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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 March 31, 2004
--------------------------------------------
/ / 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.)
2 Huntington Quadrangle
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 / /
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act). Yes /X/ No / /
THE NUMBER OF SHARES OF COMMON STOCK ISSUED AND OUTSTANDING AS OF MAY 3, 2004
WAS 46,698,941 WHICH INCLUDES REDEEMABLE COMMON SHARES.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Consolidated Financial Statements 3
Consolidated Balance Sheets at March 31, 2004
(unaudited) and December 31, 2003 3
Unaudited Consolidated Statements of Operations for the
three months ended March 31, 2004 and 2003 4
Unaudited Consolidated Statements of Cash Flows for the three
months ended March 31, 2004 and 2003 5
Notes to the Unaudited Condensed Consolidated
Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Item 3. Qualitative and Quantitative Disclosures about Market Risk 22
Item 4. Controls and Procedures 22
PART II. Other Information 23
Item 1. Legal Proceedings 23
Item 6. Exhibits and Reports on Form 8-K 23
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PART I. FINANCIAL INFORMATION
ITEM 1. Consolidated Financial Statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, 2004 December 31, 2003
-------------- -----------------
ASSETS (unaudited)
Current assets:
Cash and cash equivalents ................................................ $ 13,117,614 $ 8,486,144
Marketable securities .................................................... 22,537,598 28,199,242
Accounts receivable, net of allowances of $1,966,430 and
$1,837,934,respectively ................................................ 6,873,215 7,109,922
Prepaid expenses and other current assets ................................ 1,261,963 1,273,125
------------ ------------
Total current assets ............................................ 43,790,390 45,068,433
Property and equipment, net ................................................. 4,077,184 3,861,069
Goodwill .................................................................... 3,473,326 3,366,642
Other intangible assets, net ................................................ 368,831 396,940
Other assets ................................................................ 3,487,749 3,799,949
------------ ------------
Total assets .................................................... $ 55,197,480 $ 56,493,033
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ......................................................... $ 774,495 $ 562,305
Accrued expenses ......................................................... 2,592,876 2,777,391
Deferred revenue ......................................................... 2,712,131 2,202,179
------------ ------------
Total current liabilities ....................................... 6,079,502 5,541,875
Deferred revenue ............................................................ 582,191 395,609
------------ ------------
Total liabilities ............................................... 6,661,693 5,937,484
Commitments
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
46,927,341 and 46,745,330 shares issued, respectively ................. 46,927 46,745
Additional paid-in capital ............................................... 83,555,174 83,277,981
Deferred compensation .................................................... -- (7,969)
Accumulated deficit ...................................................... (33,285,096) (31,063,589)
Common stock held in treasury, at cost (235,000 shares) .................. (1,435,130) (1,435,130)
Accumulated other comprehensive loss ..................................... (346,088) (262,489)
------------ ------------
Total stockholders' equity ...................................... 48,535,787 50,555,549
------------ ------------
Total liabilities and stockholders' equity ...................... $ 55,197,480 $ 56,493,033
============ ============
See accompanying notes to unaudited consolidated financial statements.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
March 31,
2004 2003
---- ----
Revenues:
Software license revenue .................................. $ 3,547,831 $ 2,686,818
Maintenance revenue ....................................... 821,853 284,211
Software services and other revenue ....................... 889,114 707,878
------------ ------------
5,258,798 3,678,907
------------ ------------
Operating expenses:
Amortization of purchased and capitalized software ..... 415,048 283,741
Cost of maintenance, software services and other revenue 978,005 592,001
Software development costs ............................. 2,161,916 1,612,264
Selling and marketing .................................. 3,313,538 2,548,930
General and administrative ............................. 810,643 692,320
------------ ------------
7,679,150 5,729,256
------------ ------------
Operating loss ................................. (2,420,352) (2,050,349)
------------ ------------
Interest and other income ................................. 202,925 318,311
------------ ------------
Loss before income taxes ......................... (2,217,427) (1,732,038)
Provision for income taxes ................................ 4,080 6,815
------------ ------------
Net loss ......................................... $ (2,221,507) $ (1,738,853)
------------ ------------
Basic and diluted net loss per share ...................... $ (0.05) $ (0.04)
============ ============
Weighted average basic and diluted shares
outstanding ............................................ 46,638,740 45,499,862
============ ============
See accompanying notes to unaudited consolidated financial statements.
