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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
-----------------------------------------
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to _________ to ______________________
Commission File Number 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer Identification No.)
125 Baylis Road
Melville, New York 11747
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: 631-777-5188
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 / /
THE NUMBER OF SHARES OF COMMON STOCK ISSUED AND OUTSTANDING AS OF NOVEMBER 01,
2002 WAS 45,253,850, WHICH INCLUDES REDEEMABLE COMMON SHARES.
1
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Unaudited Consolidated Financial Statements 3
Consolidated Balance Sheets at September 30, 2002
(unaudited) and December 31, 2001 3
Unaudited Consolidated Statements of Operations for the three
and nine months ended September 30, 2002 and 2001 4
Unaudited Consolidated Statements of Cash Flows for the
nine months ended September 30, 2002 and 2001 5
Notes to the Unaudited Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 10
Item 3. Qualitative and Quantitative Disclosures about Market Risk 20
Item 4. Controls and Procedures 20
PART II. Other Information 21
Item 6. Exhibits and Reports on Form 8-K 21
2
PART I. FINANCIAL INFORMATION
ITEM 1. Unaudited Consolidated Financial Statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, 2002 December 31, 2001
------------------ -----------------
Assets (unaudited)
Current assets:
Cash and cash equivalents ................................................ $ 26,775,722 $ 38,370,937
Marketable securities .................................................... 26,674,334 26,156,180
Accounts receivable, net ................................................. 3,438,180 2,539,987
Prepaid expenses and other current assets ................................ 1,025,881 1,077,017
------------ ------------
Total current assets ............................................ 57,914,117 68,144,121
Property and equipment, net ................................................. 1,972,855 1,605,396
Investments ................................................................. 1,290,127 2,300,062
Goodwill and other intangible assets, net ................................... 3,383,273 --
Other assets ................................................................ 2,401,277 2,421,376
------------ ------------
Total assets .................................................... $ 66,961,649 $ 74,470,955
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ......................................................... $ 234,679 $ 544,998
Accrued expenses ......................................................... 2,011,131 1,588,723
Deferred revenue ......................................................... 1,660,008 357,912
Liabilities of discontinued operations ................................... 6,453,578 8,134,322
------------ ------------
Total current liabilities ....................................... 10,359,396 10,625,955
------------ ------------
Long-term liabilities of discontinued operations ........................ -- 283,428
------------ ------------
Commitments
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
45,488,850 and 45,049,379 shares issued, respectively.................. 45,489 45,049
Additional paid-in capital ............................................... 79,256,778 77,991,996
Deferred compensation .................................................... (587,306) (1,026,674)
Accumulated deficit ...................................................... (20,759,980) (12,151,469)
Common stock held in treasury, at cost (235,000 and 190,000 shares,
respectively) .......................................................... (1,435,130) (1,220,730)
Accumulated other comprehensive income (loss) ............................ 82,402 (76,600)
------------ ------------
Total stockholders' equity ...................................... 56,602,253 63,561,572
------------ ------------
Total liabilities and stockholders' equity ...................... $ 66,961,649 $ 74,470,955
============ ============
See accompanying notes to unaudited consolidated financial statements.
3
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
------------- -------------
2002 2001 2002 2001
---- ---- ---- ----
Revenues ................................. $ 2,855,522 $ 2,521,887 $ 7,212,982 $ 2,565,287
Operating expenses:
Cost of revenues ...................... 583,947 519,887 1,751,756 1,075,061
Software development costs ............ 1,827,190 1,417,473 5,344,379 3,702,894
Selling and marketing ................. 2,200,129 1,850,936 6,501,484 5,301,639
General and administrative ............ 644,094 619,238 1,899,118 2,114,727
Impairment of prepaid royalty ......... 482,715 -- 482,715 --
------------ ------------ ------------ ------------
5,738,075 4,407,534 15,979,452 12,194,321
------------ ------------ ------------ ------------
Operating loss ................ (2,882,553) (1,885,647) (8,766,470) (9,629,034)
------------ ------------ ------------ ------------
Interest and other income ................ 405,033 441,990 1,242,894 826,097
Impairment of long-lived assets .......... (1,084,935) -- (1,084,935) --
------------ ------------ ------------ ------------
Loss before income taxes ........ (3,562,455) (1,443,657) (8,608,511) (8,802,937)
Provision for income taxes ............... -- -- -- 1,312
------------ ------------ ------------ ------------
Net loss ........................ $ (3,562,455) $ (1,443,657) $ (8,608,511) $ (8,804,249)
------------ ------------ ------------ ------------
Beneficial conversion feature attributable
to convertible preferred stock ........ -- -- -- 3,896,287
------------ ------------ ------------ ------------
Net loss attributable to common
shareholders .......................... $ (3,562,455) $ (1,443,657) $ (8,608,511) $(12,700,536)
============ ============ ============ ============
Basic and diluted net loss per share ..... $ (0.08) $ (0.04) $ (0.19) $ (0.40)
============ ============ ============ ============
Weighted average basic and diluted shares
outstanding ........................... 45,239,977 37,004,055 45,221,168 32,076,681
============ ============ ============ ============
See accompanying notes to unaudited consolidated financial statements.
