-----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, EVOCXFQrEJCCfRU3sMH4oqTMRGQ5CBVqAvmFsEHdh5Jigc9RhJ0ZrM5jzkcRzHEC Bz7TKZahDr0BXcq8joLSDw== 0000927016-02-000957.txt : 20020414 0000927016-02-000957.hdr.sgml : 20020414 ACCESSION NUMBER: 0000927016-02-000957 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20011231 FILED AS OF DATE: 20020214 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: 02546474 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 December 31, 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 offices) (Zip Code) (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 February 1, 2002, there were 33,139,963 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 (UNAUDITED) 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 .................................................... 11 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ....................................................................... 26 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS .......................................................... 27 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS .................................. 27 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)
December 31, September 30, 2001 2001 ------------ ------------- ASSETS (unaudited) Current assets: Cash and cash equivalents .............................................. $ 66,951 $ 74,805 Restricted cash ........................................................ 1,098 1,129 Accounts receivable, net of allowances ................................. 1,708 1,601 Inventories ............................................................ 799 607 Prepaid expenses and other current assets .............................. 795 857 Due from contract manufacturer ......................................... 18 380 --------- --------- Total current assets .............................................. 71,369 79,379 Property and equipment, net ................................................. 3,136 3,454 Other assets ................................................................ 240 171 --------- --------- Total assets .................................................... $ 74,745 $ 83,004 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ....................................................... $ 1,222 $ 1,350 Accrued expenses ....................................................... 2,237 2,518 Accrued restructuring and other charges ................................ 887 1,368 Due to contract manufacturer ........................................... 403 3,117 Deferred revenue ....................................................... 18 93 Current portion of capital lease obligations and notes payable ......... 52 60 --------- --------- Total current liabilities .......................................... 4,819 8,506 Capital lease obligations and notes payable, net of current portion .... - 9 Commitments and contingencies (Note 5) Stockholders' equity: Common stock ........................................................... 353 352 Additional paid-in capital ............................................. 174,484 175,288 Accumulated deficit .................................................... (100,629) (93,438) Notes receivable from stockholders ..................................... (573) (702) Deferred stock compensation ............................................ (2,231) (6,813) Treasury stock, at cost ................................................ (1,478) (198) --------- --------- Total stockholders' equity ......................................... 69,926 74,489 --------- --------- Total liabilities and stockholders' equity ...................... $ 74,745 $ 83,004 ========= =========
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 December 31, --------------------------------- 2001 2000 --------------- ----------------- Net revenues ................................................................... $ 2,101 $ 6,894 Cost of revenues: Cost of revenues ........................................................... 2,072 5,196 Cost of revenues stock compensation ........................................ 73 91 Inventory write-down ....................................................... -- 14,965 ---------- ---------- Total cost of revenues ..................................................... 2,145 20,252 ---------- ---------- Gross loss ............................................................... (44) (13,358) Operating expenses: Research and development ................................................... 1,545 3,874 Selling and marketing ...................................................... 1,182 6,501 General and administrative ................................................. 1,177 2,577 Stock compensation ......................................................... 3,667 1,254 Amortization of goodwill and intangible assets ............................. -- 150 ---------- ---------- Total operating expenses ................................................. 7,571 14,356 ---------- ---------- Loss from operations ........................................................... (7,615) (27,714) Interest income, net ........................................................... 424 1,852 ---------- ---------- Net loss ....................................................................... $ (7,191) $ (25,862) ========== ========== Net loss per common share - basic and diluted .................................. $ (0.21) $ (0.76) ========== ========== Shares used in computing net loss per common share - basic and diluted ......... 33,576 33,862
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)
Three months ended December 31, ------------------------------- 2001 2000 ------------ -------------- Cash flows from operating activities: Net loss ............................................................................. $ (7,191) $ (25,862) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization .................................................... 378 1,242 Provision for inventory reserve, net ............................................. -- 15,055 Provision for doubtful accounts .................................................. 80 575 Stock compensation ............................................................... 3,740 1,345 Interest on notes receivable from stockholders ................................... (10) (2) Changes in operating assets and liabilities, net of effects of acquisition: Accounts receivable .......................................................... (187) 5,762 Inventories .................................................................. (192) (14,016) Prepaid expenses and other current assets .................................... 62 (360) Due from contract manufacturer ............................................... 362 5,681 Accounts payable ............................................................. (128) 9,143 Due to contract manufacturer ................................................. (2,714) 5,832 Accrued expenses ............................................................. (762) (1,318) Deferred revenue ............................................................. (75) (162) --------- --------- Net cash provided by (used in) operating activities ...................... (6,637) 2,915 Cash flows from investing activities: Purchases of property and equipment .................................................. (60) (1,943) Change in restricted cash ............................................................ 31 -- Purchases of other assets ............................................................ (69) (213) Acquisition of business including acquisition expenses ............................... -- (30) --------- --------- Net cash used in investing activities .................................... (98) (2,186) Cash flows from financing activities: Payments on capital lease obligations and notes payable .............................. (17) (26) Payments received on notes receivable from stockholders .............................. 139 -- Acquisition of treasury stock ........................................................ (1,280) -- Proceeds from issuance of common stock ............................................... 39 361 --------- --------- Net cash provided by (used in) financing activities ...................... (1,119) 335 --------- --------- Net increase (decrease) in cash and cash equivalents ...................................... (7,854) 1,064 Cash and cash equivalents, beginning of period ............................................ 74,805 112,382 --------- --------- Cash and cash equivalents, end of period .................................................. $ 66,951 $ 113,446 ========= =========
The accompanying notes are an integral part of the condensed consolidated financial statements. 4 NETWORK ENGINES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) a business to be disposed of. However, SFAS 144 retains APB 30's requirement that entities report discontinued operations separately from continuing operations and extends that reporting requirement to "a component of an entity" that either has been disposed of or is classified as "held for sale." SFAS 144 also amends the guidance of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to eliminate the exception to consolidation for a temporarily controlled subsidiary. SFAS 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001, including interim periods, and, generally, its provisions are to be applied prospectively. The Company does not expect the application of SFAS 144 to have a material impact on the Company's financial position or results of operations. Comprehensive Loss During each period presented, comprehensive loss was equal to net loss. Segment Reporting The Company organizes itself as a single business segment and conducts its operations primarily in the United States. Significant Customers During the three months ended December 31, 2001, one customer accounted for approximately 73% ($1.5 million) of the Company's net revenues; this same customer accounts for approximately 89% ($1.7 million) of the Company's accounts receivable at December 31, 2001. During the three months ended December 31, 2000, one customer accounted for approximately 17% ($1.1 million) of the Company's net revenues. No customer accounted for greater than 10% of the Company's accounts receivable at December 31, 2000. 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. 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 December 31, ----------------- 2001 2000 ------ ----- Options to purchase common stock ............... 5,558 5,816 Warrants to purchase common stock .............. 1,625 1,729 Unvested restricted common stock ............... 387 786 ----- ----- 7,570 8,331 ===== ===== 4. INVENTORIES 6 Inventories consisted of the following (in thousands): December 31, September 30, 2001 2001 ---- ---- Raw materials .......................... $589 $226 Work in process ........................ 42 235 Finished goods ......................... 168 146 ---- ---- $799 $607 ==== ==== In November 2001, the Company entered into an agreement to engage a third party to provide long-term product support for the Company's discontinued product lines. Under the terms of this agreement, the Company agreed to provide training, documentation and access to qualified employees of the Company. The Company also transferred certain fully reserved inventory on hand at the time of the agreement to this third party in exchange for the third party's agreement to assume all warranty support services to previous purchasers of the Company's discontinued products. 