-4-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31,
2004 2003
Cash flows from operating activities:
Net loss ......................................... $ (2,221,507) $ (1,738,853)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization .............. 891,555 588,938
Non-cash professional services expenses .... 6,753 10,901
Equity-based compensation expense .......... 7,969 115,869
Changes in operating assets and liabilities:
Accounts receivable, net ................... 236,707 344,484
Prepaid expenses and other current assets .. 3,281 433,676
Other assets ............................... (65,465) (50,541)
Accounts payable ........................... 212,190 13,682
Accrued expenses ........................... (291,199) (44,974)
Deferred revenue ........................... 696,534 43,254
------------ ------------
Net cash used in operating activities ... (523,182) (283,564)
------------ ------------
Cash flows from investing activities:
Sale of marketable securities .................... 13,084,605 8,349,508
Purchase of marketable securities ................ (7,570,637) (2,300,000)
Purchase of property and equipment ............... (640,880) (690,047)
Purchase of software licenses .................... (25,000) (811,000)
Purchase of intangible assets .................... (23,634) (41,905)
Security Deposits ................................ (4,501) --
------------ ------------
Net cash provided by investing activities .... 4,819,953 4,506,556
------------ ------------
Cash flows from financing activities:
Proceeds from exercise of stock options .......... 270,622 102,056
------------ ------------
Net cash provided by financing activities ..... 270,622 102,056
------------ ------------
Cash flows from discontinued operations:
Payments of liabilities of discontinued operations -- (2,910,067)
------------ ------------
Effect of exchange rate changes on cash ............. 64,077 (5,437)
------------ ------------
Net increase in cash and cash equivalents ........... 4,631,470 1,409,544
Cash and cash equivalents, beginning of period ...... 8,486,144 14,191,075
------------ ------------
Cash and cash equivalents, end of period ............ $ 13,117,614 $ 15,600,619
============ ============
The Company did not pay any interest expense or income taxes for the three
months ended March 31, 2004 and 2003. See accompanying notes to unaudited
consolidated financial statements.
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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 network storage infrastructure software
solutions 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 months ended March 31, 2004 and 2003, included herein, have
been prepared, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission ("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 March 31, 2004 and the results of its operations for the three
months ended March 31, 2004 and 2003.
(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
$11.2 million and $8.2 million at March 31, 2004 and December 31, 2003,
respectively. Marketable securities at March 31, 2004 and December 31, 2003
amounted to $22.5 million and $28.2 million, respectively, and consisted of
corporate bonds and government securities, which are classified as available for
sale, and accordingly, unrealized gains and losses on marketable securities are
reflected as a component of accumulated other comprehensive loss in
stockholders' equity.
(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, the software is delivered
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. Costs of providing these
services are included in cost of revenues.
The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a software license to install the Company's software on
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certain hardware or to resell the Company's software in exchange for payments
based on the products distributed by the OEM or distributor. Nonrefundable
advances and engineering fees received by the Company from an OEM 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.
For the quarters ended March 31, 2003 and March 31, 2004, the Company had a
limited number of transactions in which it purchased hardware and bundled this
hardware with the Company's software and sold the bundled solution to its
customer. Since the software is not essential for the functionality of the
equipment included in the Company's bundled solutions, and both the hardware and
software have stand alone value to the customer, a portion of the contractual
fees is recognized as revenue when the software or hardware is delivered based
on the relative fair value of the delivered element(s).
(f) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years).
(g) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of the purchase price over the estimated
fair value of net tangible and identifiable intangible assets acquired in
business combinations. Consistent with Statement of Financial Accounting
Standards ("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has
not amortized goodwill related to its acquisitions, but instead tested the
balance for impairment. The Company's annual impairment assessment is performed
as of December 31st of each year, and additionally if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method. Amortization expense was $51,743 and $31,674 for
the three months ended March 31, 2004 and 2003, respectively. The gross carrying
amount and accumulated amortization of other intangible assets as of March 31,
2004 and December 31, 2003 are as follows:
March 31, December 31,
2004 2003
--------- ------------
Customer relationships and purchased technology:
Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (126,496) (108,425)
----------- -----------
Net carrying amount $ 90,354 $ 108,425
========== ===========
Patents and trademarks:
Gross carrying amount $ 415,865 $ 392,231
Accumulated amortization (137,388) (103,716)
---------- -----------
Net carrying amount $ 278,477 $ 288,515
========== ===========
(h) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY
Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility in
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs, of which $7,881 was amortized for the
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three months ended March 31, 2004 and 2003. Amortization of software development
costs is recorded at the greater of straight line over three years or the ratio
of current revenue of the related products to total current and anticipated
future revenue of these products.