4
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended Nine Months Ended
September 30, 2002 September 30, 2001
------------------ ------------------
Cash flows from operating activities:
Net loss ................................................ $ (8,608,511) $ (8,804,249)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization ..................... 1,235,048 312,916
Non-cash professional services expenses ........... 30,278 429,671
Equity-based compensation expense ................. 575,173 344,186
Impairment of long-lived and other assets ......... 1,567,650 --
Changes in operating assets and liabilities:
Accounts receivable, net .......................... (880,593) (820,930)
Prepaid expenses and other current assets ......... (431,579) (523,753)
Other assets ...................................... (5,179) --
Accounts payable .................................. (324,094) 1,256,577
Accrued expenses .................................. 101,179 1,301,871
Deferred revenue .................................. 653,014 292,441
------------ ------------
Net cash used in continuing operating activities (6,087,614) (6,211,270)
------------ ------------
Cash flows from investing activities:
Purchase of marketable securities ....................... (17,267,619) --
Sale of marketable securities ........................... 16,898,656 --
Purchase of investment .................................. (75,000) --
Purchase of property and equipment ...................... (935,241) (1,034,462)
Purchase of software licenses ........................... (600,000) (2,240,000)
Purchase of intangible assets ........................... (93,401) --
Net cash acquired from acquisition of NPI ............... -- 48,208,649
Net cash paid for acquisition of IP Metrics ............. (2,365,374) --
Security deposits ....................................... -- (204,587)
------------ ------------
Net cash provided by (used in) investing activities .. (4,437,979) 44,729,600
------------ ------------
Cash flows from financing activities:
Net proceeds from issuance of preferred stock ........... -- 7,932,335
Acquisition of treasury stock ........................... (214,400) --
Proceeds from exercise of stock options ................. 1,099,139 72,125
------------ ------------
Net cash provided by financing activities ............ 884,739 8,004,460
------------ ------------
Cash flows from discontinued operations:
Payments of liabilities of discontinued operations .... (1,964,172) --
------------ ------------
Effect of exchange rate changes on cash .................... 9,811 (31,295)
------------ ------------
Net (decrease) increase in cash and cash equivalents ....... (11,595,215) 46,491,495
Cash and cash equivalents, beginning of period ............. 38,370,937 7,727,182
------------ ------------
Cash and cash equivalents, end of period ................... $ 26,775,722 $ 54,218,677
============ ============
The Company did not pay any interest expense or income taxes for the nine
months ended September 30, 2002 and 2001.
See accompanying notes to unaudited consolidated financial statements.
5
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements
(1) Summary of Significant Accounting Policies
(a) The Company and Nature of Operations
FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops,
manufactures and sells storage networking infrastructure software and provides
the related maintenance, implementation and engineering services.
(b) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(c) Unaudited Interim Financial Information
The unaudited interim consolidated financial statements of the Company as of and
for the three and nine months ended September 30, 2002 and 2001, included herein
have been prepared, without audit, pursuant to the rules and regulations of the
SEC. Certain information and note disclosures normally included in financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America have been condensed or omitted pursuant to such
rules and regulations relating to interim financial statements.
In the opinion of management, the accompanying unaudited interim condensed
consolidated financial statements reflect all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at September 30, 2002 and the results of its operations for the
three and nine months ended September 30, 2002 and 2001.
(d) Cash Equivalents and Marketable Securities
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$26 million at September 30, 2002. Cash at September 30, 2002 amounted to $0.8
million. Marketable securities at September 30, 2002 amounted to $26.7 million
and consisted of corporate bonds and government securities.
(e) Revenue Recognition
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, SOFTWARE REVENUE RECOGNITION. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable and the software is
delivered, provided no significant obligations remain and collection of the
resulting receivable is deemed probable. Software delivered to a customer on a
trial basis is not recognized as revenue until a permanent key is delivered to
the customer. When a customer licenses software together with the purchase of
maintenance, the Company allocates a portion of the fee to maintenance for its
fair value based on the contractual maintenance renewal rate. Software
maintenance fees are deferred and recognized as revenue ratably over the term of
the contract. The cost of providing technical support is included in cost of
revenues.
Revenues associated with software implementation and software engineering
services are recognized as the services are performed. Network consulting
services, which are billed on a time and material basis, are also recognized as
revenue when the services are performed. Costs of providing these services are
included in cost of revenues.
6
The Company has entered into various distribution, licensing and joint promotion
agreements with OEMs and distributors, whereby the Company has provided the
reseller a non-exclusive software license to install the Company's software on
certain hardware or to resell the Company's software in exchange for royalty
payments based on the number of products distributed by the OEM or distributor.
Nonrefundable advances received by the Company from an OEM for royalties are
recorded as deferred revenue and recognized as revenue when related software
engineering services are complete, if any, and the software product master is
delivered and accepted.
Revenue from maintenance fees and services was $543,711 and $770,000 for the
three months ended September 30, 2002 and 2001, respectively and $1,167,948 and
$790,000 for the nine months ended September 30, 2002 and 2001, respectively.
All other revenues were derived from software licenses.
(f) Earnings per share (EPS)
Basic EPS is computed based on the weighted average number of shares of common
stock outstanding. Diluted EPS is computed based on the weighted average number
of common shares outstanding increased by dilutive common stock equivalents. Due
to a net loss, all common stock equivalents were excluded from diluted net loss
per share. As of September 30, 2002 potentially dilutive common stock
equivalents included 8,108,334 stock options outstanding.
(g) Comprehensive Loss
Comprehensive loss amounted to $3,429,401 and $1,381,724 for the three months
ended September 30, 2002 and 2001, respectively, and $8,449,509 and $8,761,824
for the nine months ended September 30, 2002 and 2001, respectively.
Comprehensive loss includes the Company's foreign currency translation
adjustments of $(16,359) and $(11,787) for the three months ended September 30,
2002 and 2001, respectively, and $9,811 and $(31,295) for the nine months ended
September 30, 2002 and 2001, respectively. Additionally, comprehensive loss
includes the Company's unrealized gains on marketable securities of $149,413 and
$149,191 for the three and nine months ended September 30, 2002, respectively
and $73,720 for the three and nine months ended September 30, 2001.
(h) Use of Estimates
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 reporting period.
Actual results could differ from those estimates.
(i) New Accounting Pronouncements
In July 2002, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 146, Accounting for Costs Associated with
Exit or Disposal Activities. Statement 146, which is effective prospectively for
exit or disposal activities initiated after December 31, 2002, applies to costs
associated with an exit activity, including restructurings, or with a disposal
of long-lived assets. Those activities can include eliminating or reducing
product lines, terminating employees and contracts and relocating plant
facilities or personnel. Statement 146 requires that exit or disposal costs are
recorded as an operating expense when the liability is incurred and can be
measured at fair value. Commitment to an exit plan or a plan of disposal by
itself will not meet the requirement for recognizing a liability and the related
expense under Statement 146. Statement 146 grandfathers the accounting for
liabilities that were previously recorded under EITF Issue 94-3. The Company
believes the adoption of Statement 146 will not impact its financial statements.
