. All other charges that Subtenant is required to pay hereunder, together with all interest and penalties that may accrue thereon, shall be deemed to be "Additional Rent " and in the event of non-payment thereof by Subtenant, Sublandlord shall have all the rights and remedies with respect thereto as would accrue to Landlord for non-payment of Rent under the Prime Lease. Subtenant shall pay the Rent and Additional Rent without demand or notice and without deduction, abatement, counterclaim, or set-off, except as expressly set forth herein to the Sublandlord at 25 Dan Road, Canton MA, 02021, or at such other place as designated from time to time by Sublandlord in writing. Acceptance of any late charge shall not constitute a waiver of Subtenant's default with respect to the overdue amount, nor prevent Sublandlord from exercising any of the other rights and remedies available to Sublandlord. 6. Security Deposit. Receipt of twenty four thousand, one hundred twenty-three dollars and ninety six cents ($24,123.96) is hereby acknowledged by Sublandlord as security for Subtenant's payment and performance hereunder. The Security Deposit shall be delivered to Sublandlord and shall be held throughout the term hereof as security for the faithful performance by Subtenant of each and every term, condition, covenant and provision of this Sublease and the Prime Lease. Sublandlord may apply all or any portion of the Security Deposit to repair damage to the Premises or to the restoration thereof (or to reimburse the Prime Landlord for any of the foregoing) or to any Rent and Additional Rent, including Taxes and Operating Costs which may be due from Subtenant to Sublandlord. In the event that Sublandlord shall so apply all or any portion of the said security deposit, Subtenant shall immediately upon notice, restore the same to its full amount as required hereunder, with immediately available funds. If Subtenant has performed all of the terms, covenants and conditions of this Sublease throughout the Sublease Term, Sublandlord will, within 30 days after Subtenant vacates the Sublease Premises, return to Subtenant the amount paid as a security deposit, without interest, after first deducting any sums owing to Sublandlord under the terms of this Sublease. 7. Performance of Prime Lease by Subtenant. Except as otherwise set forth in this Sublease, Subtenant assumes and agrees to keep, obey and perform all of the terms, covenants and conditions of Sublandlord as Tenant under the Prime Lease, (not including the First Amendment or the Third Amendment), with respect to the Sublease Premises. Subtenant shall be entitled to all rights afforded to Sublandlord as Tenant under the Prime Lease, except that Subtenant shall not (and Subtenant agrees that it has no right or authority to) exercise any of the rights contained in Section V, (Construction and Preparation of the Premises), Section XLIII (Brokerage), Section XLV (Security Deposit), Section XLVIII (Right of First Offer) and Section XLX (Renewal Option). 8. Subtenant's Rights as to Prime Landlord. Sublandlord shall not be liable for any nonperformance of or noncompliance with or breach or failure to observe any term, covenant or condition of the Prime Lease upon Prime Landlord's part to be kept, observed, performed or complied with, or for any delay or interruption in Prime Landlord's performing its obligations thereunder, provided that Sublandlord shall cooperate with Subtenant in assisting Subtenant in enforcing the terms of the Prime Lease, to the extent provided below. Sublandlord assigns unto Subtenant, for so long as this Sublease shall be in force and effect, any and all rights and benefits accruing to the benefit of Sublandlord under the terms, covenants and conditions of the Prime Lease (except as specifically stated in Section 7 hereof) and any causes of action which Sublandlord may have against Prime Landlord with respect to the Sublease Premises due to defaults by Prime Landlord under the Prime Lease. Sublandlord will cooperate with and join with Subtenant, including, upon reasonable request, bringing an action against the Prime Landlord in its own name to enforce the provisions of the Prime Lease, provided that such participation and/or action shall be without cost or expense to Sublandlord. 