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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
- TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____ TO _____.
Commission file number: 0 - 27794
SEGUE SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
Delaware 95-4188982
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
201 Spring Street, Lexington, Massachusetts 02421
(Address of principal executive offices)
Registrant's telephone number, including area code: (781) 402-1000
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment of this
Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant was approximately $70,518,795, as of March 31, 1999, based upon
the closing sale price of Common Stock reported for that date on the NASDAQ
National Market. Shares of Common Stock held by each officer and director and by
each person who owns 5% or more of the outstanding Common Stock have been
excluded because such persons may be deemed to be affiliates. This determination
of affiliate status is not necessarily a conclusive determination for other
purposes.
The number of shares of Registrant's Common Stock outstanding as of March
31, 1999 was 8,993,540.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed pursuant to
Regulation 14A for Registrant's 1999 Annual Meeting of Stockholders to be held
on June 4, 1999, are incorporated by reference into Part III of this Annual
Report on Form 10-K.
SEGUE SOFTWARE, INC.
FORM 10-K
TABLE OF CONTENTS
Page
PART I
Item 1. Business 2
Item 2. Properties 9
Item 3. Legal Proceedings 9
Item 4. Submission of Matters to a Vote of Security Holders 9
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters 10
Item 6. Selected Financial Data 12
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 14
Item 7a. Quantitative and Qualitative Disclosures about Market Risk 32
Item 8. Financial Statements and Supplementary Data 32
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 32
PART III
Item 10. Directors and Executive Officers of the Registrant 33
Item 11. Executive Compensation 33
Item 12. Security Ownership of Management and Certain Beneficial Owners 33
Item 13. Certain Relationships and Related Transactions 33
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 34
1
Statements made or incorporated in this Form 10-K include a number of
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. Forward-
looking statements include, without limitation, statements containing the words
"anticipates", "believes", "expects", "intends", "future" and words of similar
import which express management's belief, expectations or intentions regarding
the future performance of Segue Software, Inc. and its subsidiaries (hereafter,
collectively, ''Segue'' or the ''Company''). The Company's actual results could
differ materially from those set forth in the forward-looking statements.
Certain factors that might cause such a difference are discussed in the section
entitled "Certain Factors Affecting Future Operating Results" on page 25 of this
Form 10-K.
PART I
ITEM 1. BUSINESS
GENERAL
The Company develops, markets and supports software products, and provides
related professional services, for the management and testing of electronic
business ("e-business") applications. Segue was incorporated in California in
1988 and reincorporated in Delaware in March 1996. The Company's products are
used by webmasters, quality assurance professionals and software developers to
improve software quality, reduce development costs, manage the vast and growing
number of application components, and shorten the time required to develop and
deploy these mission-critical applications. The Company's products provide a
solution designed to assemble, model, deploy, monitor and analyze electronic
commerce ("e-commerce") systems as well as to provide automated functional and
load testing of applications deployed on the World Wide Web and on client/server
systems.
During 1997, Segue introduced new technology to provide automated software
testing for Web-enabled software applications, extending the Company's
distributed testing capabilities beyond distributed client/server applications
with GUI front ends. In addition, in 1997, the Company began to focus on load
testing through an OEM/reseller arrangement with a third party software vendor.
On December 30, 1997, the Company acquired both the third party software vendor
and the developer of the product, SQLBench International, Inc. and ARC - Dr.
Ambichl & Dr. Reindl Communication GmbH (formerly named ARC Dr. Ambichl & Dr.
Reindl OEG), hereafter referred to as "SQLBench" (see Note 2 to the Consolidated
Financial Statements).
