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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURI-
TIES EXCHANGE ACT OF 1934
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999
Commission File No. 1-11859
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PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
MASSACHUSETTS
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No. 04-2787865)
101 MAIN STREET 02142-1590
CAMBRIDGE, MA (zip code)
(Address of principal executive
offices)
(617) 374-9600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.01 PAR VALUE PER SHARE
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. / /
As of March 16, 2000, the aggregate market value of the Registrant's voting
stock held by non-affiliates of the Registrant was approximately $147 million.
There were 29,107,447 shares of the Registrant's common stock, $.01 par
value per share, outstanding on March 16, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Definitive Proxy Statement for its Annual
Meeting of Stockholders scheduled to be held on June 8, 2000 (the "2000 Proxy
Statement") are incorporated by reference into Part III of this Form 10-K and
portions of the Registrant's Annual Report to Stockholders for the Registrant's
fiscal year ended December 31, 1999 (the "1999 Annual Report") are incorporated
by reference into Part II of this Form 10-K. With the exception of the portions
of the 2000 Proxy Statement and the 1999 Annual Report expressly incorporated
into this Form 10-K by reference, such documents shall not be deemed filed as
part of this Form 10-K.
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TABLE OF CONTENTS
PART 1
ITEM PAGE
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1 Business.................................................... 1
2 Properties.................................................. 12
3 Legal Proceedings........................................... 12
4 Submission of Matters to a Vote of Security Holders......... 13
Executive Officers of the Registrant........................ 13
PART II
5 Market for Registrant's Common Stock and Related Stockholder
Matters..................................................... 15
6 Selected Consolidated Financial Data........................ 15
7 Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 16
7A Quantitative and Qualitative Disclosure About Market Risk... 28
8 Financial Statements and Supplementary Data................. 28
9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 28
PART III
10 Directors and Executive Officers of the Registrant.......... 29
11 Executive Compensation...................................... 29
12 Security Ownership of Certain Beneficial Owners and
Management.................................................. 29
13 Certain Relationships and Related Transactions.............. 29
PART IV
14 Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 30
ITEM 1:
BUSINESS
OVERVIEW
Pegasystems Inc. (the "Company") is a leading provider of Customer
Relationship Management (CRM) software that enables transaction-intensive
organizations to manage a broad array of customer interactions. Our customers
represent a wide range of industries, including banking and financial services,
insurance, healthcare management, and telecommunications.
As businesses continue to focus on understanding and managing relationships
with their customers, they are increasingly seeking to apply new technologies
more effectively and on an enterprise-wide basis. As a result, the traditional
thinking about Customer Relationship Management (CRM) has evolved towards a
broader vision of eCRM - where the `e' reflects electronic media (not paper),
enterprise-wide solutions that integrate multi-product customer contact with
fulfillment, and extended-facilities that move beyond enterprise walls through
communications technologies, including the Internet. We believe that we are well
positioned to capitalize on the opportunities presented by this evolution with
our Web technology, data connectivity, multi-channel integration and process
automation expertise.
Our software enables organizations to deliver high-quality, consistent
customer service across today's preferred interaction channels, from the
traditional call center environment to Internet self-service. This software can
be used by thousands of concurrent users to generate billions of dollars per day
in resulting transactions. Work processes initiated by our solutions are driven
by a highly adaptive "rules base", designed by the user-organization for its
specific needs. The rules base facilitates a high level of consistency in
customer interactions, yet drives different processes depending on the customer
profile or the nature of the request.
We provide implementation, consulting, training, and support services, and a
set of applications to facilitate the implementation and use of our eCRM
software. We also have alliances with third parties who offer integration
services as well as technology and selected vertical industry applications that
complement or incorporate our software.
INDUSTRY BACKGROUND
With the Internet as a powerful driving force, even the most established
"bricks-and-mortar" companies are now facing intensifying competition from
companies that, until recently, were not considered to be players in their
markets. Today's eBusiness marketplace has spawned opportunistic companies that
have evolved from different backgrounds, industries and business models. These
companies also offer a variety of cost structures, delivery processes and
distribution channels that pose a challenge to traditional firms.
Such growing competition has increased the need for companies to
differentiate themselves, and one important way they can do so is the manner in
which they manage customer relationships. To be successful, organizations must
be able to handle their customer interactions consistently--across multiple
channels and functions--and be efficient in their business processes. To build
loyal, profitable customer relationships, companies need to synchronize their
customer-facing applications and adopt a customer-centric approach to
information. As many of today's eBusiness leaders have done, companies have
sought to implement rules-based, Internet-architected solutions that will extend
that information to employees, strategic partners and customers through
end-to-end integration. The Internet also provides a unique opportunity to
achieve dramatic improvements in customer satisfaction through self-service
options.
1
THE PEGASYSTEMS SOLUTION
The Company's Internet-architected eCRM software provides
transaction-intensive organizations with a wide range of capabilities that
enhance customer interactions across multiple channels. Our solutions offer the
following advantages:
- FLEXIBILITY AND CONSISTENCY. Our eCRM software is based on rules that are
user-defined; as such, these rules drive customer interactions across the
enterprise. Without costly and time-consuming reprogramming, an
organization is able to evolve its processes to address its changing
business requirements--and extend this evolution across today's preferred
channels of interaction. Customers often modify the rules base on a weekly
basis, offering flexibility and responsiveness. Whether via the Web or in
a more traditional call center environment, rules also enable
organizations to establish consistent standards--yet interact differently
with each customer--and thereby offer one-to-one personalization of its
service, sales, marketing, business and eBusiness activities.
- IMPROVED EFFICIENCY OF CUSTOMER RELATIONSHIP MANAGEMENT. By automating the
best-practice business processes of an organization's customer service
representatives (CSRs), the Company's software actually performs work
(rather than tracks tasks) and provides guidance to CSRs or self-service
customers as they progress through interactions. Using our software, CSRs
are able to focus on revenue-enhancing opportunities or other matters
requiring personal attention. Cost savings are realized through quicker
resolution rates, fewer manual processes, and less rework.
- SCALABILITY AND ROBUST FUNCTIONALITY. The Company's rules-based Internet
architecture provides the scalability appropriate for enterprise
solutions. Our eCRM software is used by thousands of concurrent users to
generate billions of dollars per day in resulting transactions. The
rules architecture also enables organizations to evolve their eCRM
solutions to respond to changing market dynamics and capitalize on new
business opportunities.
- CUSTOMER-CENTRIC APPROACH. Our eCRM software provides organizations with a
customer-centric approach to information, enabling CSRs to view, access
and disseminate comprehensive information about their customers from
several vantage points. With this approach, CSRs are able to focus on
delivering customer service, rather than on protocols and procedures.
Detailed information about previous interactions is provided, as well as
information about cross-selling and up-selling opportunities available to
a specific customer.
- INTEGRATION CAPABILITIES. Our software is designed to be readily
integrated with our customers' existing databases and back-office legacy
systems, and with a wide variety of third-party applications and
technologies. Our software also supports vertical-specific message formats
utilized in the financial services, insurance, healthcare management and
telecommunications markets.
- MULTI-PLATFORM SERVER AND DATABASE SUPPORT. Our solutions support multiple
hardware platforms. We have implemented our solutions on IBM's MVS/CICS
and AIX/UNIX systems, Sun Microsystems' Solaris UNIX system,
Hewlett-Packard Corporation's HP-UX UNIX system, and Microsoft's
Windows/NT system. Additionally, customers have utilized several database
systems to support our applications, including Oracle, Sybase, Informix
and Microsoft SQL Server.
- TEMPLATES. We offer an eCRM Foundation Template and industry-specific
product templates that give user organizations an advanced starting point
for configuring their work processes. The eCRM Foundation Template
consists of rules, developed by the Company based on its experience in
automating the workflows of some of the world's leading customer service
organizations, that allow organizations to integrate their customer
service, sales, marketing and eBusiness initiatives. The eCRM Foundation
Template also consists of data models and user interfaces that are pre-
configured for managing a variety of Internet, intranet and call center
customer interactions. Our industry-specific templates provide a
comprehensive set of pre-configured business processes and are
customizable to meet the unique needs of each customer.
2
BUSINESS STRATEGY
Pegasystems' objective is to provide technology that facilitates the
creation of eCRM solutions tailored to its customers' changing business needs.
As the Internet causes forward-looking organizations to rethink the fundamentals
of their IT approaches and infrastructures, We intend to leverage our core
strengths - our Web technology, data connectivity, multi-channel integration,
and process automation expertise--to capitalize on the opportunities presented
by these changes.
Specific elements of our strategy include:
- TECHNOLOGICAL LEADERSHIP. We intend to continue developing and investing
in our product offerings. Current development efforts are focused on
refinements of the basic architectural underpinnings that enable our
solutions to meet the high performance and availability needs of customers
operating within an Internet-based environment. Additionally, in response
to increasing demand from customers and our systems integrator partners,
we intend to expand our configuration toolkit to encompass options for
defining workflows in Java; to model and access workflow information in
open relational databases; and to interact with third-party products using
industry-standard interfaces and protocols.
- DIRECT SALES OF TEMPLATES. We intend to increase our emphasis on direct
sales of our eCRM Foundation Template and industry-specific product
templates.
- STRATEGIC RELATIONSHIPS WITH SYSTEMS INTEGRATORS AND TECHNOLOGY COMPANIES.
As part of our Alliance Program, we expect to continue our efforts to
develop relationships with systems integrators who deliver strategic
business planning, consulting, project management and implementation
services to our customers and with whom we will pursue co-marketing
initiatives. Currently, we work with EDS and several leading consulting
groups. We also plan to continue our efforts to develop relationships with
other technology companies who will use our technology to build integrated
solutions. Currently, our technology partners include BroadVision, GeoTel
and Sun Microsystems.
- PRIVATE LABEL INITIATIVES. We intend to pursue additional relationships
with companies with which we can jointly develop eCRM solutions for
specific vertical markets that would be offered under the other party's
name. Typically, these relationships involve the use of our technology and
the other party's access to customers and insight into product
requirements. The Company currently has such relationships with, among
others, First Data Resources, which utilizes our technology as part of a
solution targeted at the credit card processing market, and
Carreker-Antinori, Inc., which develops check exception management
products based on our technology.
INDUSTRIES
The Company has targeted several industries, including:
BANKING. The Company provides software that automates customer sales and
service initiatives across varied delivery channels (such as Internet
self-service, call centers, and branch networks for banks). These solutions
improve the quality, accuracy, and efficiency of customer interactions, and
enhance the delivery of product and service offerings. Our software automates
targeted functions within banking, including customer contact management, sales
campaign management, contact center service, check research and adjustments,
funds transfer investigations, and correspondence. Our software services the
banking industry's check exception management needs through an agreement with
Carreker-Antinori, Inc.
MUTUAL FUNDS. Our software services the mutual funds industry through an
agreement with PFPC Inc., the global fund services subsidiary of PNC Bank Corp.
The integrated product--marketed by PFPC Inc. under the name IMPRESS CRM--
offers mutual fund institutions a comprehensive service solution. We also have
direct sales to customers in this market.
3
SECURITIES AND INVESTMENTS. The Company's software automates service and
sales efforts associated with corporate actions, payments and securities
settlement investigations, retail brokerage, and wholesale clearing services.
CREDIT CARD PROCESSING. The Company's products are offered to the credit
card processing market through a relicensing agreement with First Data Resources
(FDR)--a large credit card processor. Jointly developed software products
combine Pegasystems' workflow and service delivery technology with FDR's
servicing functionality and online interfaces. The resulting products give users
a flexible, user-friendly solution that can be quickly and easily adapted to
meet evolving business needs without costly programming. The Company also has
direct customers in this market.
INSURANCE. The Company's insurance software facilitates the resolution of
policyholder requests by ensuring that agents have easy access to information
that resides in multiple, disparate back-end systems. The Company's solutions
position insurance organizations to provide highly personalized customer service
and enhance cross-selling.
HEALTHCARE. The Company's healthcare software enables healthcare
organizations to more efficiently coordinate care and integrate administrative
operations. This allows health maintenance organizations, healthcare providers,
pharmacists, laboratory clinicians, and health insurers to access integrated
member information over a network of previously disconnected systems.
Personalized data presentation gives users easy access to information to quickly
respond to requests including referrals, benefits verification, and claim
status.
TELECOMMUNICATIONS. The Company's telecommunications software automates
telecommunications service providers' interactions with their customers and
other providers. These solutions integrate data obtained from multiple disparate
information systems. They allow service representatives to resolve billing
inquiries, schedule service calls, and turn service requests into sales
opportunities during the course of a single call.
CUSTOMERS
The following is a representative list of the Company's major eCRM
customers, as well as an overview of the uses to which they apply our solutions:
AMERICAN HOME ASSURANCE DIVISION OF AMERICAN INTERNATIONAL GROUP (AIG)--
Insurance customer service, Web-based policy renewal, and new business
applications.
AMERICA ONLINE--Automation of inbound customer service requests, such as
billing and membership changes, as well as cross-selling and up-selling
capabilities.
BANC ONE--Retail/check customer service and research, wholesale banking,
funds transfer, check, corporate lockbox, and interbank compensation service for
global operations.
BANCO POPULAR DE PUERTO RICO--Retail service center automation, check
research, and consumer loan inquiry and service.
BANK OF AMERICA--Numerous applications to support customer service for
wholesale and retail banking as well as sales force automation to support
brokerage sales activities.
BANK OF AMERICA--Retail/check customer service and research, automation of
branch support centers; institutional funds transfer and foreign exchange
customer service for U.S. and European operations; credit and debit card
correspondence; and dispute and chargeback service processing.
BANK OF IRELAND--Retail/check clearings and research, automation of branch
support centers, and exception/credit item review and verification.
BANQUE NATIONALE DE PARIS--Institutional funds transfer service, research
and archive.
4
BARCLAYS BANK PLC--Institutional funds transfer and foreign exchange
customer service for international operations; merchant credit card service,
including telephony center, correspondence, and dispute and chargeback
processing.
BLUE CROSS BLUE SHIELD OF MASSACHUSETTS--Customer service management,
including supporting access to integrated member information to healthcare
providers, pharmacists, laboratory clinicians and health insurers.
BLUE CROSS BLUE SHIELD OF GEORGIA--Customer service management, supporting
access to integrated member information to healthcare providers, pharmacists,
laboratory clinicians and health insurers.
CEDEL BANK--Global custody and securities movement customer service.
CENTRAL VERMONT PUBLIC SERVICES CORP.--Customer service management,
supporting call center representatives with access to consolidated customer
information.
CHASE--Automation of customer service activities across wholesale bank;
extended use and accessibility of system by supporting browser access to account
officers.
CITIBANK--Global funds transfer and foreign exchange customer service;
check-related customer service and research; domestic MasterCard and Visa
service, including image integration, correspondence, and dispute and chargeback
processing.
CITIBANK LATIN AMERICA--Customer service management, to support centralized
call center for a multi-language customer base across several countries.
COLONIAL GROUP--Mutual fund customer service supporting telephony center and
correspondence.
FEDERAL RESERVE BANKS--Check processing customer service, suspense ledger
management, research, adjustment and archive.
FIDELITY INVESTMENTS--Mutual fund customer service supporting telephony
center and correspondence.
FIRST DATA CORPORATION--Relicenses the Company's solution to provide
customer service, collections, and credit application processing for credit card
issuers.
FRANKLIN TEMPLETON GROUP--Mutual fund customer service supporting telephony
center, correspondence, and research.
HOMESIDE LENDING--Escrow analysis and payment processing.
HOUSEHOLD CREDIT SERVICES--Credit card service including telephony center,
correspondence, dispute, and chargeback processing; private label customer
service for major retailers.
KAISER PERMANENTE--Automation of healthcare member, patient, provider and
payer interactions.
MARINE MIDLAND BANK--Institutional funds transfer customer service.
MELLON BANK CORPORATION--Retail/check customer service, research, and
archive; wholesale, institutional, cash management, and corporate lockbox
customer service.
ORANGE COMMUNICATIONS S.A.--Customer service management, including
management of service and sales activities in call centers, and Web-based online
dealer activation at the point of sale.
RIGGS BANK--Retail banking call center for sales and service activities,
including cross-selling and problem resolution capabilities.
SEARS ROEBUCK--Customer service and authorization at the Regional Credit
Card Operations Centers of Sears Credit, the consumer credit division.