Purchased software technology of $1,999,667 and $2,381,833, net of
accumulated amortization of $2,886,334 and $2,479,167, is included in other
assets in the balance sheets as of March 31, 2004 and December 31, 2003,
respectively. Amortization expense was $407,167 and $275,860 for the three
months ended March 31, 2004 and 2003, respectively.
(i) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
(j) LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. If the sum of the expected future cash flows, undiscounted and
without interest, is less than the carrying amount of the asset, an impairment
loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value.
(k) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, and related interpretations including FASB
Interpretation No. 44, ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING STOCK
COMPENSATION, AN INTERPRETATION OF APB OPINION NO. 25 to account for its
fixed-plan stock options. Under this method, compensation expense is recorded
only if on the date of grant the current market price of the underlying stock
exceeded the exercise price. SFAS No. 123, Accounting for Stock-Based
Compensation, established accounting and disclosure requirements using a
fair-value-based method of accounting for stock-based employee compensation
plans. As allowed by SFAS No. 123, the Company has elected to continue to apply
the intrinsic-value-based method of accounting described above, and has adopted
the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the
fair value method under SFAS No. 123, the Company's pro forma net loss and
diluted net loss per share would have been adjusted to the pro forma amounts
indicated below:
For the Three Months Ended March 31,
2004 2003
------------- -------------
Net loss as reported $ (2,221,507) $ (1,738,853)
Add stock-based employee compensation expense included
in reported net income, net of tax $ 7,969 $ 115,869
Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax $ (1,683,131) $ (1,317,042)
------------- -------------
Net loss - pro forma $ (3,896,669) $ (2,940,026)
============== =============
Basic net loss per common share-as reported $ (0.05) $ (0.04)
Basic net loss per common share- pro forma $ (0.08) $ (0.06)
-8-
The per share weighted average fair value of stock options granted was $6.43 and
$1.79 for the three months ended March 31, 2004 and 2003, respectively, on the
date of grant using the Black-Scholes option-pricing method with the following
weighted average assumptions:
2004 - expected dividend yield of 0%, risk free interest rate of 3%, expected
stock volatility of 160%, and an expected option life of five years for options
granted to employees of the Company, and an option life of ten years for options
granted to non-employees;
2003 - expected dividend yield of 0%, risk free interest rate of 3%, expected
stock volatility ranging from 68% to 153% and an expected option life of five
years for options granted to employees of the Company, and an option life of ten
years for options granted to non-employees;
(l) FINANCIAL INSTRUMENTS
As of March 31, 2004 and December 31, 2003, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.
(m) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations.
(n) 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 net losses for the periods presented, all common stock
equivalents were excluded from diluted net loss per share. As of March 31, 2004,
potentially dilutive common stock equivalents included 9,591,747 stock options
outstanding and 750,000 warrants outstanding.
(o) COMPREHENSIVE LOSS
Comprehensive loss amounted to $2,305,106 and $1,873,919 for the three
months ended March 31, 2004 and 2003, respectively. Comprehensive loss includes
the Company's net loss and foreign currency translation adjustments of $64,077
and $(5,437) for the three months ended March 31, 2004 and 2003, respectively.
Additionally, comprehensive loss includes the Company's unrealized losses on
marketable securities of $(147,676) and $(129,629) for the three months ended
March 31, 2004 and 2003, respectively.
(p) 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.
(q) NEW ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board ("FASB") determined
that stock-based compensation should be recognized as a cost in the financial
statements and that such cost be measured according to the fair value of the
-9-
stock options. The FASB has not as yet finalized the methodology for calculating
fair value and plans to issue an accounting standard that would become effective
in 2005. The Company will continue to monitor communications on this subject
from the FASB to determine the impact on the Company's consolidated financial
statements.