In the second quarter of 1998, the Company introduced "LiveQuality", an e-
business scenario testing solution, and continued its strategic transition from
general software testing to the more specialized world of e-business testing. In
the fourth quarter of 1998, the Company added to its e-business product line
with the acquisitions of Eventus Software, Inc. ("Eventus") and Black & White
Software, Inc. ("B&W"), providing the Company with tools that assist in the
assembly and deployment of sophisticated e-business applications and diagnose
and monitor communications between distributed application objects (see Note 2
to the Consolidated Financial Statements). The Company's e-business software
revenue was 61% and 33% of total software revenue for the years ended December
31, 1998 and 1997, respectively. The Company's
2
client/server products, its historical core product line, represented 39% and
67% of total software revenue for the years ended December 31, 1998 and 1997,
respectively.
The Company has implemented a program of extensive training of its sales
organization of its existing and newly acquired products.
During the first quarter of 1999, the Company began to execute a
restructuring plan to consolidate its marketing, product development and
administrative operations in order to achieve cost efficiencies through the
elimination of redundant functions. The Company realigned its marketing and
product development operations to redirect focus on its strongest product lines
and better integrate the efforts of certain product development teams. The
Company expects to recognize a one-time pre-tax charge of approximately $1.0
million during the first quarter of 1999 related to the restructuring plan. The
restructuring charge includes approximately $830,000 for severance and other
employee-related costs of the terminated staff and approximately $190,000 for
facility-related costs, including the accrual of estimated lease obligations
associated with the closure of excess office facilities.
The Company believes that there is an opportunity for an e-business
management methodology that ensures software reliability across current and
future computing paradigms.
INDUSTRY BACKGROUND
Companies worldwide are rapidly implementing e-business applications that
customers can access twenty-four hours a day, seven days a week. As businesses
expand the use of technology to manage information and processes, and as
software has become a more important component in the delivery of products and
services, consistent and effective operation of software applications has become
more critical to their success. While the real-time communication prompted by
e-business has created constant access to a company's services and products, it
also brings with it constant exposure. This exposure is forcing companies to re-
think the stability of their systems, as the cost of an unexpected shutdown
would cripple even the strongest of organizations.
Unlike mainframe environments, where applications, operating systems and
hardware were designed by a single vendor as an integrated solution, or
traditional client/server systems, where application development follows a
process of specify, design, develop, test and release, Web-based systems are
developed across many different functional areas in an organization, are
designed in component fashion and are continuously being assembled, validated
and deployed based on market conditions. In addition, Web-based systems consist
of component layers of applications, middleware, operating systems, databases,
browsers, servers, and processors and network technology designed separately by
multiple vendors. For example, in a Web-based configuration, a browser might
access a Netscape Web server that then sends requests to a router installed on a
Microsoft NT server that distributes the requests to an Oracle database located
on a Sun Solaris server. There is a higher probability for application
instability or failure when the component layers of Web-based applications are
developed separately by multiple vendors and integrated to form a business
system.
3
Web applications present enormous challenges to webmasters, quality
assurance professionals and software developers. These challenges include
integrating the efforts of many diverse contributors, managing a large and
growing number of varied application components, and keeping applications up-to-
date with changing content while simultaneously maintaining system reliability
and accuracy.
Traditional automated functional and regression testing tools, which are
designed for a specific component on a particular platform, do not adequately
address the complexities of distributed computing. First, they are not designed
to validate distributed application logic and data. Second, tests created by
these tools become obsolete when a component is replaced or upgraded. Third,
traditional automated functional and regression testing tools are unable to
recover when a bug is encountered in the component being tested, meaning that
truly unattended testing in a distributed environment is impossible with such
tools. Finally, they do not deliver the capability to design, create, manage
and reuse tests across multiple platforms and system configurations, resulting
in additional costs and time spent on the software development and quality
assurance processes.
As businesses move mission-critical applications to the Internet to give
customers greater access to such applications, such businesses need to test and
measure the true capacity and scalability of web applications in order to avoid
shutdowns, delays and other problems, and provide quality service. Such tests
should help users determine whether (i) web applications scale with anticipated
Internet volume, (ii) such applications can operate with little or no downtime,
and (iii) new content can be deployed quickly and reliably. By building load
testing into the application testing process early in the development cycle, the
performance of the application in a "real world" environment can be tested
before the application is deployed and exposed to real customers.