(2) Acquisitions
On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned subsidiary of
the Company, acquired all of the common stock of IP Metrics Software, Inc. ("IP
Metrics"), a provider of intelligent trunking software for mission-critical
networks, for approximately $2.4 million in cash plus payments contingent on the
level of revenues from IP Metrics' products and services for a period of
twenty-four months.
7
The fair value of the net tangible liabilities of IP Metrics assumed was $0.9
million. The Company purchased certain intangible assets, including customer
relationships and purchased technology with a fair value of $0.2 million. These
intangible assets are being amortized under the straight-line method over an
estimated useful life of 3 years, the expected period of benefit. The purchase
price in excess of the fair value of the net tangible and intangible assets
acquired and liabilities assumed by the Company amounted to $3.1million and has
been recorded as goodwill.
On August 22, 2001, pursuant to an Agreement and Plan of Merger and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor") merged
with Network Peripherals Inc. ("NPI"), with NPI as the surviving corporation.
Under the terms of the Merger Agreement, all of FalconStor's preferred shares
were converted into common shares and the stockholders of FalconStor received
0.721858 shares of NPI common stock for each share of FalconStor common stock
that they held. Although NPI acquired FalconStor, as a result of the
transaction, FalconStor stockholders held a majority of the voting interests in
the combined enterprise after the merger. Accordingly, for accounting purposes,
the acquisition was a "reverse acquisition" and FalconStor was the "accounting
acquiror." Further, as a result of NPI's decision on June 1, 2001 to discontinue
its NuWave and legacy business, at the time of the merger NPI was a
non-operating public shell with no continuing operations, and no intangible
assets associated with NPI were purchased by FalconStor. As a result, the
transaction was accounted for as a recapitalization of FalconStor and recorded
based on the fair value of NPI's net tangible assets acquired by FalconStor,
with no goodwill or other intangible assets being recognized. Costs incurred by
FalconStor directly related to the transaction, amounting to $8,882,998, were
charged to additional paid-in capital. The conversion of all of FalconStor's
preferred stock into common stock resulted in an additional 20,207,460 shares of
common stock outstanding and, for accounting purposes, the merger resulted in
the issuance of 13,348,605 common shares to NPI's pre-merger shareholders. In
connection with the merger, the name of NPI was changed to FalconStor Software,
Inc.
The following unaudited pro forma consolidated financial information gives
effect to the above described acquisition of IP Metrics and merger with NPI, as
if they had occurred at the beginning of the respective periods by consolidating
the continuing results of operations of the Company, IP Metrics and NPI for the
three and nine months ended September 30, 2002 and 2001. The unaudited pro forma
consolidated financial information reflects NPI as a discontinued operation.
Three months Ended Nine months Ended
September 30, September 30,
2002 2001 2002 2001
Revenues $ 2,855,522 $ 2,684,246 $ 7,673,660 $ 2,822,149
Net loss from continuing operations (3,562,455) (1,471,339) (9,008,643) (9,026,612)
Basic and diluted net
loss from continuing operations per share $ (0.08) $ (0.03) $ (0.20) $ (0.21)
Weighted average basic and
diluted shares outstanding 45,239,977 44,694,012 45,221,168 43,518,342
The pro forma information is provided for illustrative purposes only and does
not represent what the actual consolidated results of operations would have been
had the merger occurred on the dates assumed, nor are they necessarily
indicative of future results of operations.
(3) Segment Reporting
The Company is organized in a single operating segment for purposes of making
operating decisions and assessing performance. Revenues from the United States
to customers in the following geographical areas for the three and nine months
8
ended September 30, 2002 and 2001 and the location of long-lived assets as of
September 30, 2002 and December 31, 2001 are summarized as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2002 2001 2002 2001
---------- ---------- ---------- -----------
Revenues:
United States $1,673,411 $ 722,903 $4,166,703 $ 766,303
Asia and other international 1,182,111 1,798,984 3,046,279 1,798,984
---------- ---------- ---------- ----------
Total revenues $2,855,522 $2,521,887 $7,212,982 $2,565,287
========== ========== ========== ==========
September 30, December 31,
2002 2001
------------- ------------
Long-lived assets (includes all non-current assets):
United States $8,640,564 $5,963,235
Asia and other international 406,968 363,599
---------- ----------
Total long-lived assets $9,047,532 $6,326,834
========== ==========
(4) Impairment of Long-Lived and Other Assets
In October 2001, the Company entered into an agreement with Network-1 Security
Solutions, Inc ("NSSI"), a publicly traded company, whereby $2.8 million was
paid to NSSI, of which $2.3 million was for the purchase of convertible
preferred stock accounted for under the cost method and $0.5 million was for a
non-refundable prepaid royalty recoupable against future product sales of NSSI's
product. Primarily due to the decline since May, 2002 in the market value of
NSSI's common stock underlying the convertible preferred stock to a value which
is below the Company's cost, the Company has concluded the decline in the fair
value of its investment in NSSI's preferred stock is other than temporary.
Accordingly, in September, 2002 the Company recorded an impairment charge to
write-down its investment in NSSI preferred stock to its fair value of $1.2
million. In addition, due to the lack of market acceptance of the NSSI product
in its current state, the prepaid royalty is not recoverable and was written
off. As a result, in September, 2002, the Company recorded a $1.6 million charge
for the impairment of long-lived and other assets related to its NSSI agreement.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains "Forward-looking statements" within the meaning
of Section 27a of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These forward-looking statements can be identified by the
use of predictive, future-tense or forward-looking terminology, such as
"believes," "anticipates," "expects," "estimates," "plans," "may," "intends,"
"will," or similar terms. investors are cautioned that any forward-looking
statements are not guarantees of future performance and involve significant
risks and uncertainties, and that actual results may differ materially from
those projected in the forward-looking statements. The following discussion
should be read together with the condensed consolidated financial statements and
notes to those statements included elsewhere in this report.