5. CONTINGENCIES On December 29, 1999, a former employee, George Flate, commenced a lawsuit against the Company and two former officers and directors of the Company in Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he was unlawfully terminated as Vice President of OEM Sales by the Company in an effort to deprive him of commission payments. He is seeking undisclosed damages based on two contractual claims relating to his employment, although the Company anticipates 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 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. Although the Company believes that these claims are without merit and 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. Costs incurred to date have not been material. The case has proceeded through discovery and the court has scheduled a trial date of May 20, 2002. On or about December 3, 2001, Margaret Vojnovich filed in the United States District Court for the Southern District of New York a lawsuit against Network Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial Officer and Vice President of Administration (collectively, the "Executive Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally alleges that the Underwriter Defendants violated the federal securities laws by conspiring and agreeing to raise and increase the compensation received by the Underwriter Defendants by agreeing with some recipients of an allocation of IPO stock to agree to purchase shares of manipulated securities in the after-market of the IPO at pre-determined price levels designed to maintain, distort and/or inflate the price of the Company's common stock in the aftermarket. The suit also alleges that the Underwriter Defendants received undisclosed and excessive brokerage commissions and that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants' individual and collective underwritings, compensation and revenues. The suit further alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the IPO without disclosing to investors that the Underwriter Defendants in the offering, including the lead underwriters, had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks damages, rescission of the purchase prices paid by purchasers of shares of the Company's common stock and certification of a plaintiff class consisting of all persons who acquired shares of the 7 Company's common stock between July 13, 2000 and December 6, 2000. The Company is in the process of reviewing this suit and intends to respond in a timely manner. The Company is unable to predict the outcome of this suit and its ultimate effect, if any, on the Company's financial condition, however the Company's defense against these claims could result in the expenditure of significant financial and managerial resources. On August 14, 2001, the Company announced that its Board of Directors had approved the repurchase of up to $5.0 million of the Company's common stock in the open market or in non-solicited privately negotiated transactions. The Company plans to use any repurchased shares for its employee stock plans. During the year ended September 30, 2001 and quarter ended December 31, 2001, the Company repurchased 300,900 and 1,548,572 shares of common stock at a cost of approximately $198,000 and $1,280,000, respectively. 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, plus assumed net liabilities of approximately $95,000 and acquisition expenses of approximately $63,000, resulted in goodwill and intangible assets of approximately $2,698,000. The Company's pro forma statements of operations prior to the acquisition would not differ materially from reported results. In July 2001, the Company completed an intensive review of its business, which resulted in its implementation of a restructuring plan. This restructuring plan included a discontinuation of much of the customized hardware and software that had previously been a part of the Company's product development process. As a result of this restructuring and an assessment of expected future cash flows, the Company determined that the recoverability of the IP Performance-related intangible assets was unlikely. Accordingly, the Company recognized an impairment charge for the full amount of the remaining un-amortized intangible assets, approximately $2,023,000, during the fourth quarter of fiscal 2001. Prior to the impairment, the Company had been amortizing the goodwill and intangible assets over a three-year period resulting in approximately $150,000 and $675,000 of amortization expense during the quarter ended December 31, 2000 and the year ended September 30, 2001, respectively. The Company also issued 321,756 shares of restricted common stock to key employee shareholders of IP Performance. Under the terms of the restricted stock agreements, 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 was being recognized as stock compensation expense ratably over the vesting period. In December 2001, the Company terminated all but one of the former IP Performance employees. In accordance with the restricted stock agreements with these individuals, all of the remaining un-vested restricted stock vested upon termination. As a result, during the three months ended December 31, 2001, the Company recognized the remaining deferred stock compensation of approximately $3,461,000. 7. INVENTORY WRITE-DOWN In the first quarter of fiscal 2001, the Company recorded an inventory write-down of $14,965,000 for excess and obsolete inventory related to the Company's WebEngine Blazer product. This excess and obsolete inventory was due to an unanticipated shortfall in sales of the WebEngine Blazer product during the first quarter of fiscal 2001 and the resulting reduction in expected future sales of this product. 8. RESTRUCTURING AND OTHER CHARGES 8 During the year ended September 30, 2001, the Company undertook two restructurings of its operations, the first of these restructurings occurred in April 2001 and the second in July 2001. Through the April 2001 restructuring, the Company sought to better align the Company's operating expenses with reduced revenues, and as a result of its implementation, the Company recorded a charge to operations of $2,812,000. This charge was due to a reduction in workforce from 243 employees to 170 employees, the curtailment of a planned expansion into leased facilities and other items. 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 the Company 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. The Company's July 2001 restructuring was the result of an intensive review of its business, which resulted in a re-focus of the Company's sales strategy toward strategic partnerships with independent software vendors (ISVs) and original equipment manufacturers (OEMs) and a discontinuation of much of the customized hardware and software that was previously included in the Company's products. As a result of the implementation of the July 2001 restructuring, the Company recorded a charge to operations of approximately $6,871,000. This charge included approximately $1,643,000 of employee related costs as the Company reduced its workforce by 70 employees, approximately $2,224,000 as a result of the Company's disposal of certain property and equipment, approximately $2,023,000 to write off goodwill and intangible assets which were deemed to be impaired, approximately $618,000 of facility costs associated with non-cancelable operating leases for space which will not be occupied and approximately $363,000 of other charges. In addition to the April and July restructurings, in March 2001 the Company recorded a charge due to the retirement of 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 server appliance product. The total of the restructuring and other charges detailed above was approximately $10,886,000. The reduction in the Company's workforce implemented during the year ended September 30, 2001, impacted employees in all of the Company's groups, including manufacturing, research and development, selling and marketing and general and administrative. The following table sets forth restructuring accrual activity during the three months ended December 31, 2001:
Employee Facility Relat Related Other Total -------- -------- -------- -------- Restructuring accrual balance at September 30, 2001 $ 491 $ 559 $ 318 $ 1,368 Cash payments (247) (87) (147) (481) ------- ------- ------- ------- Restructuring accrual balance at December 31, 2001 $ 244 $ 472 $ 171 $ 887 ======= ======= ======= =======
The Company expects the remaining restructuring accrual balance to be fully utilized by December 31, 2002, including cash payments of approximately $750,000. 9. 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 President, Chief Executive Officer and Chief Technology Officer. These agreements were entered into to avoid significant sales of the Company's stock by Mr. Genovesi as a result of a margin call on a personal loan collateralized by Mr. Genovesi's holdings of the 9 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 ended on January 9, 2002 and the Company extended the Guarantee to January 9, 2003, at which time the balance of the amount deposited with the Bank, which is not required to satisfy any obligations under the Guarantee, 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 Reimbursement Agreement bear interest at a rate of 10% per annum. In the event of a default under 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 bore interest at a rate of 5.9% per annum and was due and payable in full upon the earlier of January 9, 2002 or 30 days following the date Mr. Genovesi ceased to be an employee of the Company. The Note was paid in full in November 2001. 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 December 31, 2001, no amounts were required to be reimbursed to the Company under the Reimbursement Agreement. In November 2001, the Company repurchased 234,822 shares of the Company's common stock from Mr. Genovesi for $225,195 in a private transaction. The purchase price was determined based on the average closing price of the Company's common stock over the ten trading days prior to the purchase date. Mr. Genovesi used the proceeds to pay all amounts outstanding under the Note, to pay down a recourse note payable to the Company and to pay taxes incurred in connection with the Company's repurchase of its common stock from Mr. Genovesi. In April 2001, the Company entered into full recourse loan agreements with certain former employees and certain current and former 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 officers as a result of alternative minimum tax obligations incurred by these employees and officers in connection with their exercise of options to purchase shares of the Company's common stock. The net amount loaned to the employees and officers under the Loan Agreements was approximately $508,000. 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 officer pledged all shares of capital stock, and options to purchase 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. In November 2001, the Company extended the repayment dates to September 2002 for loans with an aggregate principal amount of $226,996 due from two of its current officers. 10 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 Annual Report on Form 10-K for the fiscal year ended September 30, 2001 filed by the Company with the Securities and Exchange Commission. Overview We are a provider of high-density, server appliance hardware platforms and custom integration services. Server appliances are pre-configured computer network infrastructure devices designed to deliver specific application functionality. We are focused on partnering with independent software vendors ("ISVs") and original equipment manufacturers ("OEMs") to provide these strategic partners with dense server appliance hardware, integration services and appliance development, deployment and support to allow these strategic partners to deliver "turn-key" solutions to their end-user customers. When we first entered the server appliance market, we focused our business primarily on providing scalable web content servers to Internet-based organizations, content infrastructure providers and larger enterprises. It was necessary for us to design most of the hardware components that went into our servers and, as a result, we invested significant resources in the development of our products. In June 1999, we introduced the first "1U" (1.75 inch tall) server, 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 server appliances have become commoditized and a significant number of companies have entered the server appliance marketplace. In response to competitive pressures combined with the effects of a downturn in the economy, which had a significant negative impact on our "new economy" customers, we implemented 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 April 2001, a 73-employee reduction in our workforce, as well as the curtailment of planned facility expansion and other cost cutting measures. We further undertook an extensive review of our business strategy and, in July 2001, we implemented a second restructuring of our business, which de-emphasized much of our customized hardware and software development and focused our resources on what we believe to be our core competencies of hardware packaging and software integration. In addition, this restructuring of our business included a transition from primarily direct sales channels to partnerships with ISVs and OEMs in order to offer "turn-key" server appliance hardware platforms to enterprise customers. Our current server appliance hardware platforms continue to combine creative hardware packaging, cooling and software integration to provide high-density, scalable appliances in a 1U form factor. In addition, the implementation of our July 2001 restructuring plan included a reduction in our workforce from approximately 160 employees to approximately 95 employees. We incurred a charge to operations of approximately $6.9 million in the fourth quarter ended September 30, 11 2001 as we executed our July 2001 restructuring plan. At December 31, 2001, we had an accumulated deficit of approximately $100.6 million. Our revenues are derived from sales of our server appliance hardware platforms. We recognize revenues upon shipment, provided evidence of an arrangement has been received, no obligations remain 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. 