9. Insurance; Waivers. Subtenant will, during the Sublease Term, continuously maintain commercial general liability insurance as required under the Prime Lease, which insurance policy shall name Landlord and Sublandlord as additional insured parties, and a certificate thereof acceptable to Sublandlord shall be delivered to Sublandlord prior to the delivery of the Sublease Premises to Subtenant. Subtenant shall keep deposited with the Sublandlord copies of all policies of insurance, or certificates thereof, with endorsements on such policies or certificates to the effect that such insurance shall not be canceled by the insurer without at least fifteen days prior notice to Sublandlord. Subtenant will indemnify, defend and hold harmless Sublandlord and Prime Landlord from, and shall reimburse Sublandlord and Prime Landlord for, all costs and expenses, including reasonable attorneys' fees, incurred by Sublandlord and Prime Landlord in connection with the defense of all claims and demands of third persons, including but not limited to those for death, personal injuries, or property damage, arising out of any default of Subtenant in performing or observing any term, covenant, condition or provision of this Sublease, or out of the use or occupancy of the Sublease Premises by Subtenant, or out of any of the acts or omissions of the Subtenant, its agents, representatives, employees, customers, guests, invitees or other persons who are doing business with Subtenant or who are at the Sublease Premises with Subtenant's consent. Sublandlord and Subtenant hereby waive any rights each may have against the other in connection with any of the damage occasioned to Sublandlord or Subtenant, as the case may be, their respective property, the Building or its contents, arising from covered causes of loss for which insurance is carried or required to be carried pursuant to this Lease. Each party on behalf of their respective insurance companies insuring their respective property against any such loss, waive any right of subrogation that it may have against the other party. Sublandlord shall continue to maintain all insurance required to be maintained by Sublandlord under the Prime Lease with respect to the Subleased Premises provided however, that the insurance to be maintained by Subtenant pursuant to this Section 9 shall be primary as to such insurance of Sublandlord except in the event of any act or omission of Sublandlord. 10. Assignment and Subletting. Subtenant covenants and agrees that neither this Sublease nor the term and estate hereby granted, nor any interest herein or therein, will be assigned, mortgaged, pledged, encumbered or otherwise transferred, and that neither the Sublease Premises, nor any part thereof will be encumbered in any manner by reason of any act or omission on the part of Subtenant or used or occupied, or utilized for desk space or for mailing privileges, by anyone other than Subtenant, or for any use or purpose other than as stated herein, or be sublet or offered or advertised for subletting, without the prior written consent of Sublandlord in every case (which consent shall not be unreasonably withheld or delayed) and of Prime Landlord (if applicable under the Prime Lease). If Subtenant shall sublet the Sublease Premises, having first obtained Sublandlord's consent, at a rental in excess of the Rent due and payable by Subtenant under the provisions of this Sublease, such excess Rent (net of any excess due Prime Landlord in accordance with the Prime Lease) shall be split equally between the Subtenant and the Sublandlord after deduction of the Subtenant's expenses, it being agreed, however, that Sublandlord shall not be responsible for any deficiency if Subtenant shall sublet the Sublease Premises at a rental less than that provided for herein. It is hereby expressly understood and agreed, however, if Subtenant is a corporation, that the subletting, assignment, or transfer of this Sublease, and the term and estate granted, to any corporation into which Subtenant is merged or with which Subtenant is consolidated, or to any affiliate or acquirer of the stock or assets of Subtenant, which corporation shall have a net worth at least equal to that of Subtenant immediately prior to such merger or consolidation (such corporation being hereinafter called "Assignee"), without the prior written consent of Sublandlord shall not be deemed to be prohibited hereby, if, and upon the express condition that, Assignee and Subtenant shall promptly execute, acknowledge, and deliver to landlord an agreement in form and substance satisfactory to Sublandlord hereby Assignee shall agree to be bound by and upon the covenants, agreements, terms, provisions and conditions set forth in this Sublease on the part of Subtenant to be performed by whereby Assignee shall expressly agree that the provisions of this Section 10 shall, notwithstanding such assignment transfer, continue to be binding upon it with respect to all future assignments and transfers Notwithstanding any permitted assignment or subletting, Subtenant shall at all times remain directly, primarily and fully responsible and liable for the payment of all sums payable under this Sublease and for compliance with all of its obligations as Subtenant under this Sublease. The listing of any name other than that of Subtenant whether on the doors of the Sublease Premises or on the Building directly, or otherwise, shall not operate to vest any right or interest in this Sublease or in the Sublease