(r) RECLASSIFICATIONS
Certain reclassifications have been made to prior year's consolidated
financial statements to conform to the current year's presentation.
(2) 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 months
ended March 31, 2004 and March 31, 2003 and the location of long-lived assets as
of March 31, 2004 and December 31, 2003 are summarized as follows:
Three Months Ended March 31,
Revenues: 2004 2003
------------ ------------
United States $ 2,614,073 $ 2,301,566
Asia and other international $ 2,644,725 $ 1,377,341
------------ ------------
Total revenues $ 5,258,798 $ 3,678,907
============ ============
March 31, December 31,
2004 2003
-------- ------------
Long-lived assets (includes all non-current assets):
United States $ 10,327,104 $ 10,329,876
Asia and other international $ 1,079,986 $ 1,094,724
------------ ------------
Total long-lived assets $ 11,407,090 $ 11,424,600
============ ============
(3) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. As of March 31, 2004, the Company
repurchased a total of 235,000 shares for $1,435,130. The Company did not
purchase any shares in 2003 or the first quarter of 2004.
(4) CONTINGENCIES
Dot Hill Systems Corporation ("Dot Hill") has brought a third party action
against the Company alleging a right to be indemnified for certain potential
liabilities in a patent infringement action by Crossroad System (Texas), Inc.
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("Crossroad") against Dot Hill in the United States District Court for the
Western District of Texas. In the underlying action, Crossroad alleges that
multiple products sold by Dot Hill, including two that incorporate software
licensed from the Company, infringe patents held by Crossroad. While the outcome
of litigation can never be predicted with certainty, the Company believes that
it has meritorious defenses to the claims asserted by Dot Hill and to the
underlying infringement claims. The Company intends to take any and all action
necessary to vigorously defend the Company's products.
In addition to the action discussed above, the Company is subject to
various legal proceedings and claims, asserted or unasserted, which arise in the
ordinary course of business. While the outcome of any such matters cannot be
predicted with certainty, the Company believes that such matters will not have a
material adverse effect on the Company's financial condition or operating
results.
-11-
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 CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.
OVERVIEW
Our revenue for the first quarter of 2004 increased 43% compared with the
same period last year and was also higher than our revenue in the last quarter
of 2003. Historically, overall spending on network storage industry products in
the first quarter of a calendar year has been lower than the spending in the
fourth quarter of the previous year. Our ability to increase revenue in the
first quarter demonstrates the continued momentum of our products.
Our deferred revenues also increased on both a first quarter 2004/first
quarter 2003 and a first quarter 2004/fourth quarter 2003 basis. We believe this
is an indicator of the health of our business because it reflects, in part,
maintenance renewals from satisfied customers.
Our expenditures in the first quarter of 2004 also increased as compared
with both the first quarter of 2003 and the fourth quarter of 2003. While we
strive to keep expense increases to a minimum, the increases we experienced
related primarily to the hiring of additional employees to develop our products,
to support our sales and to service our customers, and to investment in property
and equipment to support our expanding business.
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED MARCH 31, 2004 COMPARED TO
THE THREE MONTHS ENDED MARCH 31, 2003.
Revenues for the three months ended March 31, 2004 increased 43% to $5.3
million compared with $3.7 million for the three months ended March 31, 2003.
Our operating expenses increased 34% from $5.7 million for three months ended
March 31, 2003 to $7.7 million for the three months ended March 31, 2004. Net
loss increased 28% from $1.7 million for the three months ended March 31, 2003
to $2.2 million for the three months ended March 31, 2004. The increase in
revenues was mainly due to an increase in demand for our network storage
solution software. Over 80% of our revenues were generated from resellers and
distributors and the remaining revenue was derived from OEM partners. Expenses
increased in all aspects of our business to support our growth. In November,
2003 we moved our headquarters to a larger facility and for the three months
ended March 31, 2004, we increased the number of employees and continued to
invest in infrastructure by purchasing additional computers and equipment. Our
headcount increased from 145 employees as of March 31, 2003 to 187 employees as
of March 31, 2004.