OVERVIEW
FalconStor was incorporated in Delaware for the purpose of developing,
manufacturing and selling storage networking infrastructure software and
providing the related maintenance, implementation and engineering services. Our
unique open software approach to storage networking enables companies to better
capture and manipulate the expanding volume of enterprise data than existing
storage solutions, without rendering those solutions obsolete. By moving the
intelligence of storage management from hardware to software, we allow companies
to adopt the state-of-the-art Fibre Channel technology while at the same time,
leverage their prior investments in Ethernet information technology (IT)
infrastructure, taking full advantage of the ubiquitous connectivity of the
industry-standard Internet Protocol (IP). Our software technology can embrace
various input/output (I/O) interface, communications standards and innovative
storage services as they are introduced. Our architecture has been recognized
and licensed by partners in Gigabit Ethernet Switch, SCSI-to-Fibre Channel
Router, Disk-Subsystem and Appliances spaces. We believe our flagship IPStor(TM)
product, which began shipping in the second quarter of 2001, is currently the
only available all-software solution that combines industry-standard
connectivity with next-generation network storage services, offering large,
distributed enterprises a complete storage management solution that includes all
four of the key service categories: universal connectivity supporting both Fibre
Channel and IP/iSCSI-based storage provisioning; virtualization; storage
services such as fail-over, mirroring, replication and snapshot; and unified SAN
(storage area network) and NAS (network-attached storage).
From March 2000 through May 2001, we received net proceeds of approximately
$17.9 million from the sale of our preferred stock, which converted into
approximately 20.2 million shares of our common stock. Our operations from
inception through the second quarter of 2001 were mainly comprised of the
development of our core storage networking infrastructure software product.
During 2000 and the first two quarters of 2001, we were in the development stage
of operations, as a result there were no significant revenues generated from our
planned principal operations. During the second quarter of 2001, we completed
the development of our principal product and released our software. We began to
generate significant revenues from software licenses in the third quarter of
2001.
On August 22, 2001, we merged with NPI, a publicly traded company. For more
information relating to the merger with NPI, including the accounting treatment,
see note 2 to the unaudited condensed consolidated financial statements.
On July 3, 2002, we acquired IP Metrics, a provider of intelligent trunking
software for mission-critical networks. For more information relating to the
acquisition of IP Metrics, including the accounting treatment, see note 2 to the
unaudited condensed consolidated financial statements.
Our critical accounting policies are those related to revenue recognition. As
described in note 1 to our unaudited condensed consolidated financial
statements, we recognize revenue in accordance with the provisions of Statement
of Position 97-2, Software Revenue Recognition, as amended. Software license
revenue is recognized only when pervasive evidence of an arrangement exists and
10
the fee is fixed and determinable. An arrangement is evidenced by a signed
customer contract for nonrefundable royalty advances received from OEMs and, a
customer purchase order for each software license to be resold by an OEM,
distributor or solution provider to an end user. The software license fees are
fixed and determinable as our standard payment terms range from 30 to 90 days,
depending on the regional billing practice, and we have not provided any of our
customers extended payment terms. When a customer licenses software together
with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED
TO THE THREE MONTHS ENDED SEPTEMBER 30, 2001.
Revenues
Revenues for the three months ended September 30, 2002 increased 13% to $2.9
million compared to $2.5 million for the three months ended September 30, 2001.
The increase in revenues was partially due to an increase in software license
revenues from $1.8 million for the three months ended September 30, 2001 to $2.3
million for the three months ended September 30, 2002. This increase in software
license revenues was due to increased market acceptance of our product as well
as an increase in the number of our channel partners, which resulted in an
increase in deployments. Another reason for the increase in revenues was an
increase in maintenance and other revenues from $50,000 for the three months
ended September 30, 2001 to $0.5 million for the three months ended September
30, 2002. This increase in maintenance and other revenues was due to an increase
in the number of maintenance and support contracts signed over the past twelve
months. Maintenance revenues are recognized ratably over the contractual
maintenance term. These increases in software license and maintenance and other
revenues were partially offset by a decrease in revenues from engineering
services. Revenue from engineering services decreased from $0.7 million for the
three months ended September 30, 2001 to $40,000 for the three months ended
September 30, 2002. This revenue has decreased since the majority of our OEM
contracts were signed in 2001 and the related engineering services, that are
typically performed at the beginning of an OEM relationship, were also completed
in 2001.
Cost of Revenues
Cost of revenues increased 12% from $0.5 million for the three months ended
September 30, 2001 to $0.6 million for the three months ended September 30,
2002. Cost of revenues consists primarily of personnel costs associated with
providing system implementations and technical support under maintenance
contracts and training. The increase in cost of revenues was due to an increase
in personnel related expenses in order to support the increase in the number of
deployments of our software and to fulfill our obligations under maintenance
support contracts.
Gross profit for the three months ended September 30, 2002 was $2.3 million or
80% of revenues compared to $2.0 million or 79% of revenues for the three months
ended September 30, 2001. The increase in gross profit was due to an increase in
revenues.
Software Development Costs
Software development costs consist primarily of personnel costs for product
development personnel and other related costs associated with the development of
new products, enhancements to existing products, quality assurance and testing.
Software development costs increased 29% from approximately $1.4 million for the
three months ended September 30, 2001 to approximately $1.8 million for the
three months ended September 30, 2002. The $0.4 million increase from the prior
year period is mainly due to an increase in product development personnel. The
increase in employees was needed to enhance and test our core storage networking
infrastructure software product, and to develop new innovative features and
options.