PRODUCTS
Segue provides a full suite of products and services, known as the
"LiveQuality E-Business Management System" (EBMS), designed to manage the
growing complexities of today's continuously deployed e-business systems. With
LiveQuality EBMS, companies can assemble, test, model, deploy, monitor and
analyze their integrated e-business applications to ensure continued system
quality and reliability, while accelerating time to market and reducing
implementation cost. In addition, the Company continues to support its legacy
client/server automated testing tools.
LIVEQUALITY E-BUSINESS MANAGEMENT SYSTEM PRODUCTS
SILKCONTROL is an enterprise content management product that helps users to
assemble diverse Web components, such as HTML, Java, JavaScript, Cascading Style
Sheets, XML, Active Server Pages and media components. The SilkControl
environment consists of a repository and multithreaded consoles that accommodate
hundreds of contributors and allow webmasters to manage multiple applications
with tens of thousands of components and provides concurrency control to prevent
overwriting of other's work and ensure the reliability of Web-based
applications. SilkControl allows for the selection and scheduling of objects for
deployment across a variety of Web and application servers.
4
SILKRADAR is a defect-tracking product used to track and manage errors in
software projects and provides the ability to associate test scenarios and known
defects to each component.
SILKTEST is an automated functional and regression testing tool for end-to-
end testing of enterprise Web applications. SilkTest includes a recovery system
that supports unattended testing 7 days a week, 24 hours a day. SilkTest is a
test planning and management tool, creating customized test plans for particular
applications and managing the testing process from a central point of control.
SilkTest also directly accesses a database, using SQL calls, to verify accurate
database content. By providing test scripts with direct ODBC standard access to
over 35 databases, SilkTest helps ensure that client/server applications
function with the associated database reliably before it deploys. SilkTest can
run across multiple platforms, technologies, browsers and environments.
SILKPERFORMER uses load testing technology to simulate real-world
conditions to help users predict capacity, scalability and performance problems
during their development process. SilkPerformer captures and simulates Web and
application server protocols including HTTP, HTTPS, FTP, POP3, LDAP, SMTP and
IIOP at varying connection speeds, from 14.4 kbs through ISDN, T1 and other
high-speed connections.
SILKPILOT provides object-level transaction validation for debugging and
testing of objects in a CORBA-based distributed environment.
SILKREALIZER models the effects on business processes under real-world
conditions such as unpredictable user loads, rapid content change, or event-
triggered volume.
SILKMETER manages the deployment and authorized usage of distributed
objects for the purpose of monitoring and billing.
SILKOBSERVER offers diagnostic and trace mechanisms for the effective
monitoring of communications between distributed application objects. It
monitors and tracts individual and group transactions, and verifies travel time,
transaction accuracy, and resource utilization.
CLIENT/SERVER TESTING PRODUCTS
QA PARTNER is an automated functional and regression testing tool for end-
to-end testing of cross-enterprise client/server applications. QA Partner
includes a recovery system that supports unattended testing 7 days a week, 24
hours a day. QA Partner runs across multiple platforms, technologies and
environments.
QA PERFORMER uses load testing technology to simulate real-world conditions
to help users predict capacity, scalability and performance problems during
their development process. QA Performer assists the user in modeling performance
improvements before incurring the cost of application rework. From database
design through to deployment, QA Performer tests mission-critical client/server
applications under challenging conditions.
5
SERVICES
The Company supplements its product offerings with training, consulting and
technical support services. The Company's services are designed to promote a
clear and consistent approach to the Company's solution and to facilitate the
penetration of the Company's products into a broader market. As of February 28,
1999, these services were provided by approximately 50 employees.