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) is affected by the mix of our product revenues and our product pricing and the timing, size and configuration of customer orders. 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 development. However, we expect research and development expenses to decrease in absolute dollars during the remainder of fiscal 2002 due to our transition away from the internal development of significant proprietary hardware and software. At December 31, 2001, there were 24 employees in research and development. 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. We expect selling and marketing expenses to decrease in absolute dollars during the remainder of fiscal 2002 due to our transition to indirect sales channels and the contraction of our international sales operations. At December 31, 2001, there were 20 employees in sales, marketing and customer support. 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. We expect general and administrative expenses to increase during the remainder of fiscal 2002 due to legal costs expected to be incurred in our defense of current litigation and any potential settlements or judgments, which could result in the event that current litigation is adversely resolved. There were 13 general and administrative employees at December 31, 2001. We 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 fair market value of our common stock and, accordingly, no additional deferred compensation has been recorded. Through December 31, 2001, we amortized $6.6 million to stock compensation expense and $6.7 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 former employees of IP Performance, Inc. ("IP Performance") who were retained as our employees in connection with our acquisition of IP Performance in November 2000. The restricted stock was to vest annually through November 2003 contingent upon continued employment. In December 2001, 12 we terminated all but one of the former IP Performance employees. In accordance with the restricted stock agreements, all of the remaining un-vested restricted stock vested upon termination. As a result, during the three months ended December 31, 2001, the Company recognized the remaining deferred stock compensation of approximately $3.5 million. During the next twelve months, we expect to amortize stock compensation of: Expected Amortization of Stock Fiscal Quarter Ending Compensation - --------------------- ------------ (in thousands) March 31, 2002 ............................................. $272 June 30, 2002 .............................................. 272 September 30, 2002 ......................................... 272 December 31, 2002 .......................................... 269 We then expect aggregate per quarter stock compensation amortization of approximately $250,000 during the remainder of fiscal 2003 and an aggregate of approximately $400,000 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. Critical Accounting Policies And Estimates Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to accounts receivable and sales allowances and inventory valuation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We assess the collectibility of revenue at the point of each sale based upon all available information. We maintain sales allowances for revenue transactions where collectibility is not reasonably assured. Estimates of collectibility are affected by our customers' financial condition at the point of sale and these estimates may differ from actual results. We write down our inventory for estimated obsolescence or un-marketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. We include inventory amounts receivable under non-cancelable inventory purchase commitments in our analysis of obsolescence or un-marketable inventory. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Results of Operations The following table sets forth financial data for the periods indicated as a percentage of net revenues: 13
Three months ended December 31, ------------------------ 2001 2000 ----------- ---------- Net revenues ...................................... 100% 100% Cost of revenues Cost of revenues ............................. 99 76 Cost of revenues stock compensation .......... 3 1 Inventory write-down (benefit) ............... - 217 ----------- ---------- Total cost of revenues ....................... 102 294 ----------- ---------- Gross profit (loss) ....................... (2) (194) Operating expenses: Research and development ..................... 74 56 Selling and marketing ........................ 56 95 General and administrative ................... 56 37 Stock compensation ........................... 174 18 Amortization of goodwill and intangible assets - 2 ----------- ---------- Total operating expenses .................. 360 208 ----------- ---------- Loss from operations .............................. (362) (402) Interest income, net .............................. 20 27 ----------- ---------- Net loss .......................................... (342%) (375%) =========== ==========
Three Months Ended December 31, 2001 and December 31, 2000 Net Revenues Net revenues decreased to $2.1 million in the three months ended December 31, 2001 from $6.9 million in the three months ended December 31, 2000. During the three months ended December 31, 2001, one customer accounted for 73% of net revenues. The decrease is due primarily to a lower average selling price of our products due to increased competitive pricing pressure as well as a decrease in product sales volumes as a result of the general economic slowdown, which significantly impacted the information technology spending of our "new economy" customer base. To a lesser extent, the decline in net revenues is the result of a decrease in license revenues. We do not expect significant future license revenues. Gross Profit (Loss) In the three months ended December 31, 2001, we had a gross loss of $44,000, an improvement from a gross loss of $13.4 million in the three months ended December 31, 2000. During the three months ended December 31, 2000, we recorded an inventory write-down of approximately $15.0 million for which there was no corresponding charge in the three months ended December 31, 2001. The inventory write-down resulted from an unanticipated decline in sales during the three months ended December 31, 2000, 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 decreased to $29,000, or 1.4% of net revenues, in the three months ended December 31, 2001 from $1.7 million, or 24.6% of net revenues, in the three months ended December 31, 2000. This decrease was primarily the result of a lower average selling price of our products in the three months ended December 14 31, 2001. To a lesser extent, the decrease in gross profit (loss) is due to a decrease in license revenues and product sales volumes during the three months ended December 31, 2001. Operating Expenses Research and Development. Research and development expenses decreased to $1.5 million in the three months ended December 31, 2001 from $3.9 million in the three months ended December 31, 2000. This decrease was due primarily to decreased compensation costs as research and development personnel decreased from 83 employees at December 31, 2000 to 24 employees at December 31, 2001. The decrease in research and development expenses is also due to a decrease in consulting, which resulted from the development of software associated with our StorageEngine Voyager during the three months ended December 31, 2000. To a lesser extent, the decrease in research and development expenses was due to a decrease in prototype and test unit costs as a result of the significant development efforts associated with our StorageEngine Voyager and WebEngine Sierra products incurred during the three months ended December 31, 2000, and a decrease in recruiting costs. Selling and Marketing. Selling and marketing expenses decreased to $1.2 million in the three months ended December 31, 2001 from $6.5 million in the three months ended December 31, 2000. This decrease was due primarily to decreased compensation costs as sales, marketing and customer support personnel decreased from 95 employees at December 31, 2000 to 20 employees at December 31, 2001. The decrease in selling and marketing expenses is also attributable to a decrease in advertising and trade show expenses as we reduced our discretionary selling and marketing expenditures during the three months ended December 31, 2001. To a lesser extent, the decrease in selling and marketing expenses is also attributable to decreased travel and recruiting costs as a result of the decrease in sales, marketing and customer support personnel. General and Administrative. General and administrative expenses decreased to $1.2 million in the three months ended December 31, 2001 from $2.6 million in the three months ended December 31, 2000. This decrease resulted from a significant bad debt expense recorded during the three months ended December 31, 2000 as a result of the downturn in the economy and its effect on our "new economy" customer base. The decrease in general and administrative expenses is also attributable to decreased consulting and professional service expenses in the three months ended December 31, 2001 and decreased compensation costs as general and administrative personnel decreased from 34 employees as of December 31, 2000 to 13 employees as of December 31, 2001. Stock Compensation. We recognized stock compensation expense of $3.7 million and $1.3 million in the three months ended December 31, 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., in November 2000, we recorded deferred stock compensation of $6.4 million. In December 2001, we terminated substantially all of the remaining employees of IP Performance, Inc. In accordance with the restricted stock agreements with these individuals, all of the related restricted stock vested upon termination and all of the remaining deferred stock compensation of $3.5 million was accelerated and recorded in the three months ended December 31, 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 $150,000 in the three months ended December 31, 2000. During fiscal 2001, we completed an intensive review of our business, which resulted in our implementation of a restructuring plan. As a result of this restructuring and an assessment of expected future cash flows, we determined that the recoverability of intangible assets resulting from our purchase of IP Performance, Inc. was uncertain. Accordingly, we recognized an impairment charge for the full amount of the remaining un-amortized intangible assets, approximately $2.0 million during the fourth quarter of fiscal 2001. Interest income, net 15 Interest income, net decreased to $424,000 in the three months ended December 31, 2001 from $1.9 million in the three months ended December 31, 2000. This decrease was due to a lower average cash and cash equivalents balance during the three months ended December 31, 2001 as a result of net operating losses incurred since 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 December 31, 2001, we had $67.0 million in cash and cash equivalents, excluding restricted cash of $1.1 million. Cash from operating activities was a cash outflow of $6.6 million in the three months ended December 31, 2001 and a cash inflow of $2.9 million in the three months ended December 31, 2000. Cash used in operating activities during the three months ended December 31, 2001 was primarily due to a net loss of $7.2 million and decreases in the amount due to our contract manufacturer and accrued expenses. Cash provided by operating activities in the three months ended December 31, 2000 was primarily due to increases in accounts payable and amounts due to our contract manufacturer, decreases in accounts receivable and amounts due from our contract manufacturer. Cash used in investing activities was $98,000 and $2.2 million in the three