Premises or be deemed to be the written consent of Sublandlord mentioned in this Section 10. If this Sublease is assigned, or if the Sublease Premises or any part thereof is sublet or occupies by anybody other than Subtenant, Sublandlord may, after default by Subtenant, collect Rent from the assignee, subtenant or occupant, and apply the net amount collected to the Rent herein reserved, but no such assignment, subletting occupancy or collection shall be deemed a waiver of this covenant, or the acceptance of the Assignee, subject or occupant as a tenant, or a release of Subtenant from the further performance by Subtenant of covenants on the part of Subtenant herein continued. The consent by Sublandlord to an assignment or subletting shall not in any way be construed to relieve Subtenant from obtaining the express consent in writing of Sublandlord to any further assignment or subletting. No assignment, subletting or use of the Sublease Premises by an affiliate of Subtenant shall affect the purpose for which the Sublease Premises may be used in accordance with this Sublease or the Prime Lease. 11. Termination. This Sublease shall terminate at the end of the Sublease Term hereof. Subtenant will peacefully and quietly vacate and surrender the Sublease Premises to Sublandlord at the expiration of the Sublease Term, in the condition called for under the Prime Lease. The existence of this Sublease is dependent and conditioned upon the continued existence of the Prime Lease, and in the event of the cancellation or termination of the Prime Lease, this Sublease automatically shall be terminated; provided, however, that this provision shall not be deemed to release Sublandlord of liability if the Prime Lease is canceled or terminated due to a default by Sublandlord as Tenant under the Prime Lease, which default did not result, in whole or in part, from a default by Subtenant under this Sublease. Sublandlord agrees not to amend, alter or modify any of the provisions of the Prime Lease affecting Subtenant, or to surrender the Prime Lease, without Subtenant's consent, which consent will not be unreasonably withheld or delayed. Sublandlord shall have no liability to Subtenant due to the termination of the Prime Lease by reason of any default by Subtenant under this Sublease. Sublandlord represents, warrants and covenants that (i) Sublandlord is the holder of the interest of the Tenant under the Prime Lease, (ii) the Prime Lease is in full force and effect and, to the best of Sublandlord's knowledge, Prime Landlord is not in default thereunder, (iii) Sublandlord has received no notice that it is in default under the Prime Lease nor has Sublandlord any knowledge of the existence of any condition or the occurrence of any event which, if not timely acted upon, would result in Sublandlord's default under the Prime Lease, (iv) nothing in the First Amendment is applicable to this Sublease or adversely affects Subtenant's rights hereunder, and (v) Sublandlord shall not suffer or voluntarily terminate or surrender the Prime Lease. 12. Default. If Subtenant defaults in its obligations under this Sublease, or if Subtenant commits, causes or allows an "Event of Default" under the Prime Lease (not including the First Amendment or the Third Amendment) to occur, Sublandlord shall have all of the same rights and remedies against Subtenant as would be available to the Prime Landlord against Sublandlord if an Event of Default occurred under the Prime Lease, as fully as if such rights and remedies were set forth in this Sublease. 13. Holdover. Notwithstanding any contrary provisions of the Prime Lease, if Subtenant retains possession of the Sublease Premises or any part thereof after expiration or earlier termination of the Sublease Term, Subtenant will pay to Sublandlord rent at 150% of the Base Rent specified in Section 5 hereof, as well as 150% of Subtenant's Proportionate Share of any Additional Rent, for the time Subtenant remains in possession and, in addition thereto, will pay Sublandlord for all other costs or damages that Sublandlord may be liable for to the Prime Landlord, by reason of Subtenant's retention of possession. The provisions of this Section do not exclude Sublandlord's rights of re-entry or any other right hereunder, including without limitation, the right to refuse 150% of monthly rent and instead to remove Subtenant through summary proceedings for holding over beyond the expiration or earlier termination of the Sublease Term. 14. Notices. Any notice or demand permitted or required hereunder shall be deemed given or made if, and shall not be deemed to have been given or made unless, it is in writing and deposited in the United States mails certified, return receipt requested, postage prepaid, or deposited cost paid with a nationally recognized, reputable overnight courier, addressed as follows: If to Sublandlord: Network Engines, Inc. 15 Dan