5
TRANS UNION CORPORATION--Credit bureau data-management customer service for
institutional customers and real estate property appraisal processing, including
browser-based access via PegaWEB.
In 1999 and 1998, respectively, First Data Resources Corporation accounted
for 12.5% and 17.2% of the Company's consolidated revenue. In 1997, Kaiser
Permanente and First Data Resources Corporation accounted for 13.7% and 10.0%,
respectively, of the Company's consolidated revenue.
PRODUCTS
The Company classifies its products into one of three basic categories:
templates, PegaSYSTEM enabling technologies, and private label products:
Templates are preconfigured sets of rules that leverage Pegasystems'
enabling technologies and experience delivering service solutions by delivering
out-of-the-box functionality that gives customers a rapid start in creating
their service solutions. Templates include:
- eCRM FOUNDATION TEMPLATE--an adaptable, baseline solution that delivers
pre-configured functionality essential to most service-intensive
industries, across vertical markets.
- PEGAPAYMENTS--a solution for international banking funds transfer
operations that automates payment and treasury research functions.
- SYSTEM ADMINISTRATION TEMPLATE--an easy-to-use interface that facilitates
basic administrative duties associated with maintaining users,
organizational structure, and system support functions.
The PegaSYSTEM family of enabling technologies provides the Company's
partners and customers with the tools necessary to create rule-based,
personalized solutions. This family of enabling technologies includes:
- PEGAWORKS--the rule-based process automation engine that is the foundation
for Pegasystems solutions. This intelligent system technology incorporates
user-defined rules to automate an organization's service activities. It
includes facilities that support work item management, messaging, outgoing
correspondence, reporting and rule maintenance.
- PEGAWEB--allows access to a Pegasystems solution through the Internet,
corporate intranets or extranets in support of self-service and Web
cross-channel collaboration activities.
- PEGACONNECT--the technology that manages connectivity, messaging and the
exchange of data among enterprise-wide applications. It provides
bi-directional interfaces that integrate structured and unstructured
messages from a wide variety of electronic sources. Using
industry-recognized connectivity standards, PegaCONNECT is used to connect
to both new applications and databases, as well as to legacy systems.
- PEGACALL--provides Computer Telephony Integration (CTI) to support call
center operations for multiple types of businesses. PegaCALL integrates
the Company's solutions with industry-standard computer telephony products
to automate telephone-based customer interactions such as service
inquiries, telemarketing, sales and collection efforts.
- PEGAREACH--a highly adaptable, HTML(Hypertext Markup Language)-based, thin
client graphical user interface that integrates with the Internet,
Microsoft Word, and other standard desktop productivity tools.
- PEGAWORKBENCH--a graphical user interface specifically adapted to
facilitate the creation of workflow rules by business experts rather than
computer programmers.
The Company's Private Label partners offer several packaged products
utilizing the Company's enabling technologies. These products include:
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- Carreker-Antinori, Inc.: EXCEPTION SUITE--an integrated, next-generation
application suite for check exception management. The CheckFlow Suite
products include film and photocopy retrieval (CheckRetrieve), All-Item
Archive (CheckAllItems), Research and Adjustments (CheckAdjust), Return
Items (CheckReturns), and Special Instructions (CheckDirect).
- PFPC, Inc.: IMPRESS CRM--a comprehensive service solution designed for the
mutual funds industry.
- First Data Resources Inc.: FIRST DATA EVOLVE--an integrated Customer
Relationship Management solution for Credit, Customer Service, and
Collections.
- Management Data GmbH: employs the Company's technology to bring an
exception management capability to its FINANCIAL TRANSACTION MANAGEMENT
SOLUTION (FTMS). With direct communication interfaces to a wide range of
wholesale financial networks, FTMS offers financial transaction control,
reconciliation, exception management, archiving, and retrieval.
TECHNOLOGY
The Company's solutions have the following key technological attributes:
INTERNET AND INTRANET ACCESS. The Company's PegaREACH solution uses the
Internet-based HTML to define display attributes for its graphical user
interface, leveraging logic and presentation rules between PegaREACH and
Internet/intranet workflows. With PegaWEB, these workflows can be accessed over
the Internet or an intranet using standard World Wide Web browsers. Pegasystems'
rules dynamically create HTML forms, menus, and displays, thereby facilitating
interaction with the Internet.
INFORMATION MANAGEMENT. Effective customer response, management, and
retention requires up-to-date information about the customer relationship,
regardless of how, why, when, or where the customer contacts the organization.
The Company's eCRM solutions access information from multiple internal and/ or
third-party data sources, organize core customer information and present it to
the user in an appropriate format.
MULTI-TIERED, DYNAMIC DISTRIBUTED PROCESSING. The Company's systems are
designed to run in an advanced, highly scalable multi-tiered environment. The
Pegasystems rule base determines the optimal location for processing to occur
based on the nature of the work and the data involved.
INHERITED WORKFLOW. The Company's solutions maintain organizational
consistency while providing flexibility for mass personalization. The rule base
of the Company's systems may be defined so that certain processes are
standardized across an organization while others may be superseded or
supplemented by "local" rules tailored to the specific requirements of groups
within the organization.
PLATFORM INDEPENDENCE. Pegasystems' solutions feature a common software
code base, which, in addition to facilitating maintenance and enhancement
development efforts, simplifies the support of multiple hardware platforms. The
Company has implemented solutions across several platforms, including IBM's
MVS/CICS and AIX/UNIX systems, Sun Microsystems' Solaris UNIX system,
Hewlett-Packard Corporation's HP-UX UNIX system, and Microsoft's Windows/NT
system. Additionally, customers have utilized several database systems to
support the Company's applications, including Oracle, Sybase, Informix and
Microsoft SQL Server. While the Company offers an advanced Windows-based
PegaREACH application for the desktop, its server applications can also drive
native HTML browser-based clients.
SCALABILITY. The scalability of the Company's multi-tiered client/server
architecture allows an organization to add departments to new or existing
servers to build enterprise solutions. Organizations currently entrust the
Company's systems with the storage and management of data relating to hundreds
of millions of financial transactions. The Company's systems can be used by over
5,000 concurrent users to manage
7
customer interactions and to process accurately and securely transactions
involving billions of dollars a day that result from those interactions.
INTERFACING WITH OTHER SYSTEMS. The Company's open architecture permits
integration with a wide variety of other applications and networks, including
relational databases, legacy systems accessed through IBM 3270 emulation, and
messaging protocols. The Company offers an Application Programming Interface
(API) that allows an organization's custom software to be integrated with the
Company's applications without the need to modify the Company's application
code. Pegasystems' PegaCONNECT components also support interfaces to IBM's
MQSeries, CORBA, 3270-based mainframe applications, and major relational
database systems. Pegasystems' solutions also integrate with other applications,
accounting systems, and imaging products.
STORAGE OPTIONS. Data storage flexibility is important to the Company's
customers, and the Company's software uses an innovative object-oriented
approach that dynamically maps data according to the type of workflow. Versions
of the Company's systems can store customer service request data in Microsoft
SQL Server, Oracle, Informix, and Sybase relational databases.
SALES AND MARKETING
The Company markets its software and services primarily through a direct
sales force. As of December 31, 1999, the Company's sales force consisted of
approximately 25 salespersons in the Company's U.S. and foreign offices.
In 1999, Pegasystems entered into a strategic alliance with
Carreker-Antinori, Inc. to jointly develop applications for check exception
management. In 1997, Pegasystems entered into a strategic relationship with
First Data Corporation, which includes an agreement with First Data Resources
(FDR) that gives FDR--the largest credit card processor in the world--world wide
rights to use and re-license Pegasystems' solutions in the credit card issuing
market. The Company has evolved its indirect distribution channel through an
agreement with PFPC Worldwide, the global fund services subsidiary of PNC Bank
Corp. The integrated product--marketed by PFPC Worldwide under the name IMPRESS
CRM--offers mutual fund institutions a comprehensive service solution. The
Company has also entered into an agreement with Management Data GmbH, whereby
the Company's technology will bring an exception management capability to
Management Data's Financial Transaction Management Solution (FTMS). In addition,
the Company has established joint marketing relationships with GeoTel, Genesys
Laboratories, Sun Microsystems, Hewlett-Packard Company, and Management Data. In
the future, the Company may also market and sell its products through other
value added resellers (VARs) and systems integrators. There can be no assurance,
however, that the Company will be able to attract and retain VARs, systems
integrators, and other third parties that will be able to market and sell the
Company's products effectively.
To support its sales force, the Company conducts marketing programs, such as
PegaVISION (annual customer conference), trade shows, industry seminars,
meetings with industry analysts, direct mail, and telemarketing. Sales leads are
also generated by the Company's consulting staff, business partners, and other
third parties.
In 1999, 1998, and 1997, sales to customers based outside of the United
States represented 21.4%, 22.6%, and 16.5%, respectively, of the Company's total
consolidated revenue.
8
The Company's export sales from the United States for 1999, 1998, and 1997
were as follows:
1999 1998 1997
-------- -------- --------
(IN THOUSANDS $)
United Kingdom....................................... 4,079 6,594 3,642
Europe............................................... 6,802 4,469 1,715
Other................................................ 5,528 2,890 1,973
------ ------ -----
16,409 13,953 7,330
See Note 1 (l) of Notes to Consolidated Financial Statements contained
elsewhere in this report.
SUPPORT AND PROFESSIONAL SERVICES
Pegasystems provides implementation, consulting, maintenance and support and
training services to license customers through its Client Services Group. As of
December 31, 1999, the Company's Client Services Group consisted of
approximately 247 people located in the Company's 14 offices.
IMPLEMENTATION SERVICES. The Company's implementation services assist
companies by optimizing the benefits of Pegasystems' solutions. In addition,
systems integrators and consulting firms often help companies to implement these
solutions. These implementation projects both help deployment of the Company's
solutions, and allow the Company's business consultants and systems engineers to
gain industry-specific knowledge that can be leveraged in future projects and
product development. Providing comprehensive business application expertise and
technical support is necessary to achieve rapid product implementation, as well
as ensure customer satisfaction.
In late 1999, the Company began to employ its Advanced Implementation
Methodology (AIM) on a pilot basis. The mission of AIM is to facilitate the
implementation of the Company's software through a disciplined end-to-end
approach to project management, designed to meet customers' budgetary and time
to market objectives. AIM integrates four important implementation elements: the
customer's business vision, the Company's technology solutions, the Company's
service products, and the Company's methodology. The Company expects to further
implement AIM during 2000.
CONSULTING AND MAINTENANCE AND SUPPORT. The Company provides comprehensive
maintenance and support services, which may include 24 hours a day, 7 days a
week customer service, periodic preventative maintenance, documentation updates,
and new software releases. In addition, the Company provides consulting services
at the customer's request.
TRAINING. The Company offers training programs for its customers'
operations staff and workflow architects responsible for evolving the
rules that drive the various processes related to customer interactions. The
Company maintains training centers in Cambridge, Massachusetts; San Francisco,
California; and Reading, England.
CONTINUOUS FEEDBACK. The Company organizes an annual PegaVISION Customer
Conference and quarterly Advisory Board meetings, which enable the Company's
customers to exchange ideas, learn about product direction, and influence the
Company's future development direction.
CUSTOMER EXTRANET. The Company provides support and professional services
through its customer extranet, ActionPlus. Based on the Company's Web-driven
self-service capabilities, ActionPlus serves as an important communication and
support vehicle between the Company and its customers. The site provides
information about implementation and utilization of the Company's software, as
well as sales and marketing support tools.
9
RESEARCH AND DEVELOPMENT
Since its inception, the Company has made substantial investments in product
development. The Company believes that its future performance depends on its
ability to maintain and enhance its current products and develop new products.
For Template products, the Company's product development priorities include
increasing the functionality of the eCRM Foundation Template and developing
additional industry-specific templates.
For the PegaSYSTEM family of enabling technologies, product development is
focused on (1) creating tools to enable organizations to configure more easily
their customer service management systems; (2) integrating the Company's
products with the Internet for customer self-service and with intranet systems
for departmental service; (3) developing standard application programming
interfaces that allow other client workstation and server applications to
interoperate with the Company's products; and (4) enhancing product quality,
platform stability, ease-of-use, and ease of installation.
The Company believes that maintaining future performance and visionary
technological leadership depends on its ability to anticipate changes, maintain
and enhance its current products, develop new products, and keep pace with the
increasingly sophisticated requirements of its prospective customers. The
Company must develop products that conform to its customers' information
technology standards, scale to meet the needs of large enterprises, operate
globally, and cost less than an internal development effort. The Company's
product development organization is responsible for product architecture,
technology development, product testing and quality assurance.
In 1999, 1998, and 1997 the Company's research and development expenses were
approximately $19.8 million, $23.8 million, and $13.5 million, respectively.
Pegasystems expects that it will need to continue to commit significant
resources to its product research and development in the future.
If the Company is unable, for technical or other reasons, to develop and
introduce new products and services or enhancements of existing products and
services in a timely manner in response to changing market conditions or
customer requirements, or if new products and services do not achieve market
acceptance, the Company's business, financial condition, and operating results
will be materially adversely affected.
COMPETITION
The CRM software market is intensely competitive and subject to rapid
change, as current competitors expand their product offerings and new companies
enter the market. Competitors vary in size and in the scope and breadth of the
products and services offered. The Company encounters competition from internal
information systems departments of potential or current customers that develop
custom software, as well as other application software providers. The Company
also competes with: (1) software companies that target the customer interaction
or workflow markets such as Siebel Systems, Vantive/Peoplesoft, Clarify and
Quintus; (2) companies that target specific service areas such as DST Systems
(financial services) and Shared Medical Systems (healthcare management) and (3)
professional services organizations such as Andersen Consulting that develop
custom software in conjunction with rendering consulting services.
In addition, the Company expects additional competition from other
established and emerging companies, such as Blaze, Firepond, Oracle,
Kana/Silknet and SAP AG, as the market continues to develop and expand into
e-based solutions. Increased competition may result in fewer sales, price
reductions, less beneficial contract terms, reduced gross margins and loss of
market share, any of which could materially and adversely affect the Company's
business, operating results and financial condition.
10
The Company believes that the principal competitive factors affecting its
market include product features such as adaptability, scalability, ability to
integrate with other products and technologies, functionality and ease-of-use,
the timely development and introduction of new products and product
enhancements, as well as product reputation, quality, performance, price,
customer service and support, and the vendor's reputation. Although the Company
believes that its products currently compete well with regard to such factors,
there can be no assurance that the Company can maintain its competitive position
against current and potential competitors.
Many of the Company's competitors can devote greater managerial or financial
resources than the Company can to develop, promote and distribute customer
service management software products and provide related implementation,
consulting, training, and support services. Additionally, there can be no
assurance that the Company's current or future competitors will not develop
products or services which may be superior in one or more respects to the
Company's or which may gain greater market acceptance. Some of the Company's
competitors have established or may establish cooperative arrangements or
strategic alliances among themselves or with third parties, thus enhancing their
abilities to compete with the Company. It is likely that new competitors will
emerge. There can be no assurance that the Company will be able to compete
successfully against current or future competitors or that the competitive
pressures faced by the Company will not materially and adversely affect its
business, operating results, and financial condition.
The Company relies on system consulting and system integration firms for
recommendation and implementation of its products during the evaluation stage of
the purchase process. These third parties often have similar, and more
established, relationships with the Company's competitors. There can be no
assurance that these third parties, many of which have significantly greater
resources than the Company, will not market software products in competition
with the Company in the future or will not otherwise reduce or discontinue their
relationships with or support of the Company and its products.
EMPLOYEES
As of December 31, 1999, the Company had approximately 517 employees, of
whom approximately 424 were based in the United States, 5 were based in Canada,
72 were based in Europe, 15 were based in Australia, and 1 was based in
Singapore. Of the total, approximately 109 perform research and development, 247
perform consulting and customer support, 77 were in sales and marketing, and 84
were in administration and finance. The Company's future performance depends in
significant part upon the continued service of its key technical, sales and
marketing, and senior management personnel and its continuing ability to attract
and retain highly qualified technical, sales and marketing and managerial
personnel. Competition for such personnel is intense and there can be no
assurance that the Company will be successful in attracting or retaining such
personnel in the future. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations." None of the Company's employees is
represented by a labor union or is subject to a collective bargaining agreement.