months ended December 31, 2001 and 2000, respectively. Cash used in investing activities was primarily for purchases of property and equipment during both periods. Cash from financing activities was a cash outflow of $1.1 million during the three months ended December 31, 2001 and a cash inflow of $335,000 during the three months ended December 31, 2000. Cash used in financing activities in the three months ended December 31, 2001 was primarily for the acquisition of treasury stock, offset in part by cash received upon the repayment of stockholder notes receivable. Cash provided by financing activities in the three months ended December 31, 2000 was primarily from the exercise of stock options and warrants. On August 14, 2001, we announced that our Board of Directors had approved the repurchase of up to $5 million of our common stock in the open market or in non-solicited privately negotiated transactions. We plan to use repurchased shares for our employee stock plans. During the year ended September 30, 2001 and quarter ended December 31, 2001, the Company repurchased 300,900 and 1,548,572 shares of common stock at a cost of approximately $198,000 and $1,280,000, respectively. As a result of restructurings implemented in fiscal 2001, we are obligated to make additional cash payments of approximately $750,000, the majority of which will be made over the next twelve months. We anticipate that funds required to make all restructuring payments will be available from our current working capital. Our future liquidity and capital requirements will depend upon numerous factors, including: . our ability to form an adequate number of strategic partnerships with ISVs and OEMs; . the level of success of our strategic ISV and OEM partners in selling server appliance solutions that include our server appliance hardware platforms; . the costs and timing of product engineering efforts and the success of these efforts; . the costs involved in obtaining, maintaining and enforcing intellectual property rights; and 16 . market developments. 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 and our 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 may need to reduce our operating expenses or discontinue one or more components of our new business strategy. Related Party Transactions In January 2001, we entered into a series of related agreements with Lawrence A. Genovesi, our current Chairman and former President, Chief Executive Officer and Chief Technology Officer. These agreements were entered into to avoid significant sales of our stock by Mr. Genovesi as a result of a margin call on a personal loan collateralized by Mr. Genovesi's holdings of our common stock. We agreed to guarantee a personal loan obtained by Mr. Genovesi from a financial institution (the "Bank") through a deposit of $1,051,850 of our cash with the Bank (the "Guarantee"). The Guarantee period ended on January 9, 2002 and we extended the Guarantee to January 9, 2003, at which time the balance of the amount deposited with the Bank, which is not required to satisfy any obligations under the Guarantee, will be returned to us. We also entered into an agreement with Mr. Genovesi whereby he has agreed to reimburse us for any obligations incurred by us under the Guarantee (the "Reimbursement Agreement"). Any unpaid balances under the Reimbursement Agreement bear interest at a rate of 10% per annum. In the event of a default under the Reimbursement Agreement by Mr. Genovesi, we have the right to apply any and all compensation due to Mr. Genovesi against all of his obligations outstanding under the Reimbursement Agreement. In addition, we entered into a revolving promissory note agreement with Mr. Genovesi of up to $210,000 (the "Note"). The Note bore interest at a rate of 5.9% per annum and was due and payable in full upon the earlier of January 9, 2002 or 30 days following the date Mr. Genovesi ceased to be an employee of Network Engines. The Note was paid in full in November 2001. In conjunction with the Guarantee, the Reimbursement Agreement and the Note, we entered into a pledge agreement with Mr. Genovesi whereby he pledged to us all shares of Network Engines common stock he owned as of the date of the agreement or subsequently acquired, and all options and other rights to acquire shares of our common stock he owned as of the date of the agreement or subsequently acquired (collectively, the "Pledged Securities"). Additionally, Mr. Genovesi pledged to us all additional securities or other consideration from time to time acquired by him 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 December 31, 2001, no amounts were required to be reimbursed to us under the Reimbursement Agreement. In November 2001, we repurchased 234,822 shares of our common stock from Mr. Genovesi for $225,195 in a private transaction. The purchase price was determined based on the average closing price of our common stock over the ten trading days prior to the purchase date. Mr. Genovesi used the proceeds to pay all amounts outstanding under the Note, to pay down a recourse note payable to us and to pay taxes incurred in connection with our repurchase of our common stock from Mr. Genovesi. In April 2001, we entered into full recourse loan agreements with certain former employees and certain current and former officers of Network Engines (the "Loan Agreements"). These loan agreements were entered into in order to avoid substantial sales of Network Engines common stock by these employees and officers as a result of alternative minimum tax obligations incurred by them in connection with their exercise of options to purchase shares of Network Engines common stock. The net amount loaned to the employees and officers under the Loan Agreements was approximately $508,000. 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 Network Engines, unless termination is involuntary and without cause. In conjunction with the Loan Agreements, each employee and officer pledged all shares of capital stock, and options to purchase capital stock, of Network Engines 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. In November 2001, we extended the repayment dates to September 2002 for loans with an aggregate principal amount of $226,996 due from two of our current officers. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board ("FASB") 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 currently does not expect SFAS 142 to have a material impact on its financial position and results of operations. In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). The objectives of SFAS 144 are to address significant issues relating to the implementation of FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" ("SFAS 121"), and to develop a single accounting model, based on the framework established in SFAS 121, for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. SFAS 144 supersedes SFAS 121; however, it retains the fundamental provisions of SFAS 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS 144 supersedes the accounting and reporting provisions of Accounting Principles Board No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"), for segments of a business to be disposed of. However, SFAS 144 retains APB 30's requirement that entities report discontinued operations separately from continuing operations and extends that reporting requirement to "a component of an entity" that either has been disposed of or is classified as "held for sale." SFAS 144 also amends the guidance of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to eliminate the exception to consolidation for a temporarily controlled subsidiary. SFAS 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001, including interim periods, and, generally, its provisions are to be applied prospectively. The Company does not expect the application of SFAS 144 to have a material impact on the Company's financial position or 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 restructured our business. There can be no assurance that our restructuring will have the intended effect on our business. During the fiscal year ended September 30, 2001, we restructured our business. Our restructuring included a considerable reduction in our workforce and our future operating expenses and an adjustment to our business strategy to concentrate our resources on our core competencies, which we believe to be hardware platform packaging and the ability to integrate our hardware platforms with various operating systems, management systems and application software systems. Our restructuring also includes a transition from primarily direct sales channels to partnerships with independent software vendors and original equipment manufacturers in order to offer "turn-key" solutions for enterprise customers. In addition, our restructuring includes the termination of sales of our WebEngine Blazer, WebEngine Roadster, WebEngine Viper, AdminEngine and StorageEngine Voyager products. There can be no assurance that our restructuring, even if fully implemented, will have a positive effect on our financial results, our operations, our market share, the market price of our common stock or public perception of us in the server appliance marketplace, or that we will ever achieve substantial revenues, any one of which could cause further decline in the market price of our common stock. If we fail to generate significant revenues from strategic partnerships with independent software vendors and original equipment manufacturers, our operations could be materially adversely affected and as a result, we may choose to discontinue one or more of the components of our new business strategy. To date, our revenues have been principally derived from direct sales to companies in the Internet marketplace, otherwise known as "new economy" customers. A major component of our restructuring is a business strategy change to focus our sales and marketing efforts on indirect sales through strategic partnerships with ISVs and OEMs. To date, we have not entered into a significant number of definitive agreements with ISVs and OEMs. We may not be able to develop a significant number of strategic partnerships with ISVs and OEMs and, even if we are successful in developing strategic partnerships with ISVs and OEMs, this strategy may fail to generate sufficient revenues to offset the demands that this strategy will place on our business. A failure to generate significant revenues from strategic partnerships could materially adversely affect our operations and, as a result, we may choose to discontinue one or more of the components of our new business strategy. Risks Related to Competition Within Our Industry If we are not able to effectively compete against providers of general-purpose servers, specific-purpose servers or other server appliance providers, our revenues will not increase and may decrease further. In the market for server appliance hardware platforms, we face significant competition from larger companies who market general-purpose servers, specific-purpose servers and server appliances 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 server appliance hardware platforms with greater functionality or support than our products, or if 18 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. If server appliances are not increasingly adopted as a solution to meet companies' computer application needs, the market for our products may not grow and the market price of 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 server appliance hardware platforms. As a result, we depend on the growing use of server appliances to meet businesses' computer application needs. The market for server appliance products has only recently begun to develop and it is evolving rapidly. Because this market is new, we cannot predict its potential size or future growth rate with a high degree of certainty. Our revenues may not grow and the market price of our common stock could decline if the server appliance market does not grow rapidly. We believe that our expectations for the growth of the server appliance market may not be fulfilled if customers continue to use general-purpose servers. The role of our products could, for example, be limited if general-purpose servers become better at performing functions currently being performed by server appliances 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. Our revenues could be reduced further if our larger competitors make acquisitions in order to join their extensive distribution capabilities with our smaller competitors' products. Large server manufacturers may not only develop their own server appliance solutions, but they may also acquire or establish cooperative relationships with our smaller competitors, including smaller private companies. Because large server manufacturers have significant financial and organizational resources available, they may be able to quickly penetrate the server appliance market by leveraging the technology and expertise of smaller companies and utilizing their own extensive distribution channels. We expect that the 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. Consolidation within the server marketplace could adversely affect our revenues. 