Road Canton MA 02021 Attn: Chief Financial Officer If to Subtenant: Techmar Communications, Inc 45 Dan Road Canton, MA 02021 Attn: Tom Swithenbank With a copy to: Mintz Levin Cohn Ferris Glovsky and Popeo One Financial Center Boston, MA 02111 Attn: Stuart Offner, Esq. It is agreed that certified mail shall be conclusively deemed received one day after it is mailed, postage prepaid, and that an item sent by recognized overnight courier shall be conclusively deemed received the day it is scheduled to be delivered. The foregoing addresses may be changed from time to time by written notice as above provided, which change shall be effective 10 days after written notice is given. Sublandlord shall promptly deliver to Subtenant copies of all notices either delivered to or received from the Prime Landlord that are applicable to this Sublease or adversely affect Subtenant's rights hereunder. 15. Real Estate Brokers. Each of Sublandlord and Subtenant represents to the other that it has not dealt with any real estate broker or any other party to whom a commission may be owed with regard to this transaction. Each party will indemnify, defend and hold the other harmless from all damages, liability and expense (including reasonable attorneys' fees) arising from any claims or demands of any broker or brokers or finders for any commission alleged to be due such broker or brokers or finders in connection with its participating in the negotiation this Sublease. 16. Quiet Enjoyment. Subtenant, upon keeping, observing and performing all of the covenants and agreements of this Sublease on its part to be kept, observed and performed, and upon paying the full amounts due under Section 5 (Rent) above and any other charges due under this Sublease, shall lawfully and peacefully hold, occupy and enjoy the Sublease Premises during the Sublease Term, free from interference by Sublandlord or anyone claiming by, through or under Sublandlord, subject to the covenants and agreements contained in the Prime Lease. 17. Entire Agreement. This Sublease contains the entire agreement between Sublandlord and Subtenant regarding the Sublease Premises. Subtenant agrees that it has not relied on any statement, representation or warranty of any person except as set out in this Sublease. This Sublease may be modified only by an agreement in writing signed by Sublandlord and Subtenant. No surrender of the Sublease Premises, or of the remainder of the Sublease Term, will be valid unless accepted by Sublandlord in writing. 18. Successors and Assigns. All provisions of this Sublease will be binding on and will inure to the benefit of the successors and assigns of Sublandlord and Subtenant, except that no person or entity holding under or through Subtenant in violation of any provision of this Sublease will have any right or interest in this Sublease or the Sublease Premises. 19. Computer Room Use for Disaster Recovery Server. Subtenant agrees that Sublandlord may, during the term of this Sublease, utilize space in the computer room in the Subleased Premises (as indicated in Exhibit A) to store and maintain a disaster back-up server ("Back-up Server") that will back up the main server that Sublandlord uses to run its business at 25 Dan Road. The Back-up Server shall be a standard commercial server, of the size that fits into a standard computer rack. Sublandlord shall be entitled to plug the Back-up Server into the electrical system for the Subleased Premises, provided, however, that if the amount of electricity consumed by the Back-up Server shall at any time be a material amount, Subtenant reserves the right to charge Sublandlord, and Sublandlord agrees to pay to Subtenant, a reasonable charge for such consumption. Sublandlord shall be responsible for providing connection from the Back-up Server to its own computer network, in a manner intended to cause as little inconvenience to Subtenant as is practical and which shall not materially interfere with Subtenant's use of the Sublease Premises. Sublandlord shall insure the Back-up Server and shall bear the risk of loss, except for losses caused by Subtenant's gross negligence or intentional misconduct. Subtenant shall afford Sublandlord with reasonable access to the Back-up Server to allow for maintenance and for use of the Back-up Server in the case where Sublandlord's main server is inoperable. Subtenant shall not use, retain, claim, disable or otherwise claim any interest in the Back-up Server. 20. Prime Landlord Consent. This Sublease, and the obligations of Sublandlord hereunder, is contingent upon the written consent of Prime Landlord hereto. 21. Signage. Subtenant shall have all of Sublandlord's signage rights under Section XXII of the Prime Lease applicable to the Subleased Premises. If requested by Subtenant, Sublandlord shall cooperate with Subtenant, at no cost to Sublandlord, in the enforcement of such rights with respect to the Prime Landlord. 