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold through
our OEM's, value-added resellers and distributors to end users and, to a lesser
extent, directly to end users. These revenues are recognized when, among other
requirements, we receive a customer purchase order and the software and
permanent key codes are delivered to the customer. We also receive nonrefundable
royalty advances and engineering fees from some of our OEM partners. These
arrangements are evidenced by a signed customer contract, and the revenue is
recognized when the software product master is delivered and accepted, and the
engineering services, if any, have been performed.
-12-
Software license revenue increased 32% from $2.7 million for the three
months ended March 31, 2003 to $3.5 million for the three months ended March 31,
2004. Increased market acceptance and demand for our product were the primary
drivers of the increase in software license revenue. A continued increase in the
number of our channel partners and OEMs also helped increase our revenues. We
expect our software license revenue to continue to grow and the percentage of
software license revenue derived from our OEM partners to increase.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenues are comprised of
software maintenance and technical support, professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Revenue derived from maintenance and technical support
contracts is deferred and recognized ratably over the contractual maintenance
term. Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In the first three months of 2004, we had a limited number of
transactions in which we purchased hardware and bundled this hardware with our
software and sold the bundled solution to our customer. A portion of the
contractual fees is recognized as revenue when the hardware or software is
delivered to the customer based on the relative fair value of the delivered
element(s). Through March 31, 2004, the software and hardware in bundled
solutions have almost always been delivered to the customer in the same quarter.
Maintenance, software services and other revenue increased 72% to $1.7 million
for the three months ended March 31, 2004 from $1.0 million for the three months
ended March 31, 2003.
The major factor behind the increase in maintenance, software services and
other revenue was an increase in the number of maintenance and technical support
contracts we sold. As we are in business longer, and as we license more
software, we expect these revenues will continue to increase. The majority of
our new customers purchase maintenance and support and most customers renew
their maintenance and support after their initial contracts expire. Maintenance
revenue increased from $0.3 million for the three months ended March 31, 2003 to
$0.8 million for the three months ended March 31, 2004. Growth in our
professional services sales, which increased from $0.3 million for the three
months ended March 31, 2003 to $0.4 million for the three months ended March 31,
2004, also contributed to the increase in software services and other revenues.
This increase in professional services revenue was related to the increase in
our software license customers that elected to purchase professional services.
Additionally, our hardware sales increased from approximately $0.4 million for
the three months ended March 31, 2003 to approximately $0.5 million for the
three months ended March 31, 2004. This increase was the result of an increase
in demand from our customers for bundled solutions.
We expect maintenance, software services and other revenues to continue to
increase.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations we have purchased or licensed various software for resale since
2001. Amortization of purchased and capitalized software increased from $0.3
million for the three months ended March 31, 2003 to $0.4 million for the three
months ended March 31, 2004. The increase in amortization expense was due to our
purchase of an additional $1.0 million of software licenses subsequent to the
first quarter of 2003. As of March 31, 2004, we had $4.9 million of purchased
software licenses that are being amortized over three years. For the three
months ended March 31, 2004, we recorded $0.4 million of amortization related to
these purchased software licenses. As of March 31, 2003, we had $3.9 million of
purchased software licenses and recorded approximately $0.3 million of
amortization for the three months ended March 31, 2003 related to these
purchased software licenses. We will continue to evaluate third party software
licenses and may make additional purchases, which would result in an increase in
amortization expense.
The Company did not capitalize any software development costs until our
initial product reached technological feasibility in March 2001. At that point,
we capitalized $0.1 million of software development costs, which are being
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amortized at the greater of straight line over three years or the ratio of
current revenue of the related products to total current and anticipated future
revenue of these products. Amortization of capitalized software costs was $7,881
for the three months ended March 31, 2004 and 2003.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues consists
primarily of personnel and other costs associated with providing software
implementations, technical support under maintenance contracts, and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware purchased for resale. Cost of maintenance, software services and
other revenues for the three months ended March 31, 2004 increased by 65% to
$1.0 million compared with $0.6 million for the three months ended March 31,
2003. The increase in cost of maintenance, software services and other revenue
was partially due to an increase in personnel. As a result of our increased
sales of maintenance and support contracts and professional services, we
required a higher number of employees to provide technical support and to
implement our software. In addition, due to an increase in hardware sales, our
hardware costs for resale increased by $0.1 million for the three months ended
March 31, 2004 compared to the three months ended March 31, 2003. Our cost of
maintenance, software services and other revenue will continue to grow in
absolute dollars as our revenue increases.