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 server appliances 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. Server appliance 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 server appliance 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 require us to retain, and may require us to hire additional, technically competent personnel. Significant delays in 19 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 server appliances and have recently released key new products, which have not yet obtained significant market acceptance. Because of our limited operating history in the server appliance 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 February 2001 we began shipping our WebEngine Sierra, our next generation server appliance, designed to replace our discontinued WebEngine Blazer product. To date, the WebEngine Sierra product has not obtained significant market acceptance and we cannot be sure whether this product, our recently introduced ApplianceEngine 1000 product, or additional new product offerings, 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 new and enhanced products do not gain market acceptance, we may not be able to attract and engage strategic ISV and OEM partners. If we are unable to attract and engage ISV and OEM partners, 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: . the growth and changing requirements of the server appliance market; . the performance, quality, price and total cost of ownership of our products; and . the availability, price, quality and performance of competing products and technologies. 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 further. Since our inception, we have incurred significant net losses, including net losses of $5.8 million, $12.2 million and $69.5 million in fiscal 1999, 2000 and 2001, respectively, as well as a net loss of $7.2 million in the three months ended December 31, 2001. We expect to continue to have net losses in the future. In addition, we had an accumulated deficit of $100.6 million as of December 31, 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. During the year ended September 30, 2001, we implemented restructuring plans to curtail discretionary selling, general and administrative expenses, consolidate our international operations, 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. 20 Our revenues fell sharply in fiscal 2001 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 fiscal 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, competition and our inexperience in identifying and engaging ISV and OEM partners. If we are unable to return to the rate of revenue growth we experienced in fiscal 2000, our stock price could experience further declines. We derive a substantial portion of our revenues from one customer, and our revenues may decline significantly if this customer cancels or delays a purchase of our products. In the three months ended December 31, 2001, one customer accounted for 73% of our net revenues. None of our customers are obligated to purchase any quantity of our products in the future. If our largest customer stops purchasing from us, delays future purchases or discontinues use of our technology, our revenues and operating results will be adversely affected, our reputation in the industry may suffer and our ability to predict cash flow accurately will decrease. Accordingly, unless and until we expand and diversify our customer base, our future success will depend upon the timing and size of future purchase orders, if any, from this customer. If the commodification of products and competition in the server appliance 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 our products has already decreased, and may continue to decrease, in response to changes in our product mix, competitive pricing pressures, or new product introductions into the server appliance marketplace. 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 maintain our gross margins, we also must continue to 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 utilization of a contract manufacturer, Sanmina-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 server appliance 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 server appliances 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 server appliance 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 further. Risks Related to Our Marketing and Sales Efforts We need to effectively manage our sales and marketing operations 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. 21 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 server appliance hardware platforms, 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. 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 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 at high volumes, which could have an adverse effect on our operations. Our agreement with Sanmina-SCI does not guarantee production levels, manufacturing line space or manufacturing prices. In addition, our agreement with Sanmina-SCI renews annually and allows either party to elect not to renew the agreement. If we are required, or if we choose, to change outside manufacturers, we may experience transitional difficulties and lose sales and customer relationships may suffer. In addition, in the event that we require additional manufacturing capacity, Sanmina-SCI may not have additional facilities available when we need them. Commencing volume production or expanding production to another facility owned by Sanmina-SCI may be expensive and time-consuming. In addition, commencement of the manufacturing of our products at additional Sanmina-SCI manufacturing sites that 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 additional outside manufacturers to manufacture our products in higher volume and at lower costs to meet increased demand and competition. Because the Sanmina Corporation and SCI Systems merger occurred very recently, there can be no assurance as to the effect, positive or negative, that this merger will have on the operation of Sanmina-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 and negatively impact our cash position. 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. 22 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, main logic boards, certain disk drives, and power supplies as well as our internally developed heat-pipe, 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. Risks Related to Our Products' Dependence on Intellectual Property and Our Use of Our Brand Our reliance upon contractual provisions, domestic copyright and trademark laws and our applied-for patents 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, there can be no guarantee that any of our patent applications will result in patents, or that any such patents would provide effective protection of our technology. 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 server appliance 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: . be time-consuming to defend; . result in costly litigation; . divert our management's attention and resources; . cause product shipment delays; or 23 . 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 A class action lawsuit has been filed against us, our chairman and one of our executive officers. On or about December 3, 2001, a class action lawsuit was filed against us, our chairman, one of our executive officers and the underwriters of our initial public offering. We are unable to predict the effects of this suit, or other similar suits, on our financial condition and our business and, although we maintain certain insurance coverage, there can be no assurance that this claim will not result in substantial monetary damages in excess of our insurance coverage. In addition, we may expend significant resources to defend this case. This class action lawsuit, or other similar suits, could negatively impact both our financial condition and the market price for our common stock. We are among the defendants in a lawsuit filed against us by a former employee. On December 29, 1999, a lawsuit was commenced against us, and two former officers and directors. We believe that the lawsuit is without merit and intend to engage a vigorous defense. However, an adverse resolution is possible and in addition, we could expend significant financial and managerial resources during the course of our defense. 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 during the past year 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 was the potential that our common stock could be de-listed from the NASDAQ National Market. However, on September 27, 2001, NASDAQ announced that it had suspended its minimum bid and market value of public float requirements for continued listing until January 2, 2002. NASDAQ adopted this measure to help companies remain listed in view of the extraordinary market conditions following the tragedy of September 11, 2001. Since the minimum bid price requirement for continued listing on NASDAQ was reinstated on January 2, 2002, we have not received notice of any new de-listing proceedings against out common stock. If we are unable to comply with NASDAQ's requirements, our common stock could be de-listed from trading on the NASDAQ. If our common stock were de-listed from NASDAQ, among other things, this could result in a number of negative implications, including reduced liquidity in our common stock as a result of the loss of market efficiencies associated with NASDAQ and the loss of federal preemption of state securities laws as well as the potential loss of confidence by suppliers, customers and employees, the loss of analyst coverage and institutional investor interest, fewer business development opportunities and greater difficulty in obtaining financing. 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 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 individuals. 24 If we fail to retain appropriate levels of qualified technical personnel, we may not be able to develop and introduce our products on a timely basis. We require the services of qualified technical personnel. We have experienced the negative effects of an economic slowdown. Our revenues have declined significantly during the past year and the market price of our common stock has decreased significantly. As a result, we have implemented 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 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 server appliance hardware platforms are complex, they could contain errors 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: . the loss of or delay in market acceptance and sales of our products; . diversion of development resources; . injury to our reputation; or . 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. While we attempt to limit our risk contractually, 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 may be 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. Any claims for damages, even if unsuccessful, 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 25 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 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. 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 and as a result, 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. 26 PART II--OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On December 29, 1999, a former employee, George Flate, commenced a lawsuit against us, and two individuals who formerly served as both officers and directors for us, 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. 