11
Selling and Marketing
Selling and marketing expenses consist primarily of sales and marketing
personnel costs, travel, commission expense, public relations expense, marketing
literature and promotions, trade show expenses, and the costs associated with
our foreign sales offices. Selling and marketing expenses were $2.2 million for
the three months ended September 30, 2002 compared to $1.9 million for the three
months ended September 30, 2001, an increase of 19%. This increase in sales and
marketing expense is partially due to an increase in personnel expenses as we
expanded our sales force to accommodate our revenue growth as well as an
increase in our marketing expenses in an effort to promote our product and to
create brand awareness.
General and Administrative
General and administrative expenses consist primarily of personnel costs of
general and administrative functions, public company related fees, directors and
officers insurance, legal and professional fees and other general corporate
overhead costs. General and administrative expenses remained relatively
consistent at $0.6 million for the three months ended September 30, 2002 and
2001.
Interest and Other Income
Interest and other income remained relatively consistent at $0.4 million for the
three months ended September 30, 2002 and 2001.
Impairment of Long-Lived and Other Assets
In October 2001, we entered into an agreement with Network-1 Security Solutions,
Inc ("NSSI"), a publicly traded company, whereby $2.8 million was paid to NSSI,
of which $2.3 million was for the purchase of convertible preferred stock
accounted for under the cost method and $0.5 million was for a non-refundable
prepaid royalty recoupable against future product sales of NSSI's product.
Primarily due to the decline since May, 2002 in the market value of NSSI's
common stock underlying the convertible preferred stock below the Company's
cost, we have concluded the decline in the fair value of our investment in
NSSI's preferred stock is other than temporary. Accordingly, in September, 2002
we recorded an impairment charge to write-down our investment in NSSI preferred
stock to its fair value of $1.2 million. In addition, due to the lack of market
acceptance of the NSSI product in its current state, the prepaid royalty is not
recoverable and was written off. As a result, in September, 2002, we recorded a
$1.6 million charge for the impairment of long-lived and other assets related to
our NSSI agreement, of which $0.5 million was an operating expense. Excluding
this asset impairment charge, operating expenses for the three months ended
September 30, 2002 remained flat compared to the three months ended June 30,
2002. This impairment charge reflects a write-down of our investment in NSSI to
$0.58 per share, NSSI's closing price on September 30, 2002. As of November 13,
2002, NSSI stock was trading at $0.17. If the stock price is lower than $0.58 at
the end of any future quarter, we may be required to record additional
impairment charges.
RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO
THE NINE MONTHS ENDED SEPTEMBER 30, 2001.
Revenues
Revenues for the nine months ended September 30, 2002 were $7.2 million compared
to $2.6 million for the nine months ended September 30, 2001. The increase in
revenues was due to the release of our principal product at the end of the
second quarter of 2001. As a result of the release of our product, for the nine
months ended September 30, 2002 our revenues from software licenses increased to
$6 million and our maintenance and other revenues increased to $0.8 million. For
the nine months ended September 30, 2001, we generated only $1.8 million in
revenues from software licenses and $50,000 in maintenance and other revenues
since our software was not released until the end of the second quarter of 2001.
Additionally, we recognized $0.7 million in engineering services for the nine
months ended September 30, 2001 related to customizing software product masters
for our OEM partners compared to $0.4 million for the nine months ended
September 30, 2002.
12
Cost of Revenues
Cost of revenues for the nine months ended September 30, 2002 increased 63% to
approximately $1.8 million compared to approximately $1.1 million for the nine
months ended September 30, 2001. The increase in cost of revenues from the prior
year is mainly due to an increase in the number of employees. As a result of the
release of our software in the second quarter of 2001, we hired additional
employees to help implement and provide maintenance and support for our
software.
Gross profit for the nine months ended September 30, 2002 was $5.5 million or
76% of revenues compared to $1.5 million or 58% of revenues for the nine months
ended September 30, 2001. The increase in gross profit was due to increased
revenues associated with the release of our software.
Software Development Costs
Software development costs were approximately $5.3 million for the nine months
ended September 30, 2002 compared to approximately $3.7 million for the nine
months ended September 30, 2001, an increase of 44%. The $1.6 million increase
from the prior year period is mainly due to an increase in product development
personnel. The increase in employees was needed to enhance and test our core
storage networking infrastructure software product, as well as to develop new
innovative features and options.
Selling and Marketing
Selling and marketing expenses increased 23% from approximately $5.3 million for
the nine months ended September 30, 2001 to approximately $6.5 million for the
nine months ended September 30, 2002. This increase in selling and marketing
expenses was due to our product being released during the end of the second
quarter of 2001. As a result of this release, we expanded our sales force to
accommodate our revenue growth and we increased our marketing efforts to promote
our product and to create brand awareness. In addition, as a result of the
increase in revenues our commission expense increased.
General and Administrative
General and administrative expenses were approximately $1.9 million for the nine
months ended September 30, 2002, a decrease of approximately $0.2 million from
the nine months ended September 30, 2001. The decrease in general and
administrative expenses was due to a non-cash consulting expense for option
grants and higher legal fees for the nine months ended September 30, 2001. For
the nine months ended September 30, 2002, we did not incur any similar expenses.
Interest and Other Income
Interest and other income was approximately $1.2 million for the nine months
ended September 30, 2002 compared to $0.8 million for the nine months ended
September 30, 2001. The $0.4 million increase in interest income was due to
higher average cash, cash equivalent and marketable securities balances as a
result of the merger with NPI.
Income Taxes
We did not record a tax benefit associated with the pre-tax loss incurred from
the period from inception (February 10, 2000) through September 30, 2002, as we
deemed that it was more likely than not that the deferred tax assets will not be
realized based on our development and now early stage operations and,
accordingly, we provided a full valuation allowance against the deferred tax
asset.
13
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2002, we had approximately $26.8 million in cash and cash
equivalents and $26.7 million in marketable securities. Net cash used in
operating activities for the nine months ended September 30, 2002 was $6.1
million compared to $6.2 million for the nine months ended September 30, 2001.