BACKLOG OF LICENSE AND MAINTENANCE REVENUES
As of December 31, 1999, the Company had software license and maintenance
agreements with customers expected to result in approximately $36.0 million of
revenue in 2000, $1.0 million of which is currently recorded as deferred
revenue. Under such agreements, the Company must fulfill certain conditions
prior to recognizing revenue thereunder, and there can be no assurances as to
when, if ever, the Company will be able to satisfy all such conditions in each
instance. As of December 31, 1998, the Company had software license and service
agreements with customers expected to result in approximately $35 million in
revenue in 1999.
11
ITEM 2
PROPERTIES
Pegasystems' principal administrative, sales, marketing, support, and
research and development operations are located in a 92,762 square foot leased
facility in Cambridge, Massachusetts. The lease for this facility expires in
2003, subject to the Company's option to extend the term for up to eight
additional years. The Company also leases space for its other offices in the
United States, Canada, Australia, France, and the United Kingdom. These leases
expire at various dates through 2006. The Company believes that additional or
alternative space will be available in the future on commercially reasonable
terms as needed.
ITEM 3
LEGAL PROCEEDINGS
CHALVERUS CASE. In November 1997 and January 1998, complaints purporting to
be class actions were filed with the United States District Court for the
District of Massachusetts (the "Court") alleging that the Company and several of
its officers violated Section 10(b) of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), Rule 10b-5 promulgated by the Commission
thereunder, and Section 20(a) of the Exchange Act. A third complaint was filed
in April 1998 but has been voluntarily dismissed without prejudice. In December
1998, the plaintiffs filed their First Amended Consolidated Complaint, that
names the Company, the Company's Chief Executive Officer (Alan Trefler) and a
former officer and director (Ira Vishner) as defendants. The Amended Complaint
alleges that the defendants issued false and misleading financial statements and
press releases concerning the Company's publicly reported earnings. The Amended
Complaint seeks certification of a class of persons who purchased the Company's
Common Stock between July 2, 1997 and October 29, 1997, and does not specify the
amount of damages sought. The Court has denied the defendants' motion to dismiss
the Amended Complaint. The case is currently in discovery.
GELFER CASE. In December 1998, a complaint also purporting to be a class
action was filed with the Court after the Company's announcement on
November 24, 1998 that it may be recording revenue adjustments to prior periods.
In April 1999 the plaintiffs filed their First Amended Class Action Complaint
("Gelfer Complaint") in that action following the January 20, 1999 restatement.
The Gelfer Complaint is filed against the Company, Alan Trefler, Ira Vishner,
the former Chief Financial Officer and alleges violations of Section 10(b) and
Section 20(a) of the Exchange Act and Rule 10b-5 promulgated by the Commission
thereunder. The Complaint is filed on behalf of a purported class of persons who
purchased the Company's common stock between April 2, 1998 through November 24,
1998 and does not specify the amount of damages sought. The defendants filed
their answer to the Gelfer Complaint after its motion to dismiss was denied.
The Company intends to defend these actions vigorously, but no assurance can
be given as to the outcomes. Management believes that it is possible that the
Company may be required to pay substantial damages or settlement costs which
could have a material adverse effect on the Company's financial position or
results of operations. In addition, regardless of the outcome of any of these
actions, it is likely that the Company will incur substantial defense costs and
that such actions will cause a diversion of management time and attention. The
Company's delay in filing its regular reports with the SEC and its announcement
that it has adjusted previously published financial statements have resulted in
negative publicity for the Company. Such events and related publicity have
adversely affected demand for the Company's products and services and may also
have an adverse effect on the Company's financial position or results of
operations.
SEC INVESTIGATION. In May 1999, the Boston office of the Securities and
Exchange Commission ("SEC") issued a Formal Order of Private Investigation of
the Company and unidentified individuals, currently or formerly associated with
the Company, which concerns past accounting matters, financial reports, and
other public disclosures and trading activity in the Company's securities during
1997 and 1998.
12
The Company has been cooperating fully with the Commission. The investigation is
confidential and ongoing.
ITEM 4
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of fiscal 1999, there were no matters submitted to
a vote of security holders.
EXECUTIVE OFFICERS OF THE REGISTRANT
The names of the Company's executive officers and certain information about
them are set forth below as of December 31, 1999:
NAME AGE POSITION(S) AND OFFICE(S) HELD
- ---- -------- ------------------------------
Alan Trefler........................... 44 Chief Executive Officer and Director
Richard H. Jones....................... 48 President and Chief Operating Officer
Joseph J. Friscia...................... 45 Vice President of Sales and Service
James P. O'Halloran.................... 67 Vice President, Chief Financial Officer, Treasurer,
Clerk and Director
Kenneth Olson.......................... 50 Vice President of Technical Development
Michael Pyle........................... 45 Vice President of Application Development
Ronald Rock (1)........................ 40 Vice President of Electronic Commerce Solutions
Dean Webster........................... 46 Vice President of Channel Services
- ------------------------
(1) Effective March 30, 2000, Mr. Rock resigned from the Company.
Executive officers of the Company are elected by the Board of Directors on
an annual basis and serve until the next annual meeting of the Board of
Directors and until their successors have been duly elected and qualified. There
are no family relationships among any of the executive officers or directors of
the Company.
Alan Trefler, a founder of the Company, serves as Chief Executive Officer
and has been a Director since the Company's organization in 1983. Prior thereto,
he managed an electronic funds transfer product for TMI Systems Corporation, a
software and services company. Mr. Trefler holds a B.A. degree in economics and
computer science from Dartmouth College.
Richard H. Jones joined the Company in October 1999. Prior to joining the
Company, he served as a chief asset management executive and member of the
operating committee at Barnett Banks, Inc., and as CEO of Fleet Investment
Services. His prior experience also includes serving as executive vice president
with Fidelity Investments, and as a principal with the consulting firm of Booz,
Allen & Hamilton. Mr. Jones holds an undergraduate degree from Duke University,
with majors in both economics and management science. He also holds an M.B.A.
degree from the Wharton School of the University of Pennsylvania.
Joseph J. Friscia joined the Company in 1984 to establish its New York
office. Mr. Friscia has served as Vice President of Sales and Service since
1987, and has recently undertaken responsibility for delivery of consulting and
installation services. Prior to joining the Company, he worked as a money
transfer operations manager with Bankers Trust Company and J. Henry Schroder
Bank and Trust Company. Mr. Friscia holds a B.A. degree from Long Island
University and an M.B.A. degree from Adelphi University.
13
James P. O'Halloran joined the Company in April 1999. In June 1999 he was
elected Senior Vice President, Chief Financial Officer, Treasurer, Clerk and
Director. From 1991 to 1999, he served as President of G & J Associates, Ltd., a
financial consulting firm. From 1956 to 1990, he was with the international
accounting firm of Arthur Andersen LLP serving as an audit partner from 1967 to
his retirement in 1990.
Kenneth Olson has served as Vice President of Technical Development since
1983. Mr. Olson holds primary responsibility for the ongoing development of
Pegasystems' technical foundation. Prior to Pegasystems, Mr. Olson's had
extensive experience in the financial and computer services industry includes
positions at TMI Systems Corporation, as well as the development and
installation of software solutions in European and Middle Eastern markets. He
holds a B.S. degree in the fields of Humanities and Science from the
Massachusetts Institute of Technology.
Mike Pyle has served as Vice President of Applications Development since
1990. Mr. Pyle joined Pegasystems in 1985 as a Manager of Application
Development, and currently, oversees the Company's application design and
engineering. Prior to joining Pegasystems, Mr. Pyle's professional background
encompassed almost thirty years of software development and managerial
experience throughout Europe and the United States. Mr. Pyle completed his
B.C.S. specializing in Computer Science and Systems Programming at the C.S.
College in London.
Ron Rock served as Senior Vice President of eStrategy. Mr. Rock joined
Pegasystems in 1998 to manage the Company's Electronic Services Division, which
provides integrated Internet-based self-service solutions. Prior to joining
Pegasystems, Mr. Rock served as Vice President of Electronic Financial Services
at Advanta Corporation, and was Director of Corporate Development for Kelly
Services. Effective March 30, 2000, Mr. Rock resigned from the Company.
Dean Webster serves as Vice President of Channel Partners. Mr. Webster
joined Pegasystems in 1997 as Director of Global Services. In 1998, he was
appointed Vice President of Global Software Services, and in 1999 became head of
the Company's new Private Label Group. Prior to joining Pegasystems,
Mr. Webster was Regional Sales Manager for Programart Corporation. Mr. Webster
has over 25 years experience in the software industry.
14
PART II
ITEM 5
MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The following table sets forth the range of high and low sales prices of the
Company's common stock on the National Association of Security Dealers Automatic
Quotation ("Nasdaq") National Market System for 1999 and 1998. The Company's
common stock is traded under the Nasdaq Symbol "PEGA." As of March 16, 2000, the
Company had approximately 59 stockholders of record and approximately 4,500
beneficial owners of the Company's common stock. On March 16, 2000, the closing
sale price of the common stock was $18.63. The Company has never declared or
paid any cash dividends on its common stock. The Company intends to retain its
earnings to finance future growth, and therefore does not anticipate paying any
dividends in the foreseeable future.
HIGH LOW
-------- --------
1999
First Quarter............................................... $ 7.50 $ 4.16
Second Quarter.............................................. $11.94 $ 4.00
Third Quarter............................................... $ 9.63 $ 7.57
Fourth Quarter.............................................. $11.69 $ 6.81
1998
First Quarter............................................... $26.13 $15.38
Second Quarter.............................................. $31.88 $16.00
Third Quarter............................................... $30.63 $14.75
Fourth Quarter.............................................. $17.63 $ 3.44
ITEM 6
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below have been derived
from the Company's consolidated financial statements. This data may not be
indicative of the Company's future condition or results of operations and should
be read in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and the consolidated financial statements
and related notes included elsewhere in this report.
YEARS ENDED DECEMBER 31,
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Consolidated Statement of Operations Data:
Total revenue............................... $ 76,629 $ 61,769 $ 44,361 $33,545 $22,247
Income (loss) from operations............... (5,920) (22,797) (3,388) 10,019 3,257
Net income (loss)........................... (2,410) (11,618) 1,085 7,500 2,878
Earnings (loss) per share:
Basic..................................... $ (0.08) $ (0.41) $ 0.04 $ 0.30 $ 0.12
Diluted................................... $ (0.08) $ (0.41) $ 0.04 $ 0.28 $ 0.12
Weighted average number of common shares
outstanding:
Basic..................................... 28,947 28,604 28,284 24,802 23,490
Diluted................................... 28,947 28,604 30,268 26,397 23,743
15
DECEMBER 31,
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(IN THOUSANDS)
Consolidated Balance Sheet Data:
Cash and cash equivalents...................... $30,004 $24,806 $52,005 $24,201 $ 511
Working capital................................ 41,888 33,883 62,708 34,364 4,393
Long-term license installments, net............ 44,646 49,000 36,403 23,802 13,399
Total assets................................... 124,991 139,260 127,520 66,855 25,876
Long-term debt................................. -- -- -- -- 816
Stockholders' equity........................... 101,045 101,919 112,721 52,385 14,674
- ------------------------
ITEM 7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
During 1997, the Company recognized revenue in accordance with Statement of
Position (SOP) 91-1, "Software Revenue Recognition", as issued by the American
Institute of Certified Public Accountants (AICPA). Under SOP 91-1, revenue from
software license arrangements was generally recognized upon delivery and product
acceptance pursuant to non-cancellable license agreements, and was based on
management's assessment that the collectibility of the long-term license
installments was probable. Additionally, upon acceptance the Company must have
had no significant remaining vendor obligations regarding the licensed software.
Effective January 1, 1998, the Company adopted the provisions of SOP 97-2,
"Software Revenue Recognition", as issued by the American Institute of Certified
Public Accountants. Under SOP 97-2, software license fees are recognized upon
customer acceptance of the software when there is persuasive evidence of an
arrangement, delivery has occurred, the fee is fixed or determinable and
collectibility of the fee is probable. Maintenance revenue is recognized ratably
over the term of the maintenance arrangement. SOP 98-4, "Deferral of the
Effective Date of a Provision of SOP 97-2," and SOP 98-9 "Modification of SOP
97-2 with respect to Certain Transactions," issued by the AICPA during 1998,
deferred and modified certain provisions of SOP 97-2. Beginning in 2000, all of
the provisions of SOP 97-2, as modified, will be effective.
The Company's revenue is derived from two sources: software license fees and
service fees. Software license fees are generally payable on a monthly basis
under license agreements, which generally have a five-year term and may be
renewed for additional years at the customer's option. The present value of
future license payments is generally recognized as revenue upon acceptance. For
purposes of the present value calculations, the discount rate used has varied
between 6.25% and 7.00% for the three years ended December 31, 1999. A portion
of the fee from each arrangement is initially deferred and recognized as
interest income over the rest of the license term.
The Company's services revenue is comprised of fees for implementation,
maintenance, training and consulting services. Software license customers are
offered the ability to enter into a maintenance contract requiring the customer
to pay a monthly maintenance fee over the term of the related license agreement.
Maintenance fees are recognized ratably over the term of the maintenance
agreement. The Company's software implementation agreements typically require
the Company to provide a specified level of implementation services for a
specified fee, typically with additional implementation services available at an
hourly rate. Implementation fees are recognized once the fair value of services
and any other elements to be delivered under the arrangement can be determined,
which has typically occurred upon customer acceptance for fixed price projects
and as incurred for time and material projects. The Company generally recognizes
training and consulting fees as the services are provided. The Company does not
defer costs related to the service elements for which revenue recognition has
been deferred.
16
In arrangements that include multiple elements (e.g., software license,
implementation services, training, etc.), the total fees under the arrangement
are deferred until such time as the fair value of each element to be delivered
under the contract can be determined, which typically has occurred upon customer
acceptance for fixed price projects and as incurred for time and material
projects. The total revenue is allocated to the individual elements based on the
relative fair values. Deferred revenue at December 31, 1999 consisted primarily
of service fees from arrangements for which acceptance of the software license
had not occurred and the fair value of free consulting hours committed by the
Company that had not been performed.
The Company's international revenues have fluctuated in the past due to the
fact that such revenues have been largely attributable to a small number of
product acceptances during a given period. International revenues were 21.4%,
22.6%, and 16.5% of total consolidated revenues in 1999, 1998, and 1997,
respectively.
Most of the Company's contracts are denominated in U.S dollars. The Company
expects that in the future more of its contracts may be denominated in foreign
currencies. The Company has not experienced any significant foreign exchange
gains or losses, and the Company does not expect that foreign currency
fluctuations will significantly affect its financial position or results of
operations.
The Company's business has historically experienced a lack of predictable
revenues. The timing of revenue recognition is related to the completion of
implementation services and acceptance of the licensed software by the customer,
the timing of which has proven to be difficult to predict accurately.
In 1999, there was a reduction in the size of the Company's sales force of
almost 50%. Given the intense competition for qualified sales personnel and the
significant amount of time required to train new sales personnel, this reduction
may adversely affect the Company's ability to meet its future sales goals. In
addition, because of the reduced size of the Company's sales force, the Company
is more focused on closing larger but fewer license transactions than in the
past. This may increase the volatility in the Company's quarterly operating
results.
On three separate occasions during the two-year period ended December 31,
1998, the Company discovered errors in its previously reported financial
statements that required it to restate its quarterly or annual financial
statements.
In addition, on August 11, 1999, the Company announced the restatement of
its financial statements for the year ended December 31, 1998 and the unaudited
three-month period ended March 31, 1999. As part of the Company's closing for
the three-month period ended June 30, 1999, the Company discovered errors in the
previously released results of operations for the three-month periods ended
December 31, 1998 and March 31, 1999. The errors, which were caused by
incorrectly bookkeeping certain credit memos and cash receipts related to
previously reversed or deferred revenue, resulted in an understatement of
service revenue and an overstatement of costs for each of the periods effected.
See Note 2 of Notes to the Consolidated Financial Statements.
The Company's independent public accountants have identified in connection
with their audits of the Company's 1997, 1998 and 1999 financial statements
material weaknesses in the Company's internal control environment. See Note 1 of
Notes to the Consolidated Financial Statements.
RESULTS OF OPERATIONS
As of January 1, 1999, the Company refined its method of classifying costs
and expenses by directly charging costs to their appropriate functional
classifications. During 1998 and 1997, all costs were allocated to the
classifications using a method based on the classification's salaries. Results
for 1998 and 1997 have been reclassified to conform with the current
methodology.