22. Non-Disturbance. Upon the request of Subtenant, Sublandlord shall, at no cost to Sublandlord, use reasonable efforts to obtain from Prime Landlord an agreement where by if the Prime Lease is terminated for any reason (other than by a default by Subtenant under this Sublease) Prime Landlord agrees to recognize Subtenant as a direct tenant under all of the terms and conditions of this Sublease. 23. Parking. Subtenant shall have all of Sublandlord's parking rights under Section II, "Use" of the Prime Lease applicable to the Subleased Premises. If requested by Subtenant, Sublandlord shall cooperate with Subtenant, at no cost to Sublandlord, in the enforcement of such rights with respect to the Prime Landlord. EXECUTION: Sublandlord and Subtenant have executed this Sublease as of the date first stated above. SUBLANDLORD: NETWORK ENGINES INC. By: /s/ Douglas G. Bryant --------------------- Its: Chief Financial Officer ----------------------- SUBTENANT: TECHMAR, INC. By: /s/ Thomas Swithenbank ---------------------- Its: Executive V.P. and Chief Financial Officer ------------------------------------------ EXHIBIT A Sublease Premises [Schematic Omitted] EXHIBIT B Prime Lease, as amended [Previously filed as Exhibits 10.1 and 10.18 of the Company's 2000 Annual Report on Form 10-K, filed with the Securities and Exchange Commission on December 21, 2000.] EX-10.32 4 dex1032.txt CONSENT TO SUB-LEASE FROM DAN ROAD BUILDINGS EXHIBIT 10.32 DAN ROAD BUILDING LLC C/O GREAT POINT INVESTORS LLC 98 NORTH WASHINGTON STREET, 5TH FLOOR BOSTON, MASSACHUSETTS 02114 TELEPHONE (617) 526-8800 TELEFAX (617) 526-8810 June 21, 2001 Network Engines, Inc. Techmar Communications, Inc. 25 Dan Road 45 Dan Road Canton, MA 02021 Canton, MA 02021 Re: Building: 45 Dan Road, Canton, MA Landlord: Dan Road Building LLC Prime Lessee: Network Engines, Inc. Date of Prime Lease: October 19, 1999 Sublet Premises: A portion of the first (1st) floor consisting of approximately 23,159 square feet. Sublessee: Techmar Communications, Inc. Date of Sublease: June 21, 2001 Gentlemen: Pursuant to terms of the Prime Lease, you have requested our consent to the Sublease, a true, complete and correct copy of which is annexed hereto and made a part hereof. We hereby grant our consent to the Sublease upon the following express terms and conditions: 1. The Sublease is and continues to be subject and subordinate to the Prime Lease and to all of its terms, covenants, conditions, provisions and agreements. 2. Neither the Sublease nor this consent shall: (a) release or discharge the Prime Lessee from any liability, whether past, present or future, under the Prime Lease; (b) operate as a consent or approval by Landlord to or of any of the terms, covenants, conditions, provisions or agreements of the Sublease and Landlord shall not be bound thereby; (c) be construed to modify, waive or affect any of the terms, covenants, conditions, provisions or agreements of the Prime Lease, or to waive any breach thereof, or any of the rights of Landlord thereunder, or to enlarge or increase Landlord's obligations thereunder; or (d) be construed as a consent by Landlord to any further subletting either by Prime Lessee or by Sublessee or to any assignment by Prime Lessee of the Prime Lease or assignment by the Sublessee of the Sublease, whether or not the Sublease purports to permit the same. 3. In the event of Prime Lessee's default under the provisions of the Prime Lease, the rent due from the Sublessee under the Sublease shall be deemed assigned to Landlord and Landlord shall have the right, following such default, at any time at Landlord's option, to give notice of such assignment to the Sublessee, and Landlord shall credit Prime Lessee with any rent received by Landlord under such assignment. From and after the occurrence of a default by Prime Lessee under the provisions of the Prime Lease, Landlord may, at its election (but without any obligation to do so), deliver a written memorandum of attornment to Sublessee, whereupon Sublessee shall attorn to Landlord and perform its obligations directly to Landlord as tenant under the Prime Lease. Notwithstanding any foregoing provision to the contrary, the acceptance of any payment on account of rent directly from the Sublessee as the result of any default of Prime Lessee shall in no manner whatsoever be deemed an attornment by the Sublessee to Landlord in the absence of a specific written agreement signed by Landlord to such effect, or serve to release Prime Lessee from any liability under the terms, covenants, conditions, provisions or agreements of the Prime Lease. 