The cash used in continuing operating activities for the nine months ended
September 30, 2002 was mainly comprised of the Company's net loss of $8.6
million and an increase in accounts receivable, prepaid expenses and other
current assets and a decrease of accounts payable totaling $1.6 million. These
amounts were partially offset by non-cash expenses of $3.4 million and increases
in deferred revenue and accrued expenses of $0.8 million. Net cash used for the
nine months ended September 30, 2001 was mainly comprised of the Company's net
loss of $8.8 million and increases in accounts receivable and prepaid expenses
and other current assets totaling $1.3 million. These amounts were partially
offset by non-cash expenses of $1.1 million and increases in accounts payable,
accrued expenses and deferred revenue of $2.8 million.
Net cash used in investing activities for the nine months ended September 30,
2002 was approximately $4.4 million compared to $44.7 million of cash provided
for the nine months ended September 30, 2001. The increase in cash used by
investing activities was mainly due to $0.4 million in net purchases of
marketable securities, $0.9 million in purchases of property and equipment, $0.6
million in purchases of software licenses and $2.4 million paid in connection
with the acquisition of IP Metrics. For the nine months ended September 30,
2001, the net cash provided was mainly attributable to the $48.2 million net
cash acquired in connection with our merger with NPI. This amount was partially
offset by $1 million in purchase of property and equipment, $2.2 million in
purchases of software licenses, and $0.2 million paid in connection with
security deposits.
Net cash provided by financing activities was approximately $0.9 million for the
nine months ended September 30, 2002. This amount was comprised of $1.1 million
of proceeds from the exercise of stock options offset by payments to acquire
treasury stock of $0.2 million. Net cash provided by financing activities for
the nine months ended September 30, 2001 was $8 million, which was mainly
comprised of proceeds from the issuance of preferred stock.
For the nine months ended September 30, 2002, the Company paid $2.0 million
related to discontinued operations.
In October 2001, our Board of Directors authorized the repurchase of up to two
million shares of our common stock, of which 235,000 shares have been purchased
through September 30, 2002.
In connection with our acquisition of IP Metrics in July 2002, we are required
to make cash payments to the former shareholders of IP Metrics, which are
contingent on the level of revenues from IP Metrics' products for a period of
twenty-four months subsequent to the acquisition.
Our principal sources of liquidity are cash, cash equivalents and marketable
securities, which are expected to be used for general corporate purposes,
including expansion of operations and capital expenditures.
We believe that our current balance of cash, cash equivalents and marketable
securities and expected cash flows from operations will be sufficient to meet
our cash requirements for at least the next twelve months.
Impact of Recently Issued Accounting Pronouncements
In July 2002, the FASB issued Statement No. 146, Accounting for Costs Associated
with Exit or Disposal Activities. Statement 146, which is effective
prospectively for exit or disposal activities initiated after December 31, 2002,
applies to costs associated with an exit activity, including restructurings, or
with a disposal of long-lived assets. Those activities can include eliminating
or reducing product lines, terminating employees and contracts and relocating
plant facilities or personnel. Statement 146 requires that exit or disposal
costs are recorded as an operating expense when the liability is incurred and
can be measured at fair value. Commitment to an exit plan or a plan of disposal
by itself will not meet the requirement for recognizing a liability and the
related expense under Statement 146. Statement 146 grandfathers the accounting
for liabilities that were previously recorded under EITF Issue 94-3. The Company
believes the adoption of Statement 146 will not impact its financial statements.
14
RISK FACTORS
We have had limited revenues and a history of losses, and we may not achieve or
maintain profitability.
Due to the early stage of our product, we have had limited revenues and
a history of losses. For the year ended December 31, 2001 and the nine months
ended September 30, 2002, we had revenues of $5,591,729 and $7,212,982,
respectively. For the period from inception (February 10, 2000) through
September 30, 2002 and for the three months ended September 30, 2002, we had a
net loss of $20,759,980 and $3,562,455, respectively. We have signed contracts
with resellers and original equipment manufacturers, or OEMs, and believe that
as a result of these contracts, our revenues should increase in the future. Our
business model depends upon signing agreements with additional OEM customers,
further developing our reseller sales channel, and expanding our direct sales
force. Any difficulty in obtaining these OEM and reseller customers or in
attracting qualified sales personnel will hinder our ability to generate
additional revenues and achieve or maintain profitability.
Failure to achieve anticipated growth could harm our business and operating
results.
Achieving our anticipated growth will depend on a number of factors,
some of which include:
o retention of key management, marketing and technical personnel;
o our ability to increase our customer base and to increase the sales of our
products; and
o competitive conditions in the storage networking infrastructure software
market.
We cannot assure you that the anticipated growth will be achieved. The
failure to achieve anticipated growth could harm our business, financial
condition and operating results.
Due to the uncertain and shifting development of the storage networking
infrastructure software market, we may have difficulty accurately predicting
revenue for future periods and appropriately budgeting for expenses.
Due to the early stage of our product, we have only a limited history
from which to predict our revenue. This limited operating experience, combined
with the rapidly evolving nature of the storage networking infrastructure
software market in which we sell our products and other factors that are beyond
our control, reduces our ability to accurately forecast our quarterly and annual
revenue. However, we use our forecasted revenue to establish our expense budget.
Most of our expenses are fixed in the short term or incurred in advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.
Global economic conditions may continue to erode, which result in decreased
revenues.
The macroeconomic environment and capital spending on information
technology have continued to erode, resulting in continued uncertainty in our
revenue expectations. The operating results of our business depend on the
overall demand for storage networking infrastructure software. Because our sales
are primarily to major corporate customers whose businesses fluctuate with
general economic and business conditions, continued soft demand for storage
networking infrastructure software caused by a weakening economy and budgetary
constraints may result in decreased revenues. Customers may continue to defer or
reconsider purchasing our software if they continue to experience a lack of
growth in their business or if the general economy fails to significantly
improve, resulting in a lack of demand for our product.