17
The following table sets forth for the years indicated the percentage of
total revenue represented by certain items reflected in the Statements of
Operations of the Company:
YEARS ENDED DECEMBER 31,
--------------------------------------
1999 1998 1997
-------- -------- --------
Revenue:
Software license.......................................... 36.7 % 47.4 % 64.6%
Services.................................................. 63.3 52.6 35.4
----- ------ -----
Total revenue......................................... 100.0 100.0 100.0
----- ------ -----
Cost of revenue:
Cost of software license.................................. 3.9 2.5 0.6
Cost of services.......................................... 41.7 46.2 30.6
----- ------ -----
Total cost of revenue................................. 45.6 48.7 31.2
----- ------ -----
Gross profit................................................ 54.4 51.3 68.8
----- ------ -----
Operating expenses:
Research and development.................................. 25.9 38.6 30.5
Selling and marketing..................................... 24.9 30.7 29.4
General and administrative................................ 11.3 18.9 16.5
----- ------ -----
Total operating expenses 62.1 88.2 76.4
----- ------ -----
Loss from operations........................................ (7.7) (36.9) (7.6)
Interest income,net......................................... 6.1 7.6 11.5
Other income,net............................................ 0.4 0.1 --
----- ------ -----
Income (loss) before provision (benefit) for income taxes... (1.2) (29.2) 3.9
Provision (benefit) for income taxes........................ 1.9 (10.4) 1.5
===== ====== =====
Net income (loss)........................................... (3.1)% (18.8)% 2.4%
===== ====== =====
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
REVENUE
Total revenue for 1999 increased 24.1% to $76.6 million from $61.8 million
for 1998. The increase was primarily due to the recognition of revenue that had
previously been deferred from projects that were completed during 1999.
Software license revenue for 1999 decreased 3.9% to $28.1 million from $29.3
million for 1998. The decrease in software license revenue was attributable to
prospect hesitance to expend resources due to their own concern regarding the
"Year 2000" problem and due to their concerns regarding the Company's ongoing
SEC investigation, and reclassifications to service revenue because the fair
value of revenue associated with implementing the licensed software was greater
than expected.
Services revenue for 1999 increased 49.2% to $48.5 million from $32.5
million for 1998. The increase in services revenue was primarily attributable to
additional consulting services provided to existing customers, the recognition
of previously deferred revenue from service projects that were completed, and
the reclassification of certain revenue that would otherwise have been
classified as license revenue because the fair value of revenue associated with
implementing the license software was greater than expected, and to a lesser
extent, increased maintenance revenue from a larger installed product base.
18
COST OF REVENUE
Cost of software license consists of amortization expense related to a stock
purchase warrant and purchased software costs, license fees associated with
third party software, and costs of product media, duplication and packaging.
Cost of software license for 1999 increased 94.1% to $3.0 million from $1.6
million for 1998, and increased as a percentage of total revenue to 3.9% for
1999 from 2.5% for 1998. As a percentage of software license revenue, cost of
software license increased to 10.7% for 1999 from 5.3% for 1998. These increases
were due primarily to $2.3 million of amorization related to purchased software.
Amounts amortized prior to the sale of products incorporating the related
purchased software were treated as research and development expenses. Product
sales incorporating such software began in the fourth quarter of 1998. The
software is being amortized through December 31, 2002. In addition, costs of
$0.5 million were incurred related to the purchase of third-party software which
was subsequently resold to a customer as part of a license arrangement.
Cost of services consists primarily of the costs of providing
implementation, consulting, maintenance, and training services. Cost of services
for 1999 increased 11.9% to $31.9 million from $28.5 million for 1998. This
increase was due to costs associated with increased staffing, such as
compensation, facilities and equipment-related costs, which resulted from
transferring certain research and development staff to the Company's client
services and software service group early in 1999. Cost of services as a
percentage of total revenue decreased to 41.7% for 1999 from 46.2% for 1998, and
decreased as a percentage of services revenue to 65.8% for 1999 from 87.8% for
1998. The resulting increase in gross margin was primarily due to the
recognition of previously deferred services revenue and the allocation of total
payments under customer arrangements to services revenue, the associated costs
of which were in both cases recognized as incurred.
OPERATING EXPENSES
Research and development expenses consist primarily of the cost of personnel
and equipment needed to conduct the Company's research and development efforts.
Research and development expenses for 1999 decreased 16.8% to $19.8 million from
$23.8 million for 1998. As a percentage of total revenue, research and
development expenses decreased to 25.9% for 1999 from 38.5% for 1998. These
decreases were primarily due to lower payroll and travel-related costs as
certain research and development staff were transferred to the Company's client
services group in early 1999, and lower software amortization costs. During the
first three quarters of 1998, the Company had recorded approximately
$1.4 million of amortization of purchased software acquired by the Company in
June 1997. Amounts amortized subsequent to the sale of products incorporating
the related purchased software were treated as cost of software license. Product
sales incorporating such software began in the fourth quarter of 1998.
Selling and marketing expenses for 1999 increased 0.7% to $19.1 million from
$19.0 million for 1998. As a percentage of total revenue, however, selling and
marketing expenses decreased to 24.9% for 1999 from 30.7% for 1998 due to the
recognition of previously deferred revenue in 1999, the associated selling and
marketing expenses of which were recognized in 1998. Although overall staffing
levels within the sales and marketing organization remained consistent with 1998
levels, there was a large decrease in the number of sales personnel which was
offset by a large increase in the number of marketing personnel.
General and administrative expenses for 1999 decreased 25.7% to $8.7 million
from $11.7 million for 1998 and decreased as a percentage of total revenue to
11.3% for 1999 from 18.9% for 1998. These decreases resulted from a negative
provision for bad debts for the year of $0.7 million due to a reduction of
$2.7 million in the allowance for doubtful accounts that occurred in the fourth
quarter of 1999. This reduction resulted from the resolution of certain customer
projects and an increased focus on the collection processes which took full
effect in the fourth quarter of 1999. See Note 3 of Notes to Consolidated
Financial Statements.
19
INTEREST INCOME, NET
Interest income, net, which consists of the portion of all license fees due
and received under software license agreements that was not recognized upon
product acceptance or license renewal, and interest income received on cash and
cash equivalents, decreased 1.0% to $4.67 million from $4.72 million in 1998.
The decrease was due to lower interest income generated on cash and cash
equivalents, offset by increased interest income due from increased license fee
billings.
OTHER INCOME, NET
Other income, net, which consists primarily of reseller development funds
received from third-party resellers of computer hardware products and mark to
market gains or losses on foreign denominated accounts receivable, increased
619.1% to $0.3 million for 1999 from $47 thousand for 1998 due to an increase in
the reseller development funds earned.
PROVISION FOR INCOME TAXES
The provision for federal and foreign income tax was $1.5 million in 1999.
The benefit for federal, state and foreign income taxes was $6.4 million in
1998. At December 31, 1999, the Company had $47.5 million in net operating loss
carryforwards and $3.0 million of AMT and research and experimentation tax
credit carryforwards available to offset future taxable income. See Note 9 of
Notes to Consolidated Financial Statements.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
REVENUE
Total revenue for 1998 increased 39.2% to $61.8 million from $44.4 million
for 1997. The increase was primarily due to an increase in services revenue.
Software license revenue for 1998 increased 2.1% to $29.3 million from $28.7
million for 1997. The increase in software license revenue was primarily
attributable to software license acceptances by new customers and software
license agreement renewals by existing customers. Significant deferrals of
license revenue occurred to coincide with the timing of customer acceptance and
the completion of implementation services. Total deferred revenue increased by
approximately $19.7 million, a majority of which was related to software license
revenue.
Services revenue for 1998 increased 107.0% to $32.5 million from $15.7
million for 1997. The increase in services revenue was primarily attributable to
additional consulting services provided to existing customers, increased
implementation services for new customers, and to a lesser extent, increased
maintenance revenue from a larger installed product base. Due to the Company's
ability to enter into larger software license transactions, the size of
corresponding services transactions increased.
COST OF REVENUE
Cost of software license consists of amortization expense related to a stock
purchase warrant and purchased software costs, royalty payments to third party
software vendors, and costs of product media, duplication and packaging. Cost of
software license for 1998 increased 463.4% to $1.6 million from $0.3 million for
1997, and increased as a percentage of total revenue to 2.5% for 1998 from 0.6%
for 1997. As a percentage of software license revenue, cost of software license
increased to 5.3% for 1998 from 1.0% for 1997. These increases were primarily
due to the costs of licensing third-party software and amortization costs
associated with a stock purchase warrant issued by the Company in June 1997,
which costs are being amortized through December 31, 2002.
20
Cost of services consists primarily of the costs of providing
implementation, consulting, maintenance, and training services. Cost of services
for 1998 increased 110.5% to $28.5 million from $13.6 million for 1997. Cost of
services as a percentage of total revenue increased to 46.2% for 1998 from 30.6%
for 1997 due to higher project costs. These increases in cost of services were
mainly due to increased staffing in the Company's client services group.
OPERATING EXPENSES
Research and development expenses consist primarily of the cost of personnel
and equipment needed to conduct the Company's research and development efforts.
Research and development expenses for 1998 increased 76.1% to $23.8 million from
$13.5 million for 1997. The increase in research and development expenses was
due to the hiring of additional development personnel in the Company's research
and development group. As a percentage of total revenue, research and
development expenses increased to 38.5% for 1998 from 30.5% for 1997. These
increases were due to the additional investments in integrating the Company's
products with the Internet and intranets, developing standard application
programming interfaces, and enhancing product quality and ease-of-use.
Selling and marketing expenses for 1998 increased 45.3% to $19.0 million
from $13.1 million for 1997. As a percentage of total revenue, selling and
marketing expenses increased to 30.7% for 1998 from 29.5% for 1997. Such
increases were attributable to the hiring of additional direct sales and
marketing personnel and increased sales commission payments attributable to
higher sales. During 1998, the Company continued to build its sales and
marketing infrastructure in its domestic and international offices.
General and administrative expenses for 1998 increased 59.3% to $11.7
million from $7.3 million for 1997 and increased as a percentage of total
revenue to 18.9% for 1998 from 16.5% for 1997. Such increases were due to
increased staffing in the accounting, computer systems and facilities management
groups needed to support the Company's growth; however, a significant portion of
the increase was due to increased professional fees. Such professional fees were
incurred as a result of additional interim audit services performed in
association with the financial restatements, the year end annual audit and legal
costs associated with ongoing class action litigation.
INTEREST INCOME, NET
Interest income, net, which consists of the portion of all license fees due
and received under software license agreements that was not recognized upon
product acceptance or license renewal, and interest income received on cash and
cash equivalents, decreased 8.1% to $4.7 million from $5.1 million in 1998. The
decrease was due to lower interest income generated on cash and cash
equivalents, offset by increased interest income due to increased license fee
billings.
PROVISION FOR INCOME TAXES
The benefit for federal, state and foreign income taxes was $6.4 million for
1998. The provision for federal, state and foreign taxes was $0.7 million in
1997. The effective tax rates were (35.6)% and 38.0% for 1998 and 1997,
respectively. At December 31, 1998, the Company had $31.0 million in net
operating loss and AMT and research and development tax credit carryforwards
available to offset future federal taxable income. See Note 9 of Notes to
Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
From inception until the Company's initial public offering of Common Stock,
the Company funded its operations primarily through cash flow from operations
and bank borrowings. In July 1996, the Company issued and sold 2.7 million
shares of Common Stock in connection with its initial public offering. Net
proceeds to the Company from such offering were approximately $29.4 million. In
January 1997, the Company issued and sold 1.8 million shares of Common Stock in
connection with a second public offering.
21
Net proceeds to the Company from such second public offering were approximately
$51.9 million. At December 31, 1999, the Company had cash and cash equivalents
of approximately $30.0 million and working capital of approximately
$41.9 million.
Net cash provided by (used in) operating activities for the years ended
December 31, 1999, 1998 and 1997 was $6.3 million, $(19.5) million, and
$(10.0) million, respectively. In 1999, cash provided by operating activities
was primarily attributable to a reduction in accounts receivable of
$15.7 million offset by operating cash losses. The increase in cash from
operating activities resulted from improved billing practices which reduced the
time between when services are performed and when such services are billed, and
intensified collection efforts.
Net cash used in investing activities for the years ended December 31, 1999,
1998 and 1997 was $2.6 million, $8.0 million and $14.5 million, respectively.
The decrease in 1999 occurred because, during 1998 and 1997, the Company
purchased significant property and equipment, consisting mainly of computer
hardware and software and furniture and fixtures, to support the expansion of
certain facilities and the Company's growing employee base.
Net cash provided by financing activities for the years ended December 31,
1999, 1998 and 1997 was $1.2 million, $0.4 million and $52.6 million,
respectively. In 1999, this was primarily attributable to the exercise of stock
options and the sale of stock under the Company's Employee Stock Purchase Plan;
in 1998, this was attributable to the exercise of stock options; and in 1997,
this was attributable primarily to the proceeds from a secondary public offering
of common stock.
In addition to cash used for investing activities, the Company has operating
leases for office space and equipment. At December 31, 1999, the Company's
commitments under non-cancellable operating leases totaled $4.0 million,
$4.0 million and $4.0 million and $2.6 million for 2000, 2001, 2002, and
thereafter. The Company's total expense under such leases was $5.2 million, $5.1
million and $3.0 million for 1999, 1998, and 1997, respectively. See Note 8 of
Notes to Consolidated Financial Statements.
The Company believes that current cash and cash equivalents will be
sufficient to fund the Company's operations for the near term. There can be no
assurance however, that changes in the Company's plans or other events affecting
the Company's operations will not result in materially accelerated or unexpected
expenditures. In addition, there can be no assurance that additional capital if
needed will be available on reasonable terms, if at all, at such time as
required by the Company.
EFFECT OF THE "YEAR 2000" ISSUE
As of the date of this filing, we have not incurred any significant business
disruptions nor have we encountered any significant issues with respect to our
software products as a result of year 2000 issues. However, while no such
significant occurrence has developed, year 2000 issues that may arise related to
key suppliers and service providers may not become apparent immediately. We have
received assurances from key suppliers and service providers such as financial
institutions, our payroll service provider and our retirement plan administrator
as to their year 2000 readiness. We can provide no assurance that we will not be
adversely affected by these suppliers and service providers due to noncompliance
in the future. We have funded our Year 2000 plan from operating cash flows and
have not separately accounted for these costs in the past. To date, the costs
have not been material.
INFLATION
Inflation has not had a significant impact on the Company's operating
results to date, and the Company does not expect it to have a significant impact
in the future. The Company's unbilled license and maintenance fees are typically
subject to annual increases based on recognized inflation indexes.
22
SIGNIFICANT CUSTOMERS
In 1999 and 1998 respectively, the Company had one customer that accounted
for 12.5% and 17.2% of the Company's total consolidated revenue. In 1997, the
Company had two customers that accounted for 13.7% and 10.0%, respectively, of
the Company's total consolidated revenue.
FORWARD-LOOKING STATEMENTS
This Annual Report contains certain forward-looking statements. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
generality of the foregoing, the words "believes", "anticipates", "plans",
"expects", and similar expressions are intended to identify forward-looking
statements. There are a number of important factors that could cause the
Company's actual results to differ materially from those indicated by
forward-looking statements made in this Annual Report and presented elsewhere by
management from time to time. Some of the important risks and uncertainties that
may cause the Company's operating results to differ materially or adversely are
discussed below.
THE COMPANY FACES LITIGATION. Negative publicity resulting from the
Company's delayed SEC filings and its restatements of prior period financial
statements have made sales more difficult to close. The Company is presently a
defendant in two private securities litigation matters. Although the Company
intends to defend these actions vigorously, no assurance can be given as to the
outcomes. It is possible that the Company may be required to pay substantial
damages or settlement costs which could have a material adverse effect on the
Company's financial position or results of operation. In addition, regardless of
the outcome of any of these actions, it is likely that the Company will incur
substantial defense costs and that such actions will cause a diversion of
management time and attention. The Company's delays in SEC filings and
adjustments made to previously published financial statements have resulted in
negative publicity for the Company. Such events and related publicity have
adversely affected demand for the Company's products and services.