Gross profit for the three months ended March 31, 2004 was $3.9 million or
74% of revenues compared with $2.8 million or 76% of revenues for the three
months ended March 31, 2003. The increase in gross profit was directly related
to the increase in revenues. The decrease in gross margins was primarily due to
the increase in amortization of purchased software licenses and was also
partially related to margins on increased hardware sales, which are typically
lower than the margins on software licenses and services.
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 34% to $2.2 million
for the three months ended March 31, 2004 from $1.6 million for the three months
ended March 31, 2003. The increase in software development costs was primarily
due to an increase in employees required to enhance and test our core network
storage software product, as well as to develop new innovative features and
options. In addition, as we entered into agreements with new OEM partners, we
required additional employees to test and customize our software with our OEM
partners' products. In the fourth quarter of 2003, we opened a development
office in China to assist in our development efforts which also contributed to
the increase in software development costs. We intend to continue recruiting and
hiring product development personnel to support our development process.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, travel, public relations expense, marketing
literature and promotions, commissions, trade show expenses, and the costs
associated with our foreign sales offices. Selling and marketing expenses
increased 30% to $3.3 million for the three months ended March 31, 2004 from
$2.5 million for the three months ended March 31, 2003. As a result of the
increase in revenue and interest in our software, our commission expense and
travel expenses increased. In addition, we continued to hire new sales and sales
support personnel and expand our worldwide presence to accommodate our revenue
growth. We believe that to continue to grow sales, our sales and marketing
expenses will continue to increase.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel costs
of general and administrative functions, public company related costs, directors
and officers insurance, legal and professional fees, and other general corporate
overhead costs. General and administrative expenses increased 17% to $0.8
million for the three months ended March 31, 2004 from $0.7 million for the
three months ended March 31, 2003. The increase in general and administrative
expenses was primarily due to an increase in headcount as well as an increase in
amortization related to patents.
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INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
decreased 36% to $0.2 million for the three months ended March 31, 2004 from
$0.3 million for the three months ended March 31, 2003. This decrease in
interest income was due to lower interest rates and lower average cash, cash
equivalent and marketable securities balances.
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 March 31, 2004, as we
deemed that it was more likely than not that the deferred tax assets will not be
realized based on our early stage operations. Accordingly, we provided a full
valuation allowance against our net deferred tax assets. Our income tax
provision consists of tax liabilities related to our foreign subsidiaries.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents totaled $13.1 million and marketable
securities totaled $22.5 million at March 31, 2004. As of March 31, 2003, we had
approximately $15.6 million in cash and cash equivalents and $30.7 million in
marketable securities. The reasons for this decrease in cash and cash
equivalents and marketable securities are discussed below. Because we have not
yet been profitable, the major use of our cash has been to fund operations.
Until we reach profitability, we will continue to use our cash to fund
operations.
In November, 2003 we moved our headquarters to a larger facility. We
continued to invest in our infrastructure to support our long-term growth during
the three months ended March 31, 2004. We made investments in property and
equipment and we increased the number of employees during the first quarter of
2004.
We currently do not have any debt and our only material commitments are
related to our office leases.
In connection with our acquisition of IP Metrics in July 2002, we must
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. In 2003, we made payments to
the former shareholders of IP Metrics totaling $287,130. As of March 31, 2004,
we accrued $0.2 million of additional purchase consideration related to sales of
IP Metrics products.
In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding common stock. Since October 2001, 235,000
shares have been repurchased at an aggregate purchase price of $1.4 million. No
shares were repurchased in 2003 or in the first quarter of 2004.
Net cash used in operating activities totaled $0.5 million for the three
months ended March 31, 2004. This was primarily a result of our net loss of $2.2
million, an increase in other assets and a decrease in accrued expenses. These
amounts were partially offset by non-cash charges of $0.9 million consisting of
depreciation and amortization, non-cash professional services expenses, and
equity-based compensation. Additional offsetting amounts include decreases in
accounts receivable, prepaid expenses and other current assets, and increases in
accounts payable and deferred revenue. Net cash used in operating activities for
the three months ended March 31, 2003 was $0.3 million. The cash used in
operating activities for the three months ended March 31, 2003 was mainly
comprised of our net loss of $1.7 million, an increase in other assets and a
decrease in accrued expenses. These amounts were partially offset by non-cash
charges of $0.7 million consisting of depreciation and amortization, non-cash
professional services expenses, and equity-based compensation. Additional
offsetting amounts include decreases in accounts receivable, prepaid expenses
and other current assets and increases in accounts payable and deferred revenue.