4. Prime Lessee and Sublessee agree and acknowledge that Landlord's consent herein is not an assignment or partial assignment of the Prime Lease, and thus does not create any privity of contract relative to the Prime Lease. This consent shall not create nor be deemed to be the basis of creating any covenant, representation or warranty, express or implied (including, without limitation, any covenant of quiet enjoyment), on the part of Landlord with respect to the terms of the Sublease, Sublessee's use and enjoyment of the Sublet Premises, or any other matter arising out of or in connection with the Sublease. Notwithstanding any provisions of the Sublease to the contrary, Sublessee shall have no right to enforce any of Prime Lessee's rights under the Prime Lease directly against the Landlord, all of such rights being personal to the Prime Lessee; provided, however, that nothing herein shall be construed to diminish or curtail Prime Lessee's rights to enforce 2 any of its rights under the Prime Lease, in its own name, as such rights may relate to the Sublet Premises. 5. The term of the Sublease shall expire and come to an end on its natural expiration date or on any premature termination date thereof or concurrently with the natural expiration date or on any premature termination of the Prime Lease for any reason whatsoever (including, without limitation, any termination by mutual consent or other right, now or hereafter agreed to by Landlord or Prime Lessee, or by operation of law or at Landlord's option in the event of a default by Prime Lessee). 6. This consent is not assignable, nor shall this consent be deemed a consent to any amendment or modification of the Sublease, without Landlord's prior written consent. 7. Prime Lessee and Sublessee covenant and agree that under no circumstances shall Landlord be liable for any brokerage commission or other charge or expense in connection with the Sublease, and Prime Lessee and Sublessee agree to indemnify Landlord against same and against any cost or expense (including but not limited to attorneys' fees) incurred by Landlord in connection with any claim for any such brokerage commission. 8. Prime Lessee and Sublessee understand and acknowledge that Landlord's consent hereto is not a consent to any improvement or alteration work being performed in the Sublet Premises, that Landlord's consent must be separately sought if and to the extent provided in the Prime Lease and will not necessarily be given, and that if such consent is given the same will be subject to Prime Lessee and Sublessee signing Landlord's standard form of agreement with respect to work being performed by persons other than Landlord. 9. Landlord's consent herein shall not constitute an agreement, representation, warranty or verification that the Sublease is in compliance with the Prime Lease or that the Sublet Premises are fit for Sublessee's purposes. 10. Notwithstanding any provisions of the Sublease to the contrary, Landlord shall have no obligations to deliver any notices or copies of notices to Sublessee, and no obligation to accept, consider, or respond to any request, inquiry, demand or other communication from Sublessee, whether of a type described in the Prime Lease, Sublease or otherwise. 11. In the event of any conflicts between the terms and provisions of the Prime Lease and the terms and provisions of the Sublease, the terms and provisions of the Prime Lease shall control. 12. The Prime Landlord represents and warrants to Subtenant that: (a) the Prime Lease is in full force and effect in accordance with and subject to all of the terms, covenants, conditions and agreements contained therein; 3 (b) the Prime Lease has not been modified, amended or supplemented, except as set forth in this Consent Letter; (c) to Prime Landlord's knowledge there does not exist any fact or circumstance which, in and of itself or with the giving of notice, the passage of time or both, would constitute an Event of Default under the Prime Lease; and (d) the "Expiration Date" under the Prime Lease is March 31, 2005. The execution of a copy of this consent by Prime Lessee and by Sublessee shall indicate the joint and several confirmation of the foregoing conditions and of their agreement to be bound thereby and shall constitute Sublessee's acknowledgment that it has received a copy of the Prime Lease from Prime Lessee. This consent shall be null and void unless a duly countersigned copy is returned to Landlord not later than seven (7) business days following the date of this consent. Very truly yours, LANDLORD: DAN ROAD BUILDING LLC By: /s/ John Baxter --------------- Its: Vice President CONFIRMED AND AGREED: PRIME LESSEE: NETWORK ENGINES, INC. June 22, 2001 a Delaware corporation --------------------------------------- Date: By: /s/ Douglas G. Bryant --------------------- Its: Chief Financial Officer SUBLESSEE: TECHMAR COMMUNICATIONS, INC. June 21, 2001 a Delaware corporation --------------------------------------- Date: By: /s/ Thomas Swithenbank ---------------------- Its: Executive V.P. and Chief Financial Officer ------------------------------------------ 4 -----END PRIVACY-ENHANCED MESSAGE-----