THE COMPANY IS BEING INVESTIGATED BY THE SECURITIES AND EXCHANGE
COMMISSION. Since May of 1999, the Boston office of the Securities and Exchange
Commission ("SEC") issued a Formal Order of Private Investigation of the Company
and certain individuals, currently or formerly associated with the Company, are
presently being investigated by the SEC concerning past accounting matters,
financial reports and other public disclosures and trading activity in the
Company's securities during 1997 and 1998. Such investigation may result in the
SEC imposing fines on the Company or taking other measures that may have a
material adverse impact on the Company's financial position or results of
operations. In addition, regardless of the outcome of the investigation, it is
likely that the Company will incur substantial defense costs and that such
investigation will cause a diversion of management time and attention. Finally,
the negative publicity resulting from the investigation has made and may
continue to make it more difficult for the Company to close sales, which in turn
could have a material adverse impact on the Company's financial position or
results of operations.
THE COMPANY CONTINUES TO HAVE MATERIAL WEAKNESSES IN ITS INTERNAL CONTROL
ENVIRONMENT. The Company's independent public accountants have identified in
connection with their audits of the Company's 1997, 1998 and 1999 financial
statements material weaknesses in the Company's internal control environment. In
connection with the completion of the 1999 audit, they informed the Company that
their management letter would include a recommendation to, among other things,
strengthen the resources in the Company's finance organization to improve
financial accounting and internal controls. Although the Company is actively
seeking to hire additional qualified personnel into such organization, these
efforts have proved to be difficult and there can be no assurance that the
Company will be successful in these efforts in the near term. The inability to
hire such personnel could have a material adverse impact on the Company's
reputation and on its financial condition and results of operations.
23
THE COMPANY'S STOCK PRICE HAS BEEN VOLATILE. Quarterly results have and are
likely to fluctuate significantly. The market price of the Company's common
stock has been and may continue to be highly volatile. Factors that are
difficult to predict, such as quarterly revenues and operating results,
statements and ratings by financial analysts, overall market performance and the
outcome of litigation, will have a significant effect on the price for shares of
the Company's common stock. Revenues and operating results have varied
considerably in the past from period to period and are likely to vary
considerably in the future. The Company plans product development and other
expenses based on anticipated future revenue. If revenue falls below
expectations, financial performance is likely to be adversely affected because
only a small portion of expenses vary with revenue. As a result,
period-to-period comparisons of operating results are not necessarily meaningful
and should not be relied upon to predict future performance.
THE TIMING OF LICENSE REVENUES IS RELATED TO THE COMPLETION OF
IMPLEMENTATION SERVICES AND PRODUCT ACCEPTANCE BY THE CUSTOMER, THE TIMING OF
WHICH HAS BEEN DIFFICULT TO PREDICT ACCURATELY. There can be no assurance that
Pegasystems will be profitable on an annual or quarterly basis or that earnings
or revenues will meet analysts' expectations. Fluctuations may be particularly
pronounced because a significant portion of revenues in any quarter is
attributable to product acceptance or license renewal by a relatively small
number of customers. Fluctuations also reflect a policy of recognizing revenue
upon product acceptance or license renewal in an amount equal to the present
value of the total committed payments due during the term. Customers generally
do not accept products until the end of a lengthy sales cycle and an
implementation period, typically ranging from one to six months but in some
cases significantly longer. Risks over which the Company has little or no
control, including customers' budgets, staffing allocation, and internal
authorization reviews, can significantly affect the sales and acceptance cycles.
Changes dictated by customers may delay product implementation and revenue
recognition.
THE COMPANY WILL NEED TO DEVELOP NEW PRODUCTS, EVOLVE EXISTING ONES, AND
ADAPT TO TECHNOLOGICAL CHANGE. Technological developments, customer
requirements, programming languages and industry standards change frequently in
the Company's markets. As a result, success in current markets and new markets
will depend upon the Company's ability to enhance current products, to develop
and introduce new products that meet customer needs, keep pace with
technological changes, respond to competitive products, and achieve market
acceptance. Product development requires substantial investments for research,
refinement and testing. There can be no assurance that the Company will have
sufficient resources to make necessary product development investments.
Pegasystems may experience difficulties that will delay or prevent the
successful development, introduction or implementation of new or enhanced
products. Inability to introduce or implement new or enhanced products in a
timely manner would adversely affect future financial performance. The Company's
products are complex and may contain errors. Errors in products will require the
Company to ship corrected products to customers. Errors in products could cause
the loss of or delay in market acceptance or sales and revenue, the diversion of
development resources, injury to the Company's reputation, or increased service
and warranty costs which would have an adverse effect on financial performance.
THE COMPANY HAS HISTORICALLY SOLD TO THE FINANCIAL SERVICES MARKET. This
market is consolidating rapidly, and faces uncertainty due to many other
factors. The Company has historically derived a significant portion of its
revenue from customers in the financial services market, and its future growth
depends, in part, upon increased sales to this market. Competitive pressures,
industry consolidation, decreasing operating margins within this industry,
currency fluctuations, geographic expansion and deregulation affect the
financial condition of the Company's customers and their willingness to pay. In
addition, customers' purchasing patterns are somewhat discretionary. As a
result, some or all of the factors listed above may adversely affect the demand
by customers. The financial services market is undergoing intense domestic and
international consolidation. In recent years, several customers have been merged
or consolidated. Future mergers or consolidations may cause a decline in
revenues and adversely affect the Company's future financial performance.
24
THE COMPANY'S GROWTH STRATEGY REQUIRES EXPANSION INTO NEW VERTICAL
MARKETS. The results of this strategy are uncertain. A critical part of the
Company's growth strategy is to continue selling products to markets other than
financial services, such as insurance, telecommunications, and health care. The
Company will need to hire additional personnel with expertise in these other
markets and otherwise invest in people and technologies to facilitate this
expansion. Deterioration in economic or market conditions generally may also
adversely affect the demand by customers in these other markets. There can be no
assurance that the Company will be successful in selling products to these other
markets or in continuing to attract and retain personnel with the necessary
industry expertise. Inability to effectively penetrate these other markets could
have an adverse effect on future financial performance.
IF EXISTING CUSTOMERS DO NOT RENEW THEIR LICENSES, THE COMPANY'S FINANCIAL
RESULTS MAY SUFFER. A significant portion of total revenue has been
attributable to license renewals. While historically a substantial majority of
customers have renewed their licenses, there can be no assurance that a
substantial majority of customers will continue to renew expiring licenses. A
decrease in license renewals absent offsetting revenue from other sources would
have a material adverse effect on future financial performance. In addition,
possible transition to a prepaid extended term license may have a material
adverse impact on the amount of license renewal revenues in future periods.
THE COMPANY DEPENDS ON CERTAIN KEY PERSONNEL, AND MUST BE ABLE TO ATTRACT
AND RETAIN QUALIFIED PERSONNEL IN THE FUTURE. The business is dependent on a
number of key, highly skilled technical, managerial, consulting, sales and
marketing personnel, including Mr. Trefler, the Company's Chief Executive
Officer. The loss of key personnel could adversely affect financial performance.
The Company does not have any significant key-man life insurance on any officers
or employees and does not plan to put any in place. The Company's success will
depend in large part on the ability to hire and retain qualified personnel. The
number of potential employees who have the extensive knowledge of computer
hardware and operating systems needed to develop, sell and maintain its products
is limited, and competition for their services is intense, and there can be no
assurance that the Company will be able to attract and retain such personnel. If
the Company is unable to do so, the Company's business, operating results, and
financial condition could be materially adversely affected. Several senior
managers of the Company have resigned over the last year.
THE MARKET FOR THE COMPANY'S OFFERINGS IS INCREASINGLY AND INTENSELY
COMPETITIVE, RAPIDLY CHANGING, AND HIGHLY FRAGMENTED. The market for customer
relationship management software and related implementation, consulting and
training services is intensely competitive and highly fragmented. The Company
currently encounters significant competition from internal information systems
departments of potential or existing customers that develop custom software. It
also competes with companies that target the customer interaction and workflow
markets and professional services organizations that develop custom software in
conjunction with rendering consulting services. Competition for market share and
pressure to reduce prices and make sales concessions are likely to increase.
Many competitors have far greater resources and may be able to respond more
quickly and efficiently to new or emerging technologies, programming languages
or standards or to changes in customer requirements or preferences. Competitors
may also be able to devote greater managerial and financial resources to
develop, promote and distribute products and provide related consulting and
training services. There can be no assurance that the Company will be able to
compete successfully against current or future competitors or that the
competitive pressures faced by the Company will not materially adversely affect
its business, operating results, and financial condition.
THE COMPANY MUST MANAGE INCREASED BUSINESS COMPLEXITY AND GROWTH
EFFECTIVELY. The business has grown in size, geographic scope and complexity
and product offerings and the customer base has expanded. This growth and
expansion has placed, and is expected to continue to place, a significant strain
on management, operations and capital needs. Continued growth will require the
Company to hire, train and retrain many employees in the United States and
abroad, particularly additional sales and financial personnel. The Company will
also need to enhance its financial and managerial controls and reporting
systems. There can be no assurance that the Company will attract and retain the
personnel necessary to
25
meet its business challenges. Failure to manage growth effectively may
materially adversely affect future financial performance.
THE COMPANY SUFFERED RECENT ATTRITION IN ITS SALES FORCE. In 1999, there
was a reduction in the size of the Company's sales force of almost 50%. Given
the intense competition for qualified sales personnel and the significant amount
of time required to train new sales personnel, this reduction may adversely
affect the Company's ability to meet its future sales goals. In addition,
because of the reduced size of the Company's sales force, the Company is more
focused on closing larger but fewer license transactions than in the past. This
may increase the volatility in the Company's quarterly operating results.
THE COMPANY RELIES ON CERTAIN THIRD PARTY RELATIONSHIPS. The Company has a
number of relationships with third parties that are significant to sales,
marketing and support activities and product development efforts. The Company
relies on relational database management system applications and development
tool vendors, software and hardware vendors, and consultants to provide
marketing and sales opportunities for the direct sales force and to strengthen
the Company's products through the use of industry-standard tools and utilities.
The Company also has relationships with third parties that distribute its
products. In particular, the Company relies on its relationship with First Data
Corporation for the distribution of products to the credit card and mutual fund
markets and on Carreker-Antinori, Inc. for the distribution of its products to
the banking industry. There can be no assurance that these companies, most of
which have significantly greater financial and marketing resources, will not
develop or market products that compete with those of the Company in the future
or will not otherwise end their relationships with or support of the Company.
THE COMPANY MAY FACE PRODUCT LIABILITY AND WARRANTY CLAIMS. The Company's
license agreements typically contain provisions intended to limit the nature and
extent of the Company's risk of product liability and warranty claims. There is
a risk that a court might interpret these terms in a limited way or could hold
part or all of these terms to be unenforceable. Also, there is a risk that these
contract terms might not bind a party other than the direct customer.
Furthermore, some of the Company's licenses with its customers are governed by
non-U.S. law, and there is a risk that foreign law might give the Company less
or different protection. Although the Company has not experienced any material
product liability claims to date, a product liability suit or action claiming a
breach of warranty, whether or not meritorious, could result in substantial
costs and a diversion of management's attention and the Company's resources.
THE EURO'S ADOPTION IMPOSES PRODUCT AND MARKET RISKS. A new currency, the
"Euro", was introduced in certain Economic and Monetary Union ("EMU") countries
in early 1999. It is expected that by 2002 (at the latest) all participating EMU
countries will use the Euro as their single currency. As a result, software used
by many companies headquartered or maintaining a subsidiary in a participating
EMU country is expected to be Euro-enabled. In less than three years, all
companies headquartered or maintaining a subsidiary in an EMU country will need
to be Euro-enabled. These changes will change budgetary, accounting and fiscal
systems in companies and public administration, and require the simultaneous
handling of parallel currencies and conversion of legacy data. These
requirements (and the fact that the final rules and regulations are not yet
available) may curb market demand for the Company's products because the budgets
and priorities of its customers and prospective customers may change. The
Company is monitoring the rules and regulations as they become known in order to
make any changes to its software products that the Company deems necessary to
comply with such rules and regulations. Although the Company believes that its
most recent products address these requirements, there can be no assurance that,
once the final rules and regulations are completed, the Company's software will
contain all of the necessary changes or meet all of the Euro requirements. Any
inability to comply with the Euro requirements could have an adverse effect on
the Company's business, operating results and financial condition.
THE COMPANY FACES RISKS FROM OPERATIONS AND CUSTOMERS BASED OUTSIDE OF THE
U.S. Sales to customers headquartered outside of the United States represented
approximately 21.4%, 22.6%, and 16.5% of the Company's total revenue in 1999,
1998, and 1997, respectively. The Company, in part through its wholly-
26
owned subsidiaries based in the United Kingdom, Singapore, Sweden and Australia,
markets products and renders consulting and training services to customers based
in Canada, the United Kingdom, France, Switzerland, Ireland, Luxembourg, Mexico,
Sweden, Australia, Austria, Hong Kong and Singapore. The Company has established
offices in continental Europe and in Australia. The Company believes that its
continued growth will necessitate expanded international operations requiring a
diversion of managerial attention and financial resources. The Company
anticipates hiring additional personnel to accommodate international growth, and
the Company may also enter into agreements with local distributors,
representatives, or resellers. If the Company is unable to do one or more of
these things in a timely manner, the Company's growth, if any, in its foreign
operations will be restricted, and the Company's business, operating results,
and financial condition could be materially and adversely affected.
In addition, there can be no assurance that the Company will be able to
maintain or increase international market demand for its products. Most of the
Company's international sales are denominated in U.S. dollars. Accordingly, any
appreciation of the value of the U.S. dollar relative to the currencies of those
countries in which the Company distributes its products may place the Company at
a competitive disadvantage by effectively making its products more expensive as
compared to those of its competitors.
Additional risks inherent in the Company's international business activities
generally include unexpected changes in regulatory requirements, increased
tariffs and other trade barriers, the costs of localizing products for local
markets and complying with local business customs, longer accounts receivable
patterns and difficulties in collecting foreign accounts receivable,
difficulties in enforcing contractual and intellectual property rights,
heightened risks of political and economic instability, the possibility of
nationalization or expropriation of industries or properties, difficulties in
managing international operations, potentially adverse tax consequences
(including restrictions on repatriating earnings and the threat of "double
taxation"), enhanced accounting and internal control expenses, and the burden of
complying with a wide variety of foreign laws. There can be no assurance that
one or more of these factors will not have a material adverse effect on the
Company's foreign operations, and, consequentially, the Company's business,
operating results, and financial condition.
THE COMPANY FACES RISKS RELATED TO INTELLECTUAL PROPERTY CLAIMS OR
APPROPRIATION OF ITS INTELLECTUAL PROPERTY RIGHTS. The Company relies primarily
on a combination of copyright, trademark and trade secrets laws, as well as
confidentiality agreements to protect its proprietary rights. In October 1998,
the Company was granted a patent by the United States Patent and Trademark
Office relating to the architecture of the Company's systems. There can be no
assurance that such patent will not be invalidated or circumvented or that
rights granted thereunder or the description contained therein will provide
competitive advantages to the Company's competitors or others. Moreover, despite
the Company's efforts to protect its proprietary rights, unauthorized parties
may attempt to copy aspects of the Company's products or to obtain the use of
information that the Company regards as proprietary. In addition, the laws of
some foreign countries do not protect the Company's proprietary rights to as
great an extent as do the laws of the United States. There can be no assurance
that the Company's means of protecting its proprietary rights will be adequate
or that the Company's competitors will not independently develop similar
technology.
The Company is not aware that any of its products infringe the proprietary
rights of third parties. There can be no assurance, however, that third parties
will not claim infringement by the Company with respect to current or future
products. The Company expects that software product developers will increasingly
be subject to infringement claims as the number of products and competitors in
the Company's industry segment grows and the functionality of products in
different industry segments overlaps. Any such claims, with or without merit,
could be time-consuming, result in costly litigation, cause product shipment
delays, or require the Company to enter into royalty or licensing agreements.
Such royalty or licensing agreements, if required, may not be available on terms
acceptable to the Company or at all, which could have a material adverse effect
upon the Company's business, operating results, and financial condition.
27
ITEM 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may affect the Company due to
adverse changes in financial market prices and rates. The Company's market risk
exposure is primarily the result of fluctuations in foreign exchange rates. The
Company has not entered into derivative or hedging transactions to manage risk
in connection with such fluctuations.