Net cash provided by investing activities was $4.8 million for the three
months ended March 31, 2004, due primarily to net sales of marketable securities
of $5.5 million. This amount was partially offset by purchases of property and
equipment of $0.6 million and purchases of intangible assets of $0.1 million.
Net cash used in investing activities was $4.5 million for the three months
ended March 31, 2003, due primarily to net sales of marketable securities of
$6.0 million. This amount was partially offset by purchases of property and
equipment of $0.7 million and purchases of software licenses of $0.8 million.
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Net cash provided by financing activities was $0.3 million and $0.1
million for the three months ended March 31, 2004 and 2003, respectively. These
amounts were related to the exercise of stock options.
Our only material contractual obligations relate to our operating leases.
We have an operating lease covering our primary office facility that expires in
February, 2012. We also have several operating leases related to a second
domestic office and offices in foreign countries. The expiration dates for these
leases range from 2004 through 2012.
For the three months ended March 31, 2003 we paid $2.9 million related to
discontinued operations. As of December 31, 2003, all significant liabilities
related to our discontinued operations had been paid.
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 April 2003, the Financial Accounting Standards Board ("FASB")
determined that stock-based compensation should be recognized as a cost in the
financial statements and that such cost be measured according to the fair value
of the stock options. The FASB has not as yet finalized the methodology for
calculating fair value and plans to issue an accounting standard that would
become effective in 2005. We will continue to monitor communications on this
subject from the FASB to determine the impact on our consolidated financial
statements.
RISK FACTORS
WE HAVE HAD LIMITED REVENUES AND A HISTORY OF LOSSES, AND WE MAY NOT ACHIEVE OR
MAINTAIN PROFITABILITY.
We have had limited revenues and a history of losses. For the year ended
December 31, 2003 and the three months ended March 31, 2004, we had revenues of
$16.9 million and $5.3 million, respectively. For the period from inception
(February 10, 2000) through March 31, 2004, for the fiscal year ended December
31, 2003 and for the three months ended March 31, 2004, we had net losses of
$33.3 million, $7.4 million and $2.2 million, 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, although we are unable to predict whether we will be profitable. Our
business model depends upon signing agreements with additional OEM customers,
further developing our reseller sales channel, and expanding our 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 network storage 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.
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WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.
During the third quarter of 2003, we signed a lease for new office space
that commenced on November 1, 2003 and continues through February, 2012. The
lease obligations are substantially greater than our prior lease obligations.
This commitment could impact our ability to achieve or to maintain
profitability.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE
INFRASTRUCTURE SOFTWARE MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING
REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage 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.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall demand
for network storage infrastructure software. Because our sales are primarily to
major corporate customers, any softness in demand for network storage
infrastructure software may result in decreased revenues.
THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE NEW AND
UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT DEVELOP AS WE EXPECT.
The rapid adoption of Storage Area Networks (SAN) and Network Attached
Storage (NAS) solutions is critical to our future success. The markets for SAN
and NAS 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 NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET, OUR OPERATING RESULTS MAY
SUFFER.
The network storage 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 network
storage 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 network storage 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 or NAS 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
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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.
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with our resellers and OEM partners to
develop storage appliances that combine certain aspects of IPStor functionality
with third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. If the storage appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales would be impacted negatively.
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.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products by
our OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage infrastructure software market and in other markets. The OEM
customers and resellers may choose to focus their sales efforts on other
products in the network storage infrastructure software market or other markets.
The OEM customers might also choose not to continue to develop or to market
products which include our products. This would likely result in lower revenues
to us and would impede our ability to grow our business.
ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.
As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.
WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.
Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. We cannot guarantee that our current strategic partners, or
those companies with whom we may partner in the future, will continue to be our
partners for any period of time.