The markets for storage area networks, network attached storage, and direct
attached storage are new and uncertain, and our business will suffer if they do
not develop as we expect.
15
The rapid adoption of Storage Area Networks (SAN), Network Attached
Storage (NAS), and Direct Attached Storage (DAS) storage solutions is critical
to our future success. The markets for SAN, NAS and DAS solutions are still
unproven, making it difficult to predict their potential sizes or future growth
rates. Most potential customers have made substantial investments in their
current storage networking infrastructure, and they may elect to remain with
current network architectures or to adopt new architecture, in limited stages or
over extended periods of time. We are uncertain whether a viable market for our
products will develop or be sustainable. If these markets fail to develop, or
develop more slowly than we expect, our business, financial condition and
results of operations would be adversely affected.
If we are unable to develop and manufacture new products that achieve acceptance
in the storage networking infrastructure software market, our operating results
may suffer.
The storage networking infrastructure software market continues to
evolve and as a result there is continuing demand for new products. Accordingly,
we may need to develop and manufacture new products that address additional
storage networking infrastructure software market segments and emerging
technologies to remain competitive in the data storage software industry. We are
uncertain whether we will successfully qualify new storage networking
infrastructure software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking infrastructure software products. Any failure to address
additional market segments could harm our business, financial condition and
operating results.
Our products must conform to industry standards in order to be accepted by
customers in our markets.
Our current products are only one part of a SAN, NAS or DAS storage
system. All components of these systems must comply with the same industry
standards in order to operate together efficiently. We depend on companies that
provide other components of these systems to conform to industry standards. Some
industry standards may not be widely adopted or implemented uniformly, and
competing standards may emerge that may be preferred by OEM customers or end
users. If other providers of components do not support the same industry
standards as we do, or if competing standards emerge, our products may not
achieve market acceptance, which would adversely affect our business.
Our complex products may have errors or defects that could result in reduced
demand for our products or costly litigation.
Our IPStor platform is complex and is designed to be deployed in large
and complex networks. Many of our customers have unique infrastructures, which
may require additional professional services in order for our software to work
within their infrastructure. Because our products are critical to the networks
of our customers, any significant interruption in their service as a result of
defects in our product within our customers' networks could result in lost
profits or damage to our customers. These problems could cause us to incur
significant service and warranty costs, divert engineering personnel from
product development efforts and significantly impair our ability to maintain
existing customer relationships and attract new customers. In addition, a
product liability claim, whether successful or not, would likely be time
consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.
Our OEM Customers require our products to undergo a lengthy and expensive
qualification process that does not assure product sales.
Prior to offering our products for sale, our OEM customers require that
each of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification of a product by an OEM does not assure
any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including sales, marketing and management efforts, toward
qualifying our products with OEMs in anticipation of sales to them. If we are
unsuccessful or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.
16
The storage networking infrastructure software market is highly competitive and
intense competition could negatively impact our business.
The storage networking infrastructure software market is intensely
competitive even during periods when demand is stable. Some of our current and
potential competitors have longer operating histories, significantly greater
resources, broader name recognition and a larger installed base of customers
than we have. Those competitors and other potential competitors may be able to
establish rapidly or to expand storage networking infrastructure software
offerings more quickly, adapt to new technologies and customer requirements
faster, and take advantage of acquisition and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us; or
o bundle their products with other products to increase demand for their
products.
In addition, some OEMs with whom we do business, or hope to do business, may
enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.
Our future quarterly results may fluctuate significantly, which could cause our
stock price to decline.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive
prices before we do;
o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;
o our customers canceling, rescheduling or deferring significant orders for
our products, particularly in anticipation of new products or enhancements
from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.
Our board of directors may selectively release shares of our common stock from
lock-up restrictions.
Currently, approximately 1.9 million shares of our common stock are
subject to contractual lock-up restrictions expiring on April 30, 2003, and
approximately 26.7 million shares of our common stock are subject to contractual
lock-up restrictions expiring on April 30, 2004. Our board of directors may, in
its sole discretion, release any or all of the shares of our common stock from
lock-up restrictions at any time with or without notice. Any release of such
shares from lock-up restrictions may be applied on a proportionate or selective
basis. If the release is selectively applied, the stockholders whose shares are
not released will be forced to hold such shares while other stockholders may
sell. In addition, the release of any of such shares could depress our stock
price. Our board of directors has agreed to a phased release of up to
17
approximately 1.5 million shares between November 1, 2002 and April 1, 2004,
from the shares that are subject to contractual lock-up restrictions expiring on
April 30, 2004.
Our stock price may be volatile
The market price of our common stock has been volatile in the past and
may be volatile in the future. For example, during the nine months ended
September 30, 2002, the market price of our common stock as quoted on the NASDAQ
National Market System fluctuated between $4.02 and $11.97. The market price of
our common stock may be significantly affected by the following factors:
o actual or anticipated fluctuations in our operating results;
o failure to meet financial estimates;
o changes in market valuations of other technology companies,
particularly those in the storage networking infrastructure software
market;
o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures or
capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
We have a significant amount of authorized but unissued preferred stock, which
may affect the likelihood of a change of control in our company.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Finally, we have entered into change of
control agreements with certain executives.
We have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders' percentage ownership of our common stock.
As of September 30, 2002, we have outstanding options to purchase an
aggregate of 8,108,334 shares of our common stock at a weighted average exercise
price of $3.47 per share.
The exercise of all of the outstanding options would dilute the
then-existing stockholders' percentage ownership of common stock, and any sales
in the public market of the common stock issuable upon such exercise could
adversely affect prevailing market prices for the common stock. In addition, the
existence of a significant amount of outstanding options may encourage short
selling by the option holders since the exercise of the outstanding options
could depress the price of our common stock. Moreover, the terms upon which we
would be able to obtain additional equity capital could be adversely affected
because the holders of such securities can be expected to exercise or convert
them at a time when we would, in all likelihood, be able to obtain any needed
capital on terms more favorable than those provided by such securities.