The Company derived approximately 21.4% of its total revenue in 1999 from
sales to customers based outside of the United States. Certain of the Company's
international sales are denominated in foreign currencies. The price in dollars
of products sold outside the United States in foreign currencies will vary as
the value of the dollar fluctuates against such foreign currencies. Although the
Company's sales denominated in foreign currencies in 1999 were not material,
there can be no assurance that such sales will not be material in the future and
that there will not be increases in the value of the dollar against such
currencies that will reduce the dollar return to the Company on the sale of its
products in such foreign currencies.
ITEM 8
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statement schedules are set forth in Item 14, "Exhibits, Financial
Statement Schedules and Reports on Form 8-K" of this Form 10-K and are filed
herewith.
ITEM 9
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None
28
PART III
ITEM 10
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information relating to the Directors of the Company is set forth in the
section entitled "Election of Directors" in the 2000 Proxy Statement, which
section is incorporated herein by reference. Information relating to the
executive officers of the Company is set forth in Part I, immediately following
Item 4, of this Report under the caption "Executive Officers of the Registrant."
Information relating to compliance with Section 16(a) of the Securities Exchange
Act of 1934 is set forth in the section entitled "Section 16(a) Beneficial
Ownership Reporting Compliance" in the 2000 Proxy Statement, which section is
incorporated herein by reference.
ITEM 11
EXECUTIVE COMPENSATION
Information relating to executive compensation is set forth in the sections
entitled "Director Compensation," "Executive Compensation," "Option Grants,"
"Aggregated Option Exercises and Year-End Option Table," and "Compensation
Committee Interlocks and Insider Participation" in the 2000 Proxy Statement,
which sections are incorporated herein by reference.
ITEM 12
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information relating to ownership of equity securities of the Company by
certain beneficial owners and management is set forth in the section entitled
"Principal and Management Stockholders" in the 2000 Proxy Statement, which
section is incorporated herein by reference.
ITEM 13
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information relating to certain relationships and related transactions is
set forth in the section entitled "Certain Transactions" in the 2000 Proxy
Statement, which section is incorporated herein by reference.
29
PART IV
ITEM 14
EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
The following consolidated financial statements are required to be filed as
part of this report:
ITEM
Report of Independent Public Accountants
Consolidated Balance Sheets at December 31, 1999 and 1998
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
All financial statement schedules are omitted because the required
information is not present or not present in sufficient amounts to
require submission of the schedule or because the information is
reflected in the consolidated financial statements or notes thereto.
(3) Exhibits
The exhibits listed in the Exhibit Index immediately preceding such
exhibits are filed as part of this Annual Report on Form 10-K.
(b) Reports on Form 8-K
No Reports on Form 8-K were filed by the Company during the quarter ended
December 31, 1999.
30
SIGNATURES
Pursuant to the requirements to Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
PEGASYSTEMS INC.
Date: April 2, 2000
By: /s/ JAMES P. O'HALLORAN
-----------------------------------------
James P. O'Halloran,
SENIOR VICE PRESIDENT, CHIEF FINANCIAL
OFFICER, TREASURER, CLERK, AND DIRECTOR
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below on April 2, 2000 by the
following persons on behalf of the Registrant and in the capacities indicated.
SIGNATURE TITLE
--------- -----
/s/ ALAN TREFLER Chairman, Chief Executive Officer,
------------------------------------ and Director (principal
Alan Trefler executive officer)
Vice President, Chief Financial
/s/ JAMES P. O'HALLORAN Officer, Treasurer, Clerk and
------------------------------------ Director (principal financial
James P. O'Halloran officer and chief accounting
officer)
/s/ STEVEN F. KAPLAN
------------------------------------ Director
Steven F. Kaplan
/s/ EDWARD A. MAYBURY
------------------------------------ Director
Edward A. Maybury
/s/ EDWARD B. ROBERTS
------------------------------------ Director
Edward B. Roberts
/s/ LEONARD A. SCHLESINGER
------------------------------------ Director
Leonard A. Schlesinger
31
PEGASYSTEMS INC.
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
- ----------- -----------
3.3.* Restated Articles of Organization of the Registrant.
3.4.* Restated By-Laws of the Registrant.
4.1.* Specimen certificate representing the Common Stock.
10.1.** Amended and Restated 1994 Long-Term Incentive Plan.
10.2.** 1996 Non-Employee Director Stock Option Plan.
10.3.** 1996 Employee Stock Purchase Plan.
10.13.* Lease Agreement dated February 26, 1993 between the
Registrant and Riverside Office Park Joint Venture.
10.14.* Amendment Number 1 to Lease Agreement dated August 7, 1994
between the Registrant and Riverside Office Park Joint
Venture.
10.15.+ Warrant agreement dated June 27, 1997 by and between the
Registrant and First Data Resources Inc.
21.1 Subsidiaries of the Registrant.
23.1. Consent of Arthur Andersen LLP.
27.1. Financial Data Schedule--1999.
- ------------------------
* Filed as exhibit to the Registrant's Registration Statement on Form S-1
(Registration No. 333-03807) or an amendment thereto and incorporated herein
by reference to the same exhibit number.
+ Filed as exhibit 10.15 to the Registrant's Form 10-K for 1997 and
incorporated herein by reference to the same exhibit number.
** Filed in the Company's 1998 Proxy Statement and incorporated herein by
reference.
32
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Pegasystems Inc.:
We have audited the accompanying consolidated balance sheets of Pegasystems
Inc. and its subsidiaries as of December 31, 1999 and 1998 and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 1999. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
As further discussed in Note 10, two class action lawsuits have been filed
by certain stockholders against the Company and certain of its current and
former officers and directors, the outcome of which is uncertain at this time.
Management believes that it is possible that the Company may be required to pay
substantial damages or settlement costs which could have a material adverse
effect on the Company's financial position or results of operations. In
addition, regardless of the outcome of any of these actions, it is likely that
the Company will incur substantial defense costs and that such actions will
cause a diversion of management's time and attention. The Company's delays in
SEC filings and adjustments made to previously published financial statements
have resulted in negative publicity for the Company. Such events and related
publicity have adversely affected demand for the Company's products and services
and may also have an adverse effect on the Company's financial position or
results of operations.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Pegasystems Inc. and its subsidiaries as of December 31, 1999 and 1998 and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 1999 in conformity with accounting
principles generally accepted in the United States.
/s/ ARTHUR ANDERSEN LLP
-------------------------------------------------------------------
Boston, Massachusetts
March 27, 2000
33
PEGASYSTEMS INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE-RELATED DATA)
DECEMBER 31,
-------------------
1999 1998
-------- --------
ASSETS
Current assets:
Cash and cash equivalents................................. $ 30,004 $ 24,806
Trade and installment accounts receivable, net of
allowance for doubtful accounts of $1,026 in 1999 and
$2,753 in 1998.......................................... 32,814 43,478
Prepaid expenses and other current assets................. 1,676 1,954
-------- --------
Total current assets.................................... 64,494 70,238
Long-term license installments.............................. 44,646 49,000
Equipment and improvements, net............................. 8,335 10,044
Purchased software and other, net........................... 7,516 9,978
-------- --------
Total assets............................................ $124,991 $139,260
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..................... $ 13,643 $ 14,808
Deferred revenue.......................................... 8,765 21,424
Current portion of capital lease obligations.............. 198 123
-------- --------
Total current liabilities............................... 22,606 36,355
Commitments and Contingencies (Notes 8 and 10)
Deferred income taxes....................................... 1,000 750
Capital lease obligations, net of current portion........... 253 202
Other long-term liabilities................................. 87 34
Stockholders' equity:
Preferred stock, $.01 par value, 1,000,000 shares
authorized; no shares issued and outstanding............ -- --
Common stock, $.01 par value, 45,000,000 shares
authorized; 28,995,821 shares and 28,683,100 shares
issued and outstanding in 1999 and 1998, respectively... 290 287
Additional paid-in capital................................ 88,941 87,757
Deferred compensation..................................... (18) (36)
Stock warrant............................................. 2,897 2,897
Retained earnings......................................... 9,079 11,489
Accumulated other comprehensive loss...................... (144) (475)
-------- --------
Total stockholders' equity.............................. 101,045 101,919
-------- --------
Total liabilities and stockholders' equity.............. $124,991 $139,260
======== ========
The accompanying notes are an integral part of these consolidated financial
statements
34
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
Revenue:
Software license.......................................... $28,123 $ 29,259 $28,657
Services.................................................. 48,506 32,510 15,704
------- -------- -------
Total revenue........................................... 76,629 61,769 44,361
------- -------- -------
Cost of revenue:
Cost of software license.................................. 3,018 1,555 276
Cost of services.......................................... 31,928 28,544 13,559
------- -------- -------
Total cost of revenue................................... 34,946 30,099 13,835
------- -------- -------
Gross profit................................................ 41,683 31,670 30,526
Operating expenses:
Research and development.................................. 19,810 23,809 13,517
Selling and marketing..................................... 19,115 18,980 13,067
General and administrative................................ 8,678 11,678 7,330
------- -------- -------
Total operating expenses................................ 47,603 54,467 33,914
------- -------- -------
Loss from operations........................................ (5,920) (22,797) (3,388)
Interest income, net........................................ 4,672 4,721 5,137
Other income, net........................................... 338 47 --
------- -------- -------
Income (loss) before provision (benefit) for income taxes... (910) (18,029) 1,749
Provision (benefit) for income taxes........................ 1,500 (6,411) 664
------- -------- -------
Net income (loss)....................................... $(2,410) $(11,618) $ 1,085
======= ======== =======
Earnings (loss) per share:
Basic..................................................... $ (0.08) $ (0.41) $ 0.04
======= ======== =======
Diluted................................................... $ (0.08) $ (0.41) $ 0.04
======= ======== =======
Weighted average number of common shares outstanding:
Basic..................................................... 28,947 28,604 28,284
======= ======== =======
Diluted................................................... 28,947 28,604 30,268
======= ======== =======
The accompanying notes are an integral part of these consolidated financial
statements
35
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
COMMON ACCULUATED
STOCK ADDITIONAL DEFERRED OTHER
NUMBER OF PAID-IN DEFERRED STOCK RETAINED COMPREHENSIVE
SHARES AMOUNT CAPITAL COMPENSATION WARRANT EARNINGS LOSS
--------- -------- ---------- ------------ -------- -------- -------------
Balance at December 31, 1996.......... 26,392 $264 $30,206 $(73) $ -- $ 22,022 $ (34)
Issuance of common stock, net of
issuance costs of $485,198.......... 1,837 18 51,925
Exercise of stock options............. 316 3 638
Tax benefit from exercise of stock
options............................. 4,072
Foreign currency translation
adjustment.......................... (320)
Amortization of deferred
compensation........................ 18
Issuance of stock warrant............. 2,897
Net income............................ 1,085
------ ---- ------- ---- ------ -------- -----
Comprehensive income..................
Balance at December 31, 1997.......... 28,545 285 86,841 (55) 2,897 23,107 (354)
Exercise of stock options............. 138 2 429
Tax benefit from exercise of stock
options............................. 487
Foreign currency translation
adjustment.......................... (121)
Amortization of deferred
compensation........................ 19
Net loss.............................. (11,618)
------ ---- ------- ---- ------ -------- -----
Comprehensive loss....................
Balance at December 31, 1998.......... 28,683 287 87,757 (36) 2,897 11,489 (475)
Exercise of stock options............. 222 2 664
Issuance of stock under Employee Stock
Purchase Plan....................... 91 1 434
Issuance of compensatory stock
option.............................. 86
Foreign currency translation
adjustment.......................... 331
Amortization of deferred
compensation........................ 18
Net loss.............................. (2,410)
------ ---- ------- ---- ------ -------- -----
Comprehensive loss....................
Balance at December 31, 1999.......... 28,996 $290 $88,941 $(18) $2,897 $ 9,079 $(144)
====== ==== ======= ==== ====== ======== =====
TOTAL
STOCK- TOTAL
HOLDERS' COMPREHENSIVE
EQUITY INCOME (LOSS)
-------- -------------
Balance at December 31, 1996.......... $ 52,385 $ --
Issuance of common stock, net of
issuance costs of $485,198.......... 51,943
Exercise of stock options............. 641
Tax benefit from exercise of stock
options............................. 4,072
Foreign currency translation
adjustment.......................... (320) (320)
Amortization of deferred
compensation........................ 18
Issuance of stock warrant............. 2,897
Net income............................ 1,085 1,085
-------- -------
Comprehensive income.................. 765
Balance at December 31, 1997.......... 112,721
Exercise of stock options............. 431
Tax benefit from exercise of stock
options............................. 487
Foreign currency translation
adjustment.......................... (121) (121)
Amortization of deferred
compensation........................ 19
Net loss.............................. (11,618) (11,618)
-------- -------
Comprehensive loss.................... (11,739)
Balance at December 31, 1998.......... 101,919
Exercise of stock options............. 666
Issuance of stock under Employee Stock
Purchase Plan....................... 435
Issuance of compensatory stock
option.............................. 86
Foreign currency translation
adjustment.......................... 331 331
Amortization of deferred
compensation........................ 18
Net loss.............................. (2,410) (2,410)
-------- -------
Comprehensive loss.................... $(2,079)
Balance at December 31, 1999.......... $101,045
========
The accompanying notes are an integral part of these consolidated financial
statements
36
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
Cash flows from operating activities:
Net income (loss)......................................... $ (2,410) $(11,618) $ 1,085
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Provision (benefit) for deferred income taxes........... 250 (6,596) 722
Depreciation and amortization........................... 6,833 5,595 3,159
Provision for (reduction in) doubtful accounts.......... (727) 2,165 1,938
Issuance of compensatory stock option................... 86 -- --
Change in operating assets and liabilities:
Trade and installment accounts receivable............. 15,745 (37,921) (20,276)
Prepaid expenses and other current assets............. 278 (440) (279)
Accounts payable and accrued expenses................. (1,165) 9,663 1,978
Deferred revenue...................................... (12,659) 19,670 1,701
Other long-term liabilities........................... 53 (34) --
-------- -------- --------
Net cash provided by (used in) operating
activities........................................ 6,284 (19,516) (9,972)
Cash flows from investing activities:
Purchase of equipment and improvements.................... (2,766) (7,376) (4,488)
Purchased software and other.............................. 122 (617) (10,000)
-------- -------- --------
Net cash used in investing activities............... (2,644) (7,993) (14,488)
Cash flows from financing activities:
Payments of capital lease obligations..................... 126 -- --
Issuance of common stock, net............................. -- -- 51,943
Exercise of stock options................................. 666 431 641
Sale of stock under Employee Stock Purchase Plan.......... 435 -- --
-------- -------- --------
Net cash provided by financing activities........... 1,227 431 52,584
Effect of exchange rate on cash and cash equivalents........ 331 (121) (320)
-------- -------- --------
Net increase (decrease) in cash and cash
equivalents....................................... 5,198 (27,199) 27,804
Cash and cash equivalents, at beginning of year............. 24,806 52,005 24,201
-------- -------- --------
Cash and cash equivalents, at end of year................... $ 30,004 $ 24,806 $ 52,005
======== ======== ========
Supplemental disclosures of cash flow information:
Cash paid during period:
Interest................................................ $ 32 $ 9 $ 7
Income taxes............................................ $ 28 $ 84 $ 13
-------- -------- --------
Non-cash financing activity:
Issuance of stock warrant............................... $ -- $ -- $ 2,897
======== ======== ========
Equipment acquired under capital lease.................. $ 280 $ 325 $ --
======== ======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
37
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999
1. SIGNIFICANT ACCOUNTING POLICIES
(a) BUSINESS
Pegasystems Inc. (the "Company") develops, markets, licenses and supports
customer relationship management (CRM) software that enables transaction
intensive-organizations to manage a broad array of customer interactions. The
Company also offers consulting, training, and maintenance and support services
to facilitate the installation and use of its solutions.
(B) MANAGEMENT ESTIMATES AND REPORTING, OPERATING AND CONTROL ENVIRONMENT
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the periods
presented. Actual results could differ from those estimates. Significant assets
and liabilities with reported amounts based on estimates include trade and
installment accounts receivable, long term license installments and deferred
revenue.
Following the December 31, 1997 and 1998 audits, the Company received a
management letter from its independent public accountants that identified
material weaknesses in the Company's internal control environment.