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THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND
INTENSE COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage 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 or to expand network storage 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 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 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 past twelve months ended
March 31, 2004, the market price of our common stock as quoted on the NASDAQ
National Market System fluctuated between $3.56 and $10.32. 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;
-19-
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 AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.
As of March 31, 2004, we had outstanding options and warrants to purchase
an aggregate of 10,341,747 shares of our common stock at a weighted average
exercise price of $4.37 per share. We also have 1,310,855 shares reserved for
issuance under our stock option plans with respect to options that have not been
granted.
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. 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.
IF WE ARE REQUIRED TO RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN
EXPENSE, OUR RESULTS OF OPERATIONS WILL BE IMPACTED NEGATIVELY.
The Financial Accounting Standards Board ("FASB") has formally proposed to
require companies to recognize the fair value of stock options and other
stock-based compensation to employees as compensation expense in the statement
of operations for the 2005 reporting periods. The methodology for valuing stock
options or other stock-based compensation has not yet been finalized. If the
FASB proposal is adopted, there will be a negative impact on our results of
operations.
OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS
In August, 2003, our business was interrupted due to a large scale
blackout in the northeastern United States. While our new facilities contain
redundant power supplies and generators, our operations, and the operations of
our industry partners, remain susceptible to fire, floods, power loss, power
shortages, telecommunications failures, break-ins and similar events.
Terrorist actions domestically or abroad could lead to business
disruptions or to cancellations of customer orders or a general decrease in
corporate spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.
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THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.
We sell our products worldwide. Accordingly, our operating results could
be materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.
Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.
Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.
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 one
patent issued, multiple pending patent applications, numerous trademarks
registered and multiple 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 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 product or 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. Worldwide competition for skilled
employees in the network storage 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.
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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.
IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.
The preparation of consolidated financial statements and related
disclosure in accordance with generally accepted account principles requires
management to establish policies that contain estimates and assumptions that
affect the amounts reported in the consolidated financial statements and the
accompanying notes. Note 1 to the Consolidated Financial Statements in this
Quarterly Report on Form 10-Q describes the significant accounting policies
essential to preparing our financial statements. The preparation of these
financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosures. We base our estimates on historical experience and assumptions that
we be believe to be reasonable under the circumstances. Actual future results
may differ materially from these estimates. We evaluate, on an ongoing basis,
our estimates and assumptions.
LONG TERM CHARACTER OF INVESTMENTS.
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 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 as of the end of the period covered by this report, and,
based on their evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. No changes in the Company's internal controls over financial
reporting occurred during the quarter ended March 31, 2004, that have materially
affected, or are reasonably likely to materially affect, the Company's internal
controls over financial reporting.
Disclosure controls and procedures are 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,
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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 1. LEGAL PROCEEDINGS
Dot Hill Systems Corporation ("Dot Hill") has brought a third party action
against us alleging a right to be indemnified for certain potential liabilities
in a patent infringement action by Crossroad System (Texas), Inc. ("Crossroad")
against Dot Hill in the United States District Court for the Western District of
Texas. In the underlying action, Crossroad alleges that multiple products sold
by Dot Hill, including two that incorporate software licensed from us, infringe
patents held by Crossroad. While the outcome of litigation can never be
predicted with certainty, we believe that we have meritorious defenses to the
claims asserted by Dot Hill and to the underlying infringement claims. We intend
to take any and all action necessary to vigorously defend our products.
In addition to the action discussed above, we are subject to various legal
proceedings and claims, asserted or unasserted, which arise in the ordinary
course of business. While the outcome of any such matters cannot be predicted
with certainty, we believe that such matters will not have a material adverse
effect on our financial condition or operating results.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
31.1 Certification of the Chief Executive Officer
31.2 Certification of the Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
(18 U.S.C.ss.1350)
32.2 Certification of Chief Financial Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
(18 U.S.C.ss.1350)
99.1 Change of Control Contract dated February 2, 2004
between the Company and James Weber.
(b) Reports on Form 8-K
On February 4, 2004, we filed a Form 8-K under Items 5, 7 and
12.
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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/ James Weber
-----------------------------
James Weber
Chief Financial Officer,
Vice President and Treasurer
(Principal Accounting Officer)
May 10, 2004
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