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. Costs incurred to date have not been material. The case has proceeded through discovery and the court has established a trial date of May 20, 2002. On or about December 3, 2001, Margaret Vojnovich filed in the United States District Court for the Southern District of New York a lawsuit against Network Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial Officer and Vice President of Administration (collectively, the "Executive Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally alleges that the Underwriter Defendants violated the federal securities laws by conspiring and agreeing to raise and increase the compensation received by the Underwriter Defendants by agreeing with some recipients of an allocation of IPO stock to agree to purchase shares of manipulated securities in the after-market of the IPO at pre-determined price levels designed to maintain, distort and/or inflate the price of the Company's common stock in the aftermarket. The suit also alleges that the Underwriter Defendants received undisclosed and excessive brokerage commissions and that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants' individual and collective underwritings, compensation and revenues. The suit further alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the IPO without disclosing to investors that the Underwriter Defendants in the offering, including the lead underwriters, had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks damages, rescission of the purchase prices paid by purchasers of shares of the Company's common stock and certification of a plaintiff class consisting of all persons who acquired shares of the Company's common stock between July 13, 2000 and December 6, 2000. The Company is in the process of reviewing this suit and intends to respond in a timely manner. The Company is unable to predict the outcome of this suit and its ultimate effect, if any, on the Company's financial condition, however the Company's defense against these claims could 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 managing underwriters of our initial public offering were Donaldson, Lufkin & Jenrette, Dain Rauscher Wessels, Robertson Stephens and DLJdirect Inc. The aggregate proceeds to us from the offering were approximately $116.9 million reflecting gross proceeds of $127.0 million net of 27 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 December 31, 2001, we have used the proceeds as follows: approximately $44.1 million was used to fund the operations of the Company, approximately $4.7 million was used for the purchase of property and equipment and approximately $1.5 million was used to repurchase the Company's common stock under a stock repurchase plan. 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 December 31, 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 filed a Current Report on Form 8-K, dated November 13, 2001, disclosing the repurchase of certain common stock from our Chairman. We filed a Current Report on Form 8-K, dated December 12, 2001, disclosing a class action lawsuit filed against us and others by Margaret Vojnovich. 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: February 13, 2002 /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 10.35 Form of Retention Agreement, dated November 1, 2001, between the Registrant and James D. Murray, Douglas G. Bryant and Timothy J. Dalton. EX-10.35 3 dex1035.txt FORM OF RETENTION AGREEMENT, DATED 11/1/2001 EXHIBIT 10.35 Network Engines, Inc. Executive Retention Agreement ----------------------------- THIS EXECUTIVE RETENTION AGREEMENT by and between Network Engines, Inc., a Delaware corporation (the "Company"), and _________________ (the "Executive") is made as of __________, 2001 (the "Effective Date"). WHEREAS, the Company recognizes that, as is the case with many publicly-held corporations, various business uncertainties may arise from time to time and that such possibility, and the concerns and questions which it may raise among key personnel, may result in the departure or distraction of key personnel to the detriment of the Company and its stockholders, and WHEREAS, the Board of Directors of the Company (the "Board") has determined that appropriate steps should be taken to reinforce and encourage the continued employment and dedication of the Company's key personnel without distraction from such uncertainties, including the possibility of a change in control of the Company and related events and circumstances. NOW, THEREFORE, as an inducement for and in consideration of the Executive remaining in its employ, the Company agrees that the Executive shall receive the severance benefits set forth in this Agreement in the event the Executive's employment with the Company is terminated under the circumstances described below, whether before or after a Change in Control (as defined in Section 1.1). 1. Key Definitions. As used herein, the following terms shall have the following respective meanings: 1.1 "Change in Control" means an event or occurrence set forth ----------------- in any one or more of subsections (a) through (d) below (including an event or occurrence that constitutes a Change in Control under one of such subsections but is specifically exempted from another such subsection): (a) the acquisition by an individual, entity or group (within the meaning of Section 13(d)(3)or14(d)(2)of the Securities Exchange Act of 1934, as amended (the"Exchange Act")) (a "Person") of beneficial ownership of any capital stock of the Company if, after such acquisition, such Person beneficially owns (withinthe meaning of Rule 13d-3 promulgated under the Exchange Act) 30% or more of either (x) the then-outstanding shares of common stock of the Company (the "Outstanding Company Common Stock") or (y) the combined voting power of the then-outstanding securities of the Company entitled to vote generally in the election of directors (the "Outstanding Company Voting Securities"); provided, however, that for purposes of this subsection (a), the -------- following acquisitions shall not constitute a Change in Control: (i) any acquisition directly from the Company (excluding an acquisition pursuant to the exercise, conversion orexchange of any security exercisable for, convertible into or exchangeable for common stock or voting securities of the Company, unless the Person exercising, converting or exchanging such security acquired such security directly from the Company or an underwriter or agent of the Company), (ii) any acquisition by the Company, (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or any corporation controlled by the Company, or (iv) any acquisition by any corporation pursuant to a transaction which complies with clauses (i) and (ii) of subsection (c) of this Section 1.1; or (b) such time as the Continuing Directors (as defined below) do not constitute a majority of the Board (or, if applicable, the Board of Directors of a successor corporation to the Company), where the term "Continuing Director" means at any date a member of the Board (i) who was a member of the Board on the date of the execution of this Agreement or (ii) who was nominated or elected subsequent to such date by at least a majority of the directors who were Continuing Directors at the time of such nomination or election or whose election to the Board was recommended or endorsed by at least a majority of the directors who were Continuing Directors at the time of such nomination or election; provided, however, that there shall be excluded from this clause (ii) -------- ------- any individual whose initial assumption of office occurred as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents, by or on behalf of a person other than the Board; or (c) the consummation of a merger, consolidation, reorganization, recapitalization or statutory share exchange involving the Company or a sale or other disposition of all or substantially all of the assets of the Company in one or a series of transactions (a "Business Combination"), unless, immediately following such Business Combination, each of the following two conditions is satisfied: (i) all or substantially all of the individuals and entities who were the beneficial owners of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 50% of the then-outstanding shares of common stock and the combined voting power of the then-outstanding securities entitled to vote generally in the election of directors, respectively, of the resulting or acquiring corporation in such Business Combination (which shall include, without limitation, a corporation which as a result of such transaction owns the Company or substantially all of the Company's assets either directly or through one or more subsidiaries) (such resulting or acquiring corporation is referred to herein as the "Acquiring Corporation") in substantially the same proportions as their ownership, immediately prior to such Business Combination, of the Outstanding Company Common Stock and Outstanding Company Voting Securities, respectively; and (ii) no Person (excluding the Acquiring Corporation or any employee benefit plan (or related trust) maintained or sponsored by the Company or by the Acquiring Corporation) beneficially owns, directly or indirectly, 30% or more of the then outstanding shares of common stock of the Acquiring Corporation, or of the combined voting power of the then-outstanding securities of such corporation entitled to vote generally in the election of directors (except to the extent that such ownership existed prior to the Business Combination); or (d) approval by the stockholders of the Company of a complete liquidation or dissolution of the Company. -2- 1.2 "Change in Control Date" means the first date during the Term (as ---------------------- defined in Section 2) on which a Change in Control occurs. Anything in this Agreement to the contrary notwithstanding, if (a) a Change in Control occurs, (b) the Executive's employment with the Company is terminated prior to the date on which the Change in Control occurs, and (c) it is reasonably demonstrated by the Executive that such termination of employment (i) was at the request of a third party who has taken steps reasonably calculated to effect a Change in Control or (ii) otherwise arose in connection with or in anticipation of a Change in Control, then for purposes of this Agreement the "Change in Control Date" shall mean the date immediately prior to the date of such termination of employment. 1.3 "Cause" means: ----- (a) the Executive's failure to substantially perform his assigned duties (other than any such failure resulting from incapacity due to physical or mental illness or any failure after the Executive gives notice of termination for Good Reason), which failure is not cured within 20 days after a written demand for substantial performance is received by the Executive from the Board of Directors of the Company which specifically identifies the manner in which the Board of Directors believes the Executive has not substantially performed the Executive's duties; or (b) the Executive's engagement in illegal conduct or gross misconduct which is materially and demonstrably injurious to the Company. 1.4 "Good Reason" means the occurrence, without the Executive's ----------- written consent, of any of the events or circumstances set forth in clauses (a) through (e) below. Notwithstanding the occurrence of any such event or circumstance, such occurrence shall not be deemed to constitute Good Reason if, prior to the Date of Termination specified in the Notice of Termination (each as defined in Section 3.2(a)) given by the Executive in respect thereof, such event or circumstance has been fully corrected and the Executive has been reasonably compensated for any losses or damages resulting therefrom (provided that such right of correction by the Company shall only apply to the first Notice of Termination for Good Reason given by the Executive). (a) the assignment to the Executive of duties inconsistent in any material respect with the Executive's position (including status, offices, titles and reporting requirements), authority or responsibilities in effect on the Effective Date, or any other action or omission by the Company which results in a material diminution in such position, authority or responsibilities; (b) a reduction in the Executive's annual base salary as in effect on the Effective Date or as the same was or may be increased thereafter from time to time; (c) a change by the Company in the location at which the Executive performs his principal duties for the Company to a new location that is both (i) outside a radius of 50 miles from the Executive's principal residence immediately prior to the Effective Date and (ii) more than 35 miles from the location at which the Executive performed his principal duties for the Company immediately prior to the Effective Date; -3- (d) the failure of the Company to obtain the agreement from any successor to the Company to assume and agree to perform this Agreement, as required by Section 6.1; or (e) a purported termination of the Executive's employment which is not effected pursuant to a Notice of Termination satisfying the requirements of Section 3.2(a). The Executive's right to terminate his employment for Good Reason shall not be affected by his incapacity due to physical or mental illness. 