18
If we are unable to protect our intellectual property, our business will suffer.
Our success is dependent upon our proprietary technology. Currently,
the IPStor software suite is the core of our proprietary technology. We have
nine pending patent applications and twenty pending trademark applications
related to our IPStor product. We cannot predict whether we will receive patents
for our pending or future patent applications, and any patents that we own or
that are issued to us may be invalidated, circumvented or challenged. In
addition, the laws of certain countries in which we sell and manufacture our
products, including various countries in Asia, may not protect our products and
intellectual property rights to the same extent as the laws of the United
States.
We also rely on trade secret, copyright and trademark laws, as well as
the confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
Our technology may be subject to infringement claims that could harm our
business.
We may become subject to litigation regarding infringement claims
alleged by third parties. If an action is commenced against us, our management
may have to devote substantial attention and resources to defend these claims.
An unfavorable result for the Company could have a material adverse effect on
our business, financial condition and operating results and could limit our
ability to use our intellectual property.
Our efforts to protect our intellectual property may cause us to become involved
in costly and lengthy litigation, which could seriously harm our business.
In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights. Legal
proceedings could subject us to significant liability for damages or invalidate
our intellectual property rights. Any litigation, regardless of its outcome,
would likely be time consuming and expensive to resolve and would divert
management's time and attention. Any potential intellectual property litigation
against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual
property;
o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology or trademark, which
license may not be available on reasonable terms, or at all; or
o redesign those products that use infringing intellectual property or
cease to use an infringing trademark.
The loss of any of our key personnel could harm our business.
Our success depends upon the continued contributions of our key
employees, many of whom would be extremely difficult to replace. We do not have
key person life insurance on any of our personnel. Many of our senior management
and a significant number of our other employees have been with us for a short
period of time. Worldwide competition for skilled employees in the storage
networking infrastructure software industry is extremely intense. If we are
unable to retain existing employees or to hire and integrate new employees, our
business, financial condition and operating results could suffer. In addition,
companies whose employees accept positions with competitors often claim that the
competitors have engaged in unfair hiring practices. We may be the subject of
such claims in the future as we seek to hire qualified personnel and could incur
substantial costs defending ourselves against those claims.
Network Peripherals I nc. has liabilities and ongoing obligations to certain
customers and suppliers as a result of the winding down of its business.
Network Peripherals Inc. had existing agreements with certain
suppliers and customers. NPI may have liabilities to certain existing customers
and suppliers as a result of the termination of these agreements. While we are
19
taking steps to minimize any such potential liability, we cannot be sure that
our efforts to remove all such liability will be successful.
We may not successfully integrate the products, technologies or businesses from,
or realize the intended benefits of acquisitions.
We have made, and may continue to make, acquisitions of other
companies or their assets. Integration of the acquired products, technologies
and businesses, could divert management's time and resources. Further, we may
not be able to properly integrate the acquired products, technologies or
businesses, with our existing products and operations, train, retain and
motivate personnel from the acquired businesses, or combine potentially
different corporate cultures. If we are unable to fully integrate the acquired
products, technologies or businesses, or train, retain and motivate personnel
from the acquired businesses, we may not receive the intended benefits of the
acquisitions, which could harm our business, operating results and financial
condition.
Long term character of investments.
We made an investment in Network-1 Security Solutions, Inc. and were
required to record an impairment charge of $1.6 million from this investment in
the quarter ended September 30, 2002. Despite this loss, we may continue to make
equity investments in other entities (although we have no agreements,
commitments or understandings with respect to equity investments other than our
investment in Network-1 Security Solutions, Inc.). Our present and future equity
investments may never appreciate in value, and are subject to normal risks
associated with equity investments in businesses. These investments are new and
especially risky, and may involve technology risks as well as commercialization
risks and market risks. As a result, we may be required to write down some or
all of these investments in the future.
Unknown factors
Additional risks and uncertainties of which we are unaware or which currently we
deem immaterial also may become important factors that affect us.
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISKS. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities.
FOREIGN CURRENCY RISK. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. We do not use
derivative financial instruments to limit our foreign currency risk exposure.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
have evaluated the effectiveness of the design and operation of our disclosure
controls and procedures within 90 days of the filing date of this quarterly
report, and, based on their evaluation, our principal executive officer and
principal financial officer have concluded that these controls and procedures
are effective in timely alerting them to material information relating to the
Company (including its consolidated subsidiaries) required to be included in the
Company's periodic SEC filings. There were no significant changes in our
20
internal controls or in other factors that could significantly affect these
controls subsequent to the date of their evaluation.
Disclosure controls and procedures are our controls and other procedures
that are designed to ensure that information required to be disclosed by us in
the reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the
Securities and Exchange Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including our principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
99.1 Certification of the Chief Executive Officer.
99.2 Certification of the Chief Financial Officer.
(b) Reports on Form 8-K
On July 16, 2002, we filed a Form 8-K under Item 5.
21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FALCONSTOR SOFTWARE, INC.
/s/ ReiJane Huai
------------------------------------
ReiJane Huai
Chairman and Chief Executive Officer
/s/ Jacob Ferng
------------------------------------
Jacob Ferng
Chief Financial Officer and Vice President
(Principal Accounting Officer)
November 14, 2002
22
CERTIFICATIONS
I, ReiJane Huai, certify that:
1. I have reviewed this quarterly report on form 10-Q of FalconStor
Software, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusion about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which would adversely affect the registrants
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weakness in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
Date: November 14, 2002 /s/ ReiJane Huai
-------------------------
ReiJane Huai
Chief Executive Officer
23
I, Jacob Ferng, certify that:
1. I have reviewed this quarterly report on form 10-Q of FalconStor
Software, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusion about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which would adversely affect the registrants
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weakness in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
Date: November 14, 2002 /s/ Jacob Ferng
--------------------------------------
Jacob Ferng
Chief Financial Officer
24