In connection with the completion of the December 31, 1999 audit, the
independent public accountants have informed the Company that their management
letter will again communicate material weaknesses in the internal control
environment. The independent public accountants have further informed the
Company that their management letter will include recommendations to strengthen
the resources in the finance organization to improve financial accounting and
internal controls, and in particular to improve the controls and procedures over
the customer service project implementation process that has resulted in the
Company's inability to reasonably estimate the fair value of services to be
provided under project implementations until customer acceptance.
(C) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom
company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc.
(a United States corporation), GDOO (a Swedish company), Pegasystems Pty Ltd.
(an Australian company), Pegasystems Investments Inc. (a United States
corporation) and Pegasystems Private Limited (a Singapore company). All
intercompany accounts and transactions have been eliminated in consolidation.
(D) FOREIGN CURRENCY TRANSLATION
The translation of assets and liabilities of the Company's foreign
subsidiaries is made at year-end exchange rates, while revenue and expense
accounts are translated at the average exchange rates for the respective years
ended. The resulting translation adjustments are reflected as a separate
component of accumulated other comprehensive loss.
Realized and unrealized exchange gains or losses from transaction
adjustments are reflected in other income, net in the accompanying statements of
operations and are not material.
38
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(E) REVENUE RECOGNITION
During 1997, the Company recognized revenue in accordance with Statement of
Position (SOP) 91-1, "Software Revenue Recognition", as issued by the American
Institute of Certified Public Accountants (AICPA). Under SOP 91-1, revenue from
software license arrangements was generally recognized upon delivery and product
acceptance pursuant to non-cancelable license agreements, and was based on
management's assessment that the collectibility of the long-term license
installments was probable. Additionally, upon acceptance the Company must have
had no significant remaining vendor obligations regarding the licensed software.
Effective January 1, 1998, the Company adopted the provisions of SOP 97-2,
"Software Revenue Recognition", as issued by the American Institute of Certified
Public Accountants. Under SOP 97-2, software license fees are recognized upon
customer acceptance of the software when there is persuasive evidence of an
arrangement, delivery has occurred, the fee is fixed or determinable and
collectibility of the fee is probable. Maintenance revenue is recognized ratably
over the term of the maintenance arrangement. SOP 98-4, "Deferral of the
Effective Date of a Provision of SOP 97-2," and SOP 98-9 "Modification of SOP
97-2 with Respect to Certain Transactions," issued by the AICPA during 1998,
deferred and modified certain provisions of SOP 97-2. Beginning in 2000, all of
the provisions of SOP 97-2, as modified, will be effective.
The Company's revenue is derived from two sources: software license fees and
service fees. Software license fees are generally payable on a monthly basis
under license agreements, which generally have a five-year term and may be
renewed for additional years at the customer's option. The present value of
future license payments is generally recognized as revenue upon acceptance. For
purposes of the present value calculations, the discount rate used has varied
between 6.25% and 7.00% for the three years ended December 31, 1999. A portion
of the fee from each arrangement is initially deferred and recognized as
interest income over the rest of the license term.
The Company's services revenue is comprised of fees for implementation,
maintenance, training and consulting services. Software license customers are
offered the ability to enter into a maintenance contract requiring the customer
to pay a monthly maintenance fee over the term of the related license agreement.
Maintenance fees are recognized ratably over the terms of the maintenance
agreement. The Company's software implementation agreements typically require
the Company to provide a specified level of implementation services for a
specified fee, typically with additional implementation services available at an
hourly rate. Implementation fees are recognized once the fair value of services
and any other elements to be delivered under the arrangement can be determined,
which has typically occurred upon customer acceptance for fixed price projects
and as incurred for time and material projects. The Company generally recognizes
training, and consulting fees as the services are provided. The Company does not
defer costs related to the service elements for which revenue recognition has
been deferred.
In arrangements that include multiple elements (e.g. software license,
implementation services, training, etc.), the total fees under the arrangement
are deferred until such time as the fair value of each element to be delivered
under the contract can be determined, which typically has occurred upon customer
acceptance for fixed price projects and as incurred for time and material
projects. The total revenue is allocated to the individual elements based on the
relative fair values. Deferred revenue at December 31, 1999 consisted primarily
of service fees from arrangements for which acceptance of the software license
39
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
has not occurred and the fair value of free consulting hours committed by the
Company that had not been performed.
In the case of software license agreement renewals, license fee revenue is
recognized upon the expiration of the initial terms.
The Company provides revenue reserves for services provided in excess of
amounts estimated at the time revenue was recognized.
(F) CASH AND CASH EQUIVALENTS
The Company considers highly liquid investments with original maturities of
three months or less to be cash and cash equivalents.
(G) CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to a
concentration of credit risk consist of trade accounts receivable and long-term
license installments receivable. The Company records long-term license
installments in accordance with its revenue recognition policy, which results in
receivables from customers (primarily large organizations with strong credit
ratings).
(H) EQUIPMENT AND IMPROVEMENTS
Equipment and improvements are recorded at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the assets,
which are three years for equipment and five years for furniture and fixtures.
Leasehold improvements and equipment under capital leases are amortized over the
lesser of the life of the lease or the useful life of the asset.
(I) SOFTWARE COSTS
In compliance with the Statement of Financial Accounting Standards ("SFAS")
No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or
Otherwise Marketed", certain software costs are capitalized by the Company.
Capitalization of software costs begins upon the establishment of technological
feasibility, defined by the Company as a working model or an operative version
of the computer software product that is completed in the same language and is
capable of running on all of the platforms as the product to be ultimately
marketed. No internal costs were capitalized during 1999, 1998, or 1997 as the
amounts expended subsequent to technological feasibility were immaterial. See
Note 7 for discussion of the capitalized purchased software in connection with
the Company's Software License and Support and Warrant Agreements with First
Data Resources, Inc.
Amortization of capitalized software costs is included in cost of software
license revenue. No amortization expense for capitalized internally developed
software costs was charged to cost of software license revenue in 1999, 1998 or
1997.
(J) NET EARNINGS (LOSS) PER SHARE
The Company follows the provisions of SFAS No. 128, "Earnings Per Share".
SFAS No. 128 establishes standards for computing and presenting (loss) earnings
per share and applies to entities with
40
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
publicly held common stock or potential common stock. In accordance with the
Securities and Exchange Commission's Staff Accounting Bulletin ("SAB") No. 98,
the Company has determined that there were no nominal issuances of common stock
or potential common stock in the period prior to the Company's initial public
offering ("IPO"). The Company has applied the provisions of SFAS No. 128 and SAB
No. 98 retroactively to all periods presented.
For the years ended December 31, 1999 and 1998, diluted weighted average
shares is the same as basic weighted average shares as the inclusion of stock
options and warrants would be anti-dilutive. Calculations of basic and diluted
net earnings (loss) per share and potential common share are as follows:
YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
Basic:
Net income (loss)......................................... $(2,410) $(11,618) $ 1,085
======= ======== =======
Weighted average common shares outstanding................ 28,947 28,604 28,284
======= ======== =======
Basic earnings (loss) per share............................. $ (0.08) $ (0.41) $ 0.04
======= ======== =======
Net income (loss)......................................... $(2,410) $(11,618) $ 1,085
======= ======== =======
Weighted average common shares outstanding.................. 28,947 28,604 28,284
Effect of assumed exercise of stock options................. -- -- 1,984
======= ======== =======
Weighted average common shares outstanding, assuming
dilution.................................................. 28,947 28,604 30,268
======= ======== =======
Diluted earnings (loss) per share........................... $ (0.08) $ (0.41) $ 0.04
======= ======== =======
For the years ended December 31, 1999, 1998, and 1997, 5,399,722 options and
warrants, 1,987,020 options and warrants, and 185,481 options, respectively,
were excluded from the weighted average common shares outstanding, assuming
dilution, as their effect would be anti-dilutive.
(K) SEGMENT REPORTING
During 1998, the Company adopted SFAS No. 131, "Disclosures About Segments
of an Enterprise and Related Information". SFAS No. 131 requires certain
financial and supplementary information to be disclosed on an annual and interim
basis for each reportable operating segment of an enterprise, as defined. Based
on the criteria set forth in SFAS No. 131, the Company currently operates in one
operating segment, customer service software.
SFAS No. 131 also requires that certain enterprise-wide disclosures be made
related to products and services, geographic areas and major customers. The
Company derives substantially all of its operating revenue from the sale and
support of one group of similar products and services. Substantially all of the
Company's assets are located within the United States. During 1999, 1998 and
1997, the Company derived
41
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
its operating revenue from the following countries: (Revenues classified based
upon location of the customer.)
YEAR ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
United States.................................... $60,220 $47,816 $37,031
United Kingdom................................... 4,079 6,594 3,642
Other............................................ 12,330 7,359 3,688
------- ------- -------
$76,629 $61,769 $44,361
======= ======= =======
In 1999 and 1998, one customer accounted for approximately 12.5% and 17.2%
of the Company's total revenue, respectively. In 1997, two customers accounted
for approximately 13.7% and 10% of the Company's total revenue, respectively.
(L) NEW ACCOUNTING STANDARDS
SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities"
issued June 1998, establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, and hedging activities. It requires an entity to recognize all
derivatives as either assets or liabilities in the statements of financial
position and measure those instruments at fair value. The Company does not
expect adoption of this statement to have significant impact on its consolidated
financial position or results of operations.
In June 1999, Financial Accounting Standards Board ("FASB") issued SFAS No.
137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of
the Effective Date of FASB Statement No. 133," which defers the effective date
of SFAS No. 133 to all fiscal years beginning after June 15, 2000.
(M) STOCK OPTIONS
The Company grants stock options for a fixed number of shares to employees
with an exercise price equal to the fair market value of the shares at the date
of the grant. The Company accounts for stock option grants in accordance with
APB Opinion No. 25, "Accounting for Stock Issued to Employees", and intends to
continue to do so. During 1995, the Company granted stock options for a fixed
number of shares to employees with an exercise price less than the fair market
value of the shares at the date of the grant. For the difference between the
fair market value and the exercise price, the Company recorded deferred
compensation in the consolidated statements of stockholders' equity, which is
being expensed over the vesting period.
The Company has adopted only the disclosure provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation," and will continue to account for its
stock option plans in accordance with the provisions of APB Opinion No. 25.
(N) RECLASSIFICATIONS
As of January 1, 1999, the Company refined its method of classifying costs
and expenses by directly charging costs to their appropriate functional
classifications. During 1997 and 1998, all costs were allocated
42
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
to the classifications using a method based on the classifications' salaries.
Results for 1997 and 1998 have been reclassified to conform with the current
methodology. In addition, certain prior year balance sheet amounts have been
reclassified to conform to current year classifications.
2. RESTATEMENT
On three separate occasions during the two-year period ended December 31,
1998, the Company discovered errors in its previously reported financial
statements that have required it to restate its quarterly or annual financial
statements.
In addition, on August 11, 1999, the Company announced the restatement of
its financial statements for the year ended December 31, 1998 and the unaudited
three-month period ended March 31, 1999. As part of the Company's closing for
the three-month period ended June 30, 1999, the Company discovered errors in the
previously released results of operations for the three-month periods ended
December 31, 1998 and March 31, 1999. The errors, which were caused by
incorrectly bookkeeping certain credit memos and cash receipts related to
previously reversed or deferred revenue, resulted in an understatement of
service revenue and an overstatement of costs for each of the periods effected.
See Note 11 for disclosure of the restated unaudited selected quarterly
information for the four quarters ended December 31, 1999 and 1998.
3. ALLOWANCE FOR DOUBTFUL ACCOUNTS
During 1998 and 1997, the Company experienced difficulty in collecting
accounts receivable. The Company therefore carried balances in its Allowance for
Doubtful Accounts of $2.8 million and $2.2 million and incurred associated bad
debt expense of $2.2 million and $1.9 million in 1998 and 1997, respectively.
During 1999, the Company resolved a number of customer projects and
increased its focus on the collection processes, which took full effect in the
fourth quarter of 1999. Accordingly, the Company reduced the Allowance for
Doubtful Accounts by $2.7 million in the fourth quarter of 1999. For the year
ended December 31, 1999, general and administrative expense includes a negative
provision of $0.7 million.
43
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
4. EQUIPMENT AND IMPROVEMENTS
The cost and accumulated depreciation of equipment and improvements consist
of the following:
DECEMBER 31,
-------------------
1999 1998
-------- --------
(IN THOUSANDS)
Equipment................................................ $ 13,075 $11,987
Furniture and fixtures................................... 3,403 2,721
Leasehold improvements................................... 3,343 2,627
Equipment under capital leases........................... 622 342
-------- -------
20,443 17,677
Less: accumulated depreciation........................... (12,108) (7,633)
-------- -------
Equipment and improvements, net.......................... $ 8,335 $10,044
======== =======
Depreciation expense was approximately $4.5 million, $3.2 million and $2.0
million for the years ended December 31, 1999, 1998 and 1997, respectively.
5. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of the following:
DECEMBER 31,
-------------------
1999 1998
-------- --------
(IN THOUSANDS)
Trade accounts payable.................................... $ 1,310 $ 2,066
Employee compensation and benefits........................ 3,481 3,318
Accrued taxes............................................. 2,546 1,521
Other accrued expenses.................................... 2,545 3,042
Revenue reserve........................................... 3,761 4,861
------- -------
Accounts payable and accrued expenses..................... $13,643 $14,808
======= =======
6. STOCKHOLDERS' EQUITY
(A) COMMON STOCK
The Company has 45,000,000 authorized shares of common stock $.01 par value,
of which 28,995,821 shares were issued and outstanding at December 31, 1999.
(B) PREFERRED STOCK
The Company has authorized 1,000,000 shares of Preferred Stock, which may be
issued from time to time in one or more series. The Company's Board of Directors
has authority to issue the shares of Preferred Stock in one or more series, to
establish the number of shares to be included in each series and to fix the
designation, powers, preferences and rights of the shares of each series and the
qualifications, limitations or restrictions thereof, without any further vote or
action by the stockholders. The issuance of
44
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
Preferred Stock could decrease the amount of earnings and assets available for
distribution to holders of Common Stock, and may have the effect of delaying,
deferring or preventing a change in control of the Company. The Company had not
issued any shares of preferred stock as of December 31, 1999.
(C) LONG-TERM INCENTIVE PLAN
In 1994, the Company adopted a Long Term Incentive Plan (as amended, the
"1994 Plan") to provide employees, directors and consultants with opportunities
to purchase stock through incentive stock options and non-qualified stock
options.
In addition to options, eligible participants under the 1994 Plan may be
granted stock appreciation rights, restricted stock and long-term performance
awards. As of December 31, 1999, a total of 9.5 million shares of common stock
were reserved for issuance under the 1994 Plan.
The option price per share is determined at the date of grant. For incentive
stock options, the option price may not be less than 100% of the fair market
value of the Company's common stock at the grant date. Incentive stock options
granted to a person having greater than 10% of the voting power of all classes
of stock must have an exercise price of at least 110% of fair market value of
the Company's common stock. Options granted under the 1994 Plan generally vest
over four or five years and expire no later than ten years from the date of
grant.
(D) 1996 NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN
In 1996, the Company adopted a Non-Employee Director Stock Option Plan (the
"Director Plan"). The Director Plan provides for the grant of options for the
purchase of up to 250,000 shares of common stock of the Company.
The Director Plan is administered by the Compensation Committee and provides
that each person who becomes a director of the Company (each a "non-employee
director") after May 13, 1996, and who is not also an employee or former
employee of the Company, will receive upon initial election to the Board of
Directors an option to purchase 30,000 shares of common stock. In November 1999,
the Board of Directors of the Company approved, subject to Stockholder approval,
an amendment to the Director Plan providing for the annual grant to each
non-employee director (commencing in 2000) of an option to purchase 10,000
shares of common stock. The exercise price for all options granted under the
Director Plan is equal to the market price of the common stock on the date of
grant.
(E) 1996 EMPLOYEE STOCK PURCHASE PLAN
In 1996, the Company adopted an Employee Stock Purchase Plan (the "Stock
Purchase Plan"). Pursuant to this plan, an aggregate of 500,000 shares of common
stock were reserved for issuance.
Under the terms of the Stock Purchase Plan, employees who meet certain
eligibility requirements may purchase shares of the Company's common stock at
85% of the closing price of the common stock on the first or last day of each
offering period, whichever is lower. In 1997 and 1998, no shares were issued
under the plan. In 1999, the Company issued 91,197 shares under the plan for
gross proceeds of approximately $0.4 million. At December 31, 1999, there were
408,803 shares available for issuance under the plan.