1.5 "Disability" means the Executive's absence from the full-time ---------- performance of the Executive's duties with the Company for 180 consecutive calendar days as a result of incapacity due to mental or physical illness which is determined to be total and permanent by a physician selected by the Company or its insurers and acceptable to the Executive or the Executive's legal representative. 2. Term of Agreement. This Agreement, and all rights and obligations of the ----------------- parties hereunder, shall take effect upon the Effective Date and shall expire on the date two years after the Effective Date. "Term" shall mean the period commencing as of the Effective Date and continuing in effect through the date that is two years after the Effective Date. 3. Employment Status; Termination Following Change in Control. ---------------------------------------------------------- 3.1 Not an Employment Contract. The Executive acknowledges that this -------------------------- Agreement does not constitute a contract of employment or impose on the Company any obligation to retain the Executive as an employee and that this Agreement does not prevent the Executive from terminating employment at any time. 3.2 Termination of Employment. ------------------------- (a) Any termination of the Executive's employment by the Company or by the Executive shall be communicated by a written notice to the other party hereto (the "Notice of Termination"), given in accordance with Section 7. Any Notice of Termination shall: (i) indicate the specific termination provision (if any) of this Agreement relied upon by the party giving such notice, (ii) to the extent applicable, set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive's employment under the provision so indicated and (iii) specify the Date of Termination (as defined below). The effective date of an employment termination (the "Date of Termination") shall be the close of business on the date specified in the Notice of Termination (which date may not be less than 10 days or more than 120 days after the date of delivery of such Notice of Termination), in the case of a termination other than one due to the Executive's death, or the date of the Executive's death, as the case may be. In the event the Company fails to satisfy the requirements of Section 3.2(a) regarding a Notice of Termination, the purported termination of the Executive's employment pursuant to such Notice of Termination shall not be effective for purposes of this Agreement. (b) The failure by the Executive or the Company to set forth in the Notice of Termination any fact or circumstance which contributes to a showing of Good Reason or Cause shall not waive any right of the Executive or the Company, respectively, hereunder or -4- preclude the Executive or the Company, respectively, from asserting any such fact or circumstance in enforcing the Executive's or the Company's rights hereunder. (c) Any Notice of Termination for Cause given by the Company must be given within 90 days of the occurrence of the event(s) or circumstance(s) which constitute(s) Cause. 4. Benefits to Executive. 4.1 Stock Acceleration. If (a) a Change in Control Date or an ------------------ Acquisition Event occurs during the Term on or before the Date of Termination and (b) the Executive's employment with the Company is terminated by the Company (other than for Cause, Disability or Death) or by the Executive for Good Reason during the Term, then, effective upon the Date of Termination, (x) each outstanding option to purchase shares of Common Stock of the Company held by the Executive shall become immediately exercisable in full, and (y) each outstanding restricted stock award shall be deemed to be fully vested and will no longer be subject to any right of repurchase by the Company. If (a) neither a Change of Control Date nor an Acquisition Event occurs on or before the Date of Termination and (b) the Executive's employment with the Company is terminated by the Company (other than for Cause, Disability or Death) or by the Executive for Good Reason during the Term, then (x) the vesting of (i) each outstanding option to purchase shares of the Company held by the Executive and (ii) each outstanding restricted stock award shall be determined as though the Executive remained employed by the Company until six months after the Date of Termination, and (y) each outstanding option to purchase shares of the Company held by the Executive shall remain exercisable (to the extent vested) for a period of six months after the Date of Termination. For purposes of this Section 4.1, an Acquisition Event is the acquisition by the Company of all of the outstanding equity interests of a company or all or substantially all of the assets or business of a company. 4.2 Compensation. If the Executive's employment with the Company ------------ terminates during the Term, the Executive shall be entitled to the following benefits: (a) Termination Without Cause or for Good Reason. If the -------------------------------------------- Executive's employment with the Company is terminated by the Company (other than for Cause, Disability or Death) or by the Executive for Good Reason during the Term, then the Executive shall be entitled to the following benefits: (i) the Company shall pay to the Executive in a lump sum in cash within 30 days after the Date of Termination the aggregate of the following amounts: (1) the sum of (A) the Executive's base salary through the Date of Termination, and (B) the amount of any compensation previously deferred by the Executive (together with any accrued interest or earnings thereon) and any accrued vacation pay, in each case to the extent not previously paid (the sum of the amounts described in clauses (A) and (B) shall be hereinafter referred to as the "Accrued Obligations"); and (2) the amount equal to (A) one-half (1/2) multiplied by (B) the Executive's highest annual base salary during the three year period prior to the Effective Date. -5- (ii) for six months after the Date of Termination, or such longer period as may be provided by the terms of the appropriate plan, program, practice or policy, the Company shall continue to provide benefits to the Executive and the Executive's family at least equal to those which would have been provided to them if the Executive's employment had not been terminated, in accordance with the applicable Benefit Plans in effect on the Effective Date or, if more favorable to the Executive and his family, in effect generally at any time thereafter with respect to other peer executives of the Company and its affiliated companies; provided, however, that if the Executive becomes -------- reemployed with another employer and is eligible to receive a particular type of benefits (e.g., health insurance benefits) from such employer on terms at least as favorable to the Executive and his family as those being provided by the Company, then the Company shall no longer be required to provide those particular benefits to the Executive and his family; (iii) to the extent not previously paid or provided, the Company shall timely pay or provide to the Executive any other amounts or benefits required to be paid or provided or which the Executive is eligible to receive following the Executive's termination of employment under any plan, program, policy, practice, contract or agreement of the Company and its affiliated companies (such other amounts and benefits shall be hereinafter referred to as the "Other Benefits"); (iv) for purposes of determining eligibility (but not the time of commencement of benefits) of the Executive for retiree benefits to which the Executive is entitled, the Executive shall be considered to have remained employed by the Company until six months after the Date of Termination; and (v) if a Change in Control Date occurs during the Term and on or before the Date of Termination, the Company shall make an additional lump sum payment to the Executive equal to the sum of (A) the product of (x) the annual bonus paid or payable (including any bonus or portion thereof which has been earned but deferred) for the most recently completed fiscal year and (y) a fraction, the numerator of which is the number of days in the current fiscal year through the Date of Termination, and the denominator of which is 365 and (B) one-half multiplied by the Executive's highest annual bonus during the three-year period prior to the Effective Date. (b) Resignation Without Good Reason; Termination for Death or --------------------------------------------------------- Disability. If the Executive voluntarily terminates his employment during the - ---------- Term, excluding a termination for Good Reason, or if the Executive's employment with the Company is terminated by reason of the Executive's death or disability during the Term, then the Company shall (i) pay the Executive (or his estate, if applicable), in a lump sum in cash within 30 days after the Date of Termination, the Accrued Obligations and (ii) timely pay or provide to the Executive the Other Benefits. (c) Termination for Cause. If the Company terminates the Executive's --------------------- employment with the Company for Cause during the Term, then the Company shall (i) pay the Executive, in a lump sum in cash within 30 days after the Date of Termination, the sum of (A) the Executive's base salary through the Date of Termination and (B) the amount of any compensation previously deferred by the Executive, in each case to the extent not previously -6- paid, and (ii) timely pay or provide to the Executive the Other Benefits. (d) Severance Agreement. As a condition of receipt of any ------------------- payments under Section 4.2(a)(i), the Executive shall be required to sign a severance agreement and release prepared by and provided by the Company (the "Severance Agreement") and to abide by the provisions of the Severance Agreement. Among other things, the Severance Agreement shall contain a release and waiver of any claims the employee or his or her representative may have against the Company, its affiliates and/or representatives, and shall release those entities and persons from any liability for such claims including, but not limited to, all employment discrimination claims. 4.3 Taxes. ----- (a) Notwithstanding any other provision of this Agreement, except as set forth in Section 4.3(b), in the event that the Company undergoes a "Change in Ownership or Control" (as defined below) , the Company shall not be obligated to provide to the Executive a portion of any "Contingent Compensation Payments" (as defined below) that the Executive would otherwise be entitled to receive to the extent necessary to eliminate any "excess parachute payments" (as defined in Section 280G(b)(1) of the Internal Revenue Code of 1986, as amended (the "Code")) for the Executive. For purposes of this Section 4.3, the Contingent Compensation Payments so eliminated shall be referred to as the "Eliminated Payments" and the aggregate amount (determined in accordance with Proposed Treasury Regulation Section 1.280G-1, Q/A-30 or any successor provision) of the Contingent Compensation Payments so eliminated shall be referred to as the "Eliminated Amount." (b) Notwithstanding the provisions of Section 4.3(a), no such reduction in Contingent Compensation Payments shall be made if (i) the Eliminated Amount (computed without regard to this sentence) exceeds (ii) the aggregate present value (determined in accordance with Proposed Treasury Regulation Section 1.280G-1, Q/A-31 and Q/A-32 or any successor provisions) of the amount of any additional taxes that would be incurred by the Executive if the Eliminated Payments (determined without regard to this sentence) were paid to him (including, state and federal income taxes on the Eliminated Payments, the excise tax imposed by Section 4999 of the Code payable with respect to all of the Contingent Compensation Payments in excess of the Executive's "base amount" (as defined in Section 280G(b)(3) of the Code), and any employment taxes). The override of such reduction in Contingent Compensation Payments pursuant to this Section 4.3(b) shall be referred to as a "Section 4.3(b) Override." For purpose of this paragraph, if any federal or state income taxes would be attributable to the receipt of any Eliminated Payment, the amount of such taxes shall be computed by multiplying the amount of the Eliminated Payment by the maximum combined federal and state income tax rate provided by law. (c) For purposes of this Section 4.3 the following terms