45
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
For pro forma compensation expense, the weighted average fair value of
shares sold in 1999 was $2.79 per share.
The following table presents the combined activity for the 1994 Plan and the
Director Plan for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997
-------------------- -------------------- --------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
NUMBER OF EXERCISE NUMBER OF EXERCISE NUMBER OF EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
--------- -------- --------- -------- --------- --------
(IN THOUSANDS) (IN THOUSANDS) (IN THOUSANDS)
Outstanding options at beginning of year... 5,532 $7.61 3,099 $10.40 2,582 $ 5.04
Granted.................................. 2,834 $5.23 5,955 $12.35 1,214 $22.79
Exercised................................ (221) $3.01 (138) $ 3.13 (316) $ 2.03
Cancelled................................ (1,883) $9.69 (3,384) $18.69 (381) $20.52
------ ----- ------ ------ ----- ------
Outstanding options at end of year......... 6,262 $6.02 5,532 $ 7.61 3,099 $10.40
====== ===== ====== ====== ===== ======
Exercisable options at end of year......... 2,058 $4.33 1,065 $ 2.57 822 $ 2.13
====== ===== ====== ====== ===== ======
Weighted average fair value of options
granted during the year.................. $3.97 $ 9.34 $11.38
===== ====== ======
The following table presents weighted average price and life information
about significant option groups outstanding and exercisable at December 31,
1999:
OPTIONS OUTSTANDING
----------------------------- OPTIONS EXERCISABLE
WEIGHTED -------------------------
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
RANGE OF EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
PRICES OUTSTANDING LIFE (YEARS) PRICE OUTSTANDING PRICE
- ----------------- -------------- ------------ -------- -------------- --------
(IN THOUSANDS) (IN THOUSANDS)
$0.33-$0.39......................... 1,030 5.19 $ 0.34 981 $ 0.34
$4.22-$6.69......................... 1,879 9.34 $ 4.46 301 $ 4.22
$7.02-$10.00........................ 3,093 8.82 $ 7.94 669 $ 8.20
$10.13-$12.50....................... 24 8.42 $11.41 7 $12.41
$17.06-$19.19....................... 208 8.15 $17.09 89 $17.08
$20.56-$22.69....................... 28 7.37 $20.79 11 $20.68
----- -----
6,262 2,058
===== =====
The following are the pro forma net income (loss) and earnings (loss) per
share for 1999, 1998 and 1997, as if the compensation expense for the option
plans and the Stock Purchase Plan had been
46
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
6. STOCKHOLDERS' EQUITY (CONTINUED)
determined based on the fair value at the grant date for grants in 1999, 1998
and 1997, consistent with the provisions of SFAS No. 123:
1999 1998 1997
------------------- ------------------- -------------------
AS PRO AS PRO AS PRO
REPORTED FORMA REPORTED FORMA REPORTED FORMA
-------- -------- -------- -------- -------- --------
Net income (loss) (in thousands)....... $(2,410) $(7,776) $(11,618) $(13,783) $1,085 $ (774)
Basic earnings (loss) per share........ $ (0.08) $ (0.27) $ (0.41) $ (0.48) $ 0.04 $(0.03)
Diluted earnings (loss) per share...... $ (0.08) $ (0.27) $ (0.41) $ (0.48) $ 0.04 $(0.03)
The fair value of options at the date of grant were estimated using the
Black-Scholes option pricing model with the following weighted-average
assumptions:
1999 1998 1997
-------- --------- ---------
Volatility................................. 0.97 0.97 0.5
Expected option life (years)............... 5.0 5.0 5.0
Interest rate (risk free).................. 5.54% 4.23-5.65% 6.13-6.57%
Dividend yield............................. 0.0% 0.0% 0.0%
Volatility for 1999 and 1998 was calculated on a daily basis and was
determined to be .97 for each year. Volatility for 1997 was calculated on a
quarterly basis and was determined to be 0.5. The Company has never declared nor
paid dividends on any of its capital stock and does not expect to in the
foreseeable future.
The effects on 1999, 1998, and 1997 pro forma net income (loss) and earnings
(loss) per share of expensing the estimated fair value of stock options and
shares are not necessarily representative of the effects on reporting the
results of operations for future years as the pro forma net loss does not
include expense related to the fair value of options granted prior to January 1,
1995.
7. SOFTWARE LICENSE AND SUPPORT AND WARRANT AGREEMENTS
On June 27, 1997, the Company entered into Software License and Support and
Warrant Agreements with First Data Resources, Inc. ("FDR").
The provisions of the Software License and Support Agreement give FDR the
right to use the Company's software in connection with new products and also the
exclusive right to market, distribute and sublicense the Company's software and
new products to FDR customers and prospects. In addition to the granting of a
license to use its software, the Company also provides services to FDR in
connection with the new products. For the right to the license and the services,
FDR is expected to pay the Company a base fee of $49.25 million with additional
fees possible based on successful resale of the products. FDR has paid $21.5
million through December 31, 1999 of which $8.25 million was paid in 1999 and
remaining fees are expected to be paid on a monthly basis over the term of the
agreement. The initial term of this agreement commenced on June 27, 1997 and
runs through December 31, 2002.
In accordance with the Software License and Support Agreement, the Company
was granted a license for access to and use of the designs, specifications and
code of FDR's ESP product. As consideration for
47
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
7. SOFTWARE LICENSE AND SUPPORT AND WARRANT AGREEMENTS (CONTINUED)
this right, the Company paid FDR $10.0 million. This amount was recorded as
purchased software on the accompanying balance sheets.
In connection with the Software License and Support Agreement on June 27,
1997, the Company committed to provide a warrant to FDR. Pursuant to the Warrant
Agreement, the Company gave FDR the right to purchase 284,876 shares of the
Company's common stock at a purchase price of $28.25 per share, which
represented the fair market value of the common stock on the date of the
agreement. The warrant became exercisable on June 27, 1998 and will expire on
June 27, 2002. The warrant was valued at $2.9 million and the corresponding
deferred asset was capitalized and included in "purchased software and other" on
the accompanying balance sheets.
The Company will recognize the base fee revenue and also amortize the value
of the purchased software and the warrant on a pro rata basis over the initial 5
1/2 year term of the agreement. During the year ended December 31, 1999 and 1998
and the period from June 27, 1997 through December 31, 1997, the Company
recognized revenue of approximately $8.9 million, $8.9 million and $4.6 million,
respectively, related to the Software License and Support Agreement and recorded
amortization expense of approximately $2.3 million,$2.3 million, and $1.2
million, respectively, related to the ESP software and warrant.
8. LEASES
The Company leases certain equipment and office space under non-cancelable
capital and operating leases. Future minimum rental payments required under the
capital and operating leases with non-cancelable terms in excess of one year at
December 31, 1999 are as follows:
YEAR ENDED DECEMBER 31,
---------------------------------
CAPITAL LEASES OPERATING LEASES
-------------- ----------------
(IN THOUSANDS)
Future Minimum Payments
2000............................................ $232 $ 4,019
2001............................................ 225 3,962
2002............................................ 46 3,962
2003............................................ -- 1,550
2004............................................ -- 540
Thereafter...................................... -- 572
---- -------
503 $14,605
-------
Less--Amounts representing interest............. (52)
----
Present value of minmum lease payments.......... 451
Less--current portion........................... (198)
----
$253
====
Total rent expense under operating leases was approximately $5.2 million,
$5.1 million and $3.0 million, for the years ended December 31, 1999, 1998 and
1997, respectively.
48
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
9. INCOME TAXES
The components of income/(loss) before provision (benefit) for income taxes
are as follows:
1999 1998 1997
-------- -------- --------
Domestic......................................... $(2,451) $(14,038) $ 8,599
Foreign.......................................... 1,541 (3,991) (6,850)
------- -------- -------
Total.......................................... $ (910) $(18,029) $ 1,749
======= ======== =======
The components of the provision (benefit) for income taxes for the years
ended December 31, 1999, 1998, and 1997 consist of the following:
1999 1998 1997
-------- -------- --------
(IN THOUSANDS)
Current:
Federal.......................................... $ -- $ -- $(149)
State............................................ -- 84 (30)
Foreign.......................................... 1,250 101 121
------- ------- -----
Total current.................................. 1,250 185 (58)
Deferred:
Federal.......................................... $ 1,139 (6,380) 688
State............................................ (139) (966) 34
Foreign (750) 750 --
------- ------- -----
Total deferred................................. $ 250 (6,596) 722
------- ------- -----
$ 1,500 $(6,411) $ 664
======= ======= =====
The effective income tax rate differed from the statutory federal income tax
rate due to the following:
1999 1998 1997
-------- -------- --------
Statutory federal income tax rate.................... (35.0)% (35.0)% 34.0%
State income taxes, net of federal benefit and tax
credits............................................ (9.9)% (3.2)% 3.9%
Permanent differences................................ 66.5% (0.9)% 6.4%
Tax credits.......................................... (170.4)% (0.9)% (8.6)%
Tax effect on foreign activities..................... (4.3)% 4.4% --%
Valuation Allowance.................................. 317.9% --% --%
Other................................................ --% --% 2.3%
------ ----- ----
Effective income tax rate............................ 164.8% (35.6)% 38.0%
====== ===== ====
Deferred income taxes at December 31, 1999, 1998, and 1997 reflect the net
tax effects of net operating loss and tax credit carryforwards and temporary
differences between the carrying amounts of assets and liabilities for financial
statement purposes and the amounts used for tax purposes. The
49
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
9. INCOME TAXES (CONTINUED)
approximate income tax effect of the Company's net deferred tax asset
(liability) as of December 31, 1999 and 1998 are as follows:
DECEMBER 31,
-------------------
1999 1998
-------- --------
(IN THOUSANDS)
Software revenue........................................ $(22,483) $(14,312)
Depreciation............................................ (1,571) (2,934)
Vacation accrual........................................ 35 1,001
Receivable and other reserves........................... 4,448 3,260
Net operating loss carryforwards........................ 18,510 11,719
Tax credits............................................. 2,957 1,081
Foreign taxes........................................... -- (750)
Other................................................... -- 185
-------- --------
Net deferred tax assets (liabiltities)................ 1,896 (750)
Less valuation allowance................................ 2,896 (--)
-------- --------
$ (1,000) $ (750)
======== ========
A valuation allowance has been provided for the deferred tax asset since it
is uncertain if the Company will realize the entire benefit of the deferred tax
asset. Of the valuation allowance at December 31, 1999, approximately $276
thousand, related to stock option benefits, will be recorded directly to equity
when realized.
At December 31, 1999, the Company had alternative minimum tax ("AMT"),
research and experimentation ("R&E"), and foreign tax credit carryforwards of
approximately $3.0 million, available to offset future taxable income. The
carryforward period for the AMT credit is unlimited. The R&E credit
carryforwards generally expire from 2004 to 2019. The foreign tax credits
generally expire from 2002 to 2003.
As of December 31, 1999 the Company also has available U.S. net operating
loss carryforwards of approximately $47.5 million. The operating loss
carryforwards expire from 2011 to 2018. These carryforwards may be used to
offset future income taxes payable, if any, and are subject to review by the
U.S. Internal Revenue Service. In addition the Company has charitable
contribution carryforwards of approximately $130 thousand generally expiring
from 2001 to 2003.
A provision has not been made for the U.S. or additional foreign taxes on
$1.9 million of undistributed earnings of foreign subsidiaries that could be
subject to taxation if remitted to the U.S., because the Company plans to keep
these amounts permanently reinvested overseas.
10. LITIGATION AND CONTINGENCIES
CHALVERUS CASE. In November 1997 and January 1998, complaints purporting to
be class actions were filed with the United States District Court for the
District of Massachusetts (the "Court") alleging that the Company and several of
its officers violated Section 10(b) of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), Rule 10b-5 promulgated by the Commission
thereunder, and Section
50
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
10. LITIGATION AND CONTINGENCIES (CONTINUED)
20(a) of the Exchange Act. A third complaint was filed in April 1998 but has
been voluntarily dismissed without prejudice. In December 1998, the plaintiffs
filed their First Amended Consolidated Complaint which names the Company, the
Company's Chief Executive Officer (Alan Trefler) and a former officer and
director (Ira Vishner) as defendants. The Amended Complaint alleges that the
defendants issued false and misleading financial statements and press releases
concerning the Company's publicly reported earnings. The Amended Complaint seeks
certification of a class of persons who purchased the Company's Common Stock
between July 2, 1997 and October 29, 1997, and does not specify the amount of
damages sought. The Court has denied the defendants' motion to dismiss the
Amended Complaint. The case is currently in discovery.
GELFER CASE. In December 1998, a complaint also purporting to be a class
action was filed with the Court after the Company's announcement on
November 24, 1998 that it may be recording revenue adjustments to prior periods.
In April 1999, the plaintiffs filed their First Amended Class Action Complaint
("Gelfer Complaint") in that action following the January 20, 1999 restatement.
The Gelfer Complaint is filed against the Company, Alan Trefler, Ira Vishner,
the former Chief Financial Officer, and alleges violations of Section 10(b) and
Section 20(a) of the Exchange Act and Rule 10b-5 promulgated by the Commission
thereunder. The Complaint is filed on behalf of a purported class of persons who
purchased the Company's common stock between April 2, 1998 through November 24,
1998 and does not specify the amount of damages sought. The defendants filed
their answer to the Gelfer Complaint after its motion to dismiss was denied.
The Company intends to defend these actions vigorously, but no assurance can
be given as to the outcomes. Management believes that it is possible that the
Company may be required to pay substantial damages or settlement costs which
could have a material adverse effect on the Company's financial position or
results of operations. In addition, regardless of the outcome of any of these
actions, it is likely that the Company will incur substantial defense costs and
that such actions will cause a diversion of management time and attention. The
Company's delay in filing its regular reports with the SEC and its announcement
that it has adjusted previously published financial statements have resulted in
negative publicity for the Company. Such events and related publicity have
adversely affected demand for the Company's products and services and may also
have an adverse effect on the Company's financial position or results of
operations.
SEC INVESTIGATION. In May 1999, the Securities and Exchange Commission
("SEC") issued a Formal Order of Private Investigation of the Company and
unidentified individuals, currently or formerly associated with the Company,
which concerns past accounting matters, financial reports, and other public
disclosures and trading activity in the Company's securities during 1997 and
1998. The Company has been cooperating fully with the SEC. The investigation is
confidential and ongoing.
51
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999
11. SELECTED QUARTERLY INFORMATION (UNAUDITED)
1999
-----------------------------------------------------
1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
----------- ----------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenue......................................... $15,066 $21,347 $20,509 $19,707
Income (loss) from operations................... (7,615) (198) 924 969
Net income (loss)............................... (6,710) 1,025 2,444 831
Earnings (loss) per share--Basic................ $ (.23) $ .04 $ .08 .03
Earnings (loss) per share--Diluted.............. $ (.23) $ .03 $ .08 .03
1998
-----------------------------------------------------
1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER
----------- ----------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenue......................................... $14,234 $18,157 $17,631 $11,747
Income (loss) from operations................... (1,743) (395) (3,382) (17,277)
Net income (loss)............................... (350) 500 (1,215) (10,553)
Earnings (loss) per share--Basic................ $ (.01) $ .02 $ (.04) $ (.37)
Earnings (loss) per share--Diluted.............. $ (.01) $ .02 $ (.04) $ (.37)
The information above reflects the of quarterly restatements made by the
Company. See Note 2 for further discussion of these restatements.
12. VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS
BALANCE (DEDUCTIONS)
AT CHARGED TO CHARGED BALANCE
BEGINNING COSTS AND TO OTHER DEDUCTIONS AT END
DESCRIPTION (IN THOUSANDS) OF PERIOD EXPENSES ACCOUNT (B) OF PERIOD
- -------------------------- --------- ------------ -------- ---------- ---------
Allowance for doubtful accounts:
Year ended December 31, 1999............ $2,753 $(727) -- ($1,000) $1,026
Year ended December 31, 1998............ 2,200 2,165 -- (1,612) 2,753
Year ended December 31, 1997............ 939 1,938 285(a) (962) 2,200
- ------------------------
(a) Amount relates to service revenue reversed, which was previously charged
against the allowance for doubtful accounts.
(b) Deductions are related to accounts receivable write-offs.
52