shall have the following respective meanings: (i) "Change in Ownership or Control" shall mean a change in the ownership or effective control of the Company or in the ownership of a substantial portion of the assets of the Company determined in accordance with Section 280G(b)(2) of the Code. -7- (ii) "Contingent Compensation Payment" shall mean any payment (or benefit) in the nature of compensation that is made or made available (under this Agreement or otherwise) to a "disqualified individual" (as defined in Section 280G(c) of the Code) and that is contingent (within the meaning of Section 280G(b)(2)(A)(i) of the Code) on a Change in Ownership or Control of the Company. (d) Any payments or other benefits otherwise due to the Executive following a Change in Ownership or Control that could reasonably be characterized (as determined by the Company) as Contingent Compensation Payments (the "Potential Payments") shall not be made until the dates provided for in this Section 4.3(d). Within 30 days after each date on which the Executive first becomes entitled to receive (whether or not then due) a Contingent Compensation Payment relating to such Change in Ownership or Control, the Company shall determine and notify the Executive (with reasonable detail regarding the basis for its determinations) (i) which Potential Payments constitute Contingent Compensation Payments, (ii) the Eliminated Amount and (iii) whether the Section 4.3(b) Override is applicable. Within 30 days after delivery of such notice to the Executive, the Executive shall deliver a response to the Company (the "Executive Response") stating either (A) that he agrees with the Company's determination pursuant to the preceding sentence, in which case he shall indicate, if applicable, which Contingent Compensation Payments, or portions thereof (the aggregate amount of which, determined in accordance with Proposed Treasury Regulation Section 1.280G-1, Q/A-30 or any successor provision, shall be equal to the Eliminated Amount), shall be treated as Eliminated Payments or (B) that he disagrees with such determination, in which case he shall set forth (i) which Potential Payments should be characterized as Contingent Compensation Payments, (ii) the Eliminated Amount, (iii) whether the Section 4.3(b) Override is applicable, and (iv) which (if any) Contingent Compensation Payments, or portions thereof (the aggregate amount of which, determined in accordance with Proposed Treasury Regulation Section 1.280G-1, Q/A-30 or any successor provision, shall be equal to the Eliminated Amount, if any), shall be treated as Eliminated Payments. In the event that the Executive fails to deliver an Executive Response on or before the required date, the Company's initial determination shall be final and the Contingent Compensation Payments that shall be treated as Eliminated Payments shall be determined by the Company in its absolute discretion. If the Executive states in the Executive Response that he agrees with the Company's determination, the Company shall make the Potential Payments to the Executive within three business days following delivery to the Company of the Executive Response (except for any Potential Payments which are not due to be made until after such date, which Potential Payments shall be made on the date on which they are due). If the Executive states in the Executive Response that he disagrees with the Company's determination, then, for a period of 60 days following delivery of the Executive Response, the Executive and the Company shall use good faith efforts to resolve such dispute. If such dispute is not resolved within such 60-day period, such dispute shall be settled exclusively by arbitration in Boston, Massachusetts, in accordance with the rules of the American Arbitration Association then in effect. Judgment may be entered on the arbitrator's award in any court having jurisdiction. The Company shall, within three business days following delivery to the Company of the Executive Response, make to the Executive those Potential Payments as to which there is no dispute between the Company and the Executive regarding whether they should be made (except for any such Potential Payments which are not due to be made until after such date, which Potential Payments shall be made on the date on which they are due). The balance of the Potential Payments shall be made within three business days following the resolution of such dispute. Subject to the limitations -8- contained in Sections 4.3(a) and (b) hereof, the amount of any payments to be made to the Executive following the resolution of such dispute shall be increased by amount of the accrued interest thereon computed at the prime rate announced from time to time by the Wall Street Journal, compounded monthly from the date that such payments originally were due. (e) The provisions of this Section 4.3 are intended to apply to any and all payments or benefits available to the Executive under this Agreement or any other agreement or plan of the Company under which the Executive receives Contingent Compensation Payments. 5. Disputes. -------- 5.1 Settlement of Disputes; Arbitration. All claims by the Executive ----------------------------------- for benefits under this Agreement shall be directed to and determined by the Board of Directors of the Company and shall be in writing. Any denial by the Board of Directors of a claim for benefits under this Agreement shall be delivered to the Executive in writing and shall set forth the specific reasons for the denial and the specific provisions of this Agreement relied upon. The Board of Directors shall afford a reasonable opportunity to the Executive for a review of the decision denying a claim. Any further dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration in Boston, Massachusetts, in accordance with the rules of the American Arbitration Association then in effect. Judgment may be entered on the arbitrator's award in any court having jurisdiction. 5.2 Expenses. The Company agrees to pay as incurred, to the full -------- extent permitted by law, all legal, accounting and other fees and expenses which the Executive may reasonably incur as a result of any claim or contest by the Company, the Executive or others regarding the validity or enforceability of, or liability under, any provision of this Agreement or any guarantee of performance thereof (including as a result of any contest by the Executive regarding the amount of any payment or benefits pursuant to this Agreement), plus in each case interest on any delayed payment at the applicable Federal rate provided for in Section 7872(f)(2)(A) of the Code, but only if the Executive prevails in such claim or contest. 6. Successors. ---------- 6.1 Successor to Company. The Company shall require any successor -------------------- (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business or assets of the Company expressly to assume and agree to perform this Agreement to the same extent that the Company would be required to perform it if no such succession had taken place. Failure of the Company to obtain an assumption of this Agreement at or prior to the effectiveness of any succession shall be a breach of this Agreement and shall constitute Good Reason if the Executive elects to terminate employment, except that for purposes of implementing the foregoing, the date on which any such succession becomes effective shall be deemed the Date of Termination. As used in this Agreement, "Company" shall mean the Company as defined above and any successor to its business or assets as aforesaid which assumes and agrees to perform this Agreement, by operation of law or otherwise. 6.2 Successor to Executive. This Agreement shall inure to the benefit ---------------------- of and -9- be enforceable by the Executive's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Executive should die while any amount would still be payable to the Executive or his family hereunder if the Executive had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to the executors, personal representatives or administrators of the Executive's estate. 7. Notice. All notices, instructions and other communications given ------ hereunder or in connection herewith shall be in writing. Any such notice, instruction or communication shall be sent either (i) by registered or certified mail, return receipt requested, postage prepaid, or (ii) prepaid via a reputable nationwide overnight courier service, in each case addressed to the Company, at 25 Dan Road, Canton, Massachusetts, and to the Executive at the Executive's address indicated on the signature page of this Agreement (or to such other address as either the Company or the Executive may have furnished to the other in writing in accordance herewith). Any such notice, instruction or communication shall be deemed to have been delivered three business days after it is sent by registered or certified mail, return receipt requested, postage prepaid, or one business day after it is sent via a reputable nationwide overnight courier service. Either party may give any notice, instruction or other communication hereunder using any other means, but no such notice, instruction or other communication shall be deemed to have been duly delivered unless and until it actually is received by the party for whom it is intended. 8. Miscellaneous. 8.1 Employment by Subsidiary. For purposes of this Agreement, the ------------------------ Executive's employment with the Company shall not be deemed to have terminated solely as a result of the Executive continuing to be employed by a wholly-owned subsidiary of the Company. 8.2 Severability. The invalidity or unenforceability of any provision of ------------ this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect. 8.3 Injunctive Relief. The Company and the Executive agree that any ----------------- breach of this Agreement by the Company is likely to cause the Executive substantial and irrevocable damage and, therefore, in the event of any such breach, in addition to such other remedies which may be available, the Executive shall have the right to such specific performance and injunctive relief. 8.4 Governing Law. The validity, interpretation, construction and ------------- performance of this Agreement shall be governed by the internal laws of the Commonwealth of Massachusetts, without regard to conflicts of law principles. 8.5 Waivers. No waiver by the Executive at any time of any breach of, or ------- compliance with, any provision of this Agreement to be performed by the Company shall be deemed a waiver of that or any other provision at any subsequent time. 8.6 Counterparts. This Agreement may be executed in counterparts, each ------------ of which shall be deemed to be an original but both of which together shall constitute one and the -10- same instrument. 8.7 Tax Withholding. Any payments provided for hereunder shall be paid --------------- net of any applicable tax withholding required under federal, state or local law. 8.8 Entire Agreement. This Agreement sets forth the entire agreement of ---------------- the parties hereto in respect of the subject matter contained herein and supersedes all prior agreements, promises, covenants, arrangements, communications, representations or warranties, whether oral or written, by any officer, employee or representative of any party hereto in respect of the subject matter contained herein; and any prior agreement of the parties hereto in respect of the subject matter contained herein is hereby terminated and cancelled. 8.9 Amendments. This Agreement may be amended or modified only by a ---------- written instrument executed by both the Company and the Executive. 8.10 Executive's Acknowledgements. The Executive acknowledges that he: ---------------------------- (a) has read this Agreement; (b) has been represented in the preparation, negotiation, and execution of this Agreement by legal counsel of the Executive's own choice or has voluntarily declined to seek such counsel; (c) understands the terms and consequences of this Agreement; and (d) understands that the law firm of Hale and Dorr LLP is acting as counsel to the Company in connection with the transactions contemplated by this Agreement, and is not acting as counsel for the Executive. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year first set forth above. NETWORK ENGINES, INC. By:__________________________________ Title:_______________________________ ------------------------------------- [NAME OF EXECUTIVE] Address: ------------------------------------- ------------------------------------- ------------------------------------- -11- -----END PRIVACY-ENHANCED MESSAGE-----