Training and Consulting. The Company offers training courses and
consulting services, performed by the Company and third party consultants, in
support of its products. The training courses are held regionally in selected
U.S. cities or at the customer site. The Company has two principal objectives
for its fee-based training courses and consulting services: to produce the
agreed-upon deliverables for the projects and to enhance the customers'
understanding of the Company's methodologies and techniques.
Support Services. The Company offers annual maintenance contracts for a
fee to customers who have entered into license agreements for the use of the
Company's software products. The Company provides customer service and support
through its internal technical support organization. Support services include
the maintenance of the Company's software products in accordance with
specifications contained in the user's guide for such products and access to
technical support personnel. This support includes technical support through
the Company's internal customer support group via phone, fax and e-mail
communications. Customers who are under an active software maintenance contract
are entitled to product upgrades and enhancements, when and if released. The
Company's distributors and some of its channel partners provide initial
telephone support to end-users. The Company currently provides these services
from its Lexington facility; however, Segue will also provide these services
from its global technical support center in Belfast, Ireland, which is scheduled
to open in the third quarter of 1999.
SALES AND MARKETING
The Company sells its products through four channels: a direct sales force;
telesales representatives; a channel partner program; and international
distributors and resellers. The Company has made a significant investment in
sales and marketing in each of the last three years. As of February 28, 1999,
the Company's sales and marketing force consisted of approximately 120
employees.
Direct Sales. In the fourth quarter of 1997, the Company began focusing
its marketing and sales efforts on the e-commerce and Internet applications
market with a solution sales approach for its customers. The Company has
structured its direct sales force into an enterprise sales group consisting of
teams of one strategic sales representative and one technical support engineer.
The direct sales force focuses on large enterprise and strategic sales. As of
February 28, 1999, the Company's direct sales force consisted of approximately
50 employees. The Company has eleven sales offices throughout the United States
and Canada and one sales office in each of the United Kingdom and Germany. The
Company intends to hire additional sales and support personnel to broaden its
direct selling and distribution capabilities.
6
Telesales. The Company's telesales organization responds to incoming
inquiries generated by the Company's advertising and marketing activities.
Telesales representatives also initiate calls to existing customers, offering
them new products. As of February 28, 1999, the Company's telesales force
totaled approximately 15 employees.
Channel Partner Programs. The Company has established an indirect sales
channel of value added resellers and system integrators including Andersen
Consulting, Arthur Andersen LLP, PricewaterhouseCoopers LLP and IBM Global
Systems. In early 1999, the Company implemented a comprehensive Global Channel
Partner program to target top resellers, system integrators and consulting
partners, resulting in recent partnership agreements with Netscape, IONA and
Platinum Technology. As of February 28, 1999, the Company's internal channel
sales force totaled approximately 25 employees.
International Sales. In international markets, the Company utilizes
distributors in nine countries that are supported by approximately 10 employees
in the Company's international sales organization. The Company derived
approximately 16%, 10%, and 7% of its total software revenue from international
customers in 1998, 1997 and 1996, respectively.
In support of its sales efforts, the Company conducts sales training
courses, targeted marketing programs, including direct mail, public relations,
advertising, seminars, trade shows and telemarketing, and ongoing customer and
third party communications programs. The Company also seeks to stimulate
interest in its products through a public relations program, speaking
engagements, white papers, technical notes and other publications. The Company
has a home page on the Internet's World Wide Web, where potential customers can
access information about the Company and its products.
BACKLOG
The time between order and delivery of the Company's products is generally
short. The number of orders, as well as the size of individual orders, can vary
substantially from month to month. Because of the short period between order
receipt and shipment of products, the Company typically does not have a backlog
of unfilled orders.
RESEARCH AND DEVELOPMENT
The Company has made substantial investments in research and product
development. The Company's research and development is conducted by project
teams consisting of development and quality assurance engineers, technical
writers and product managers. The Company uses many of its own products and
methodologies in its development process. The Company organizes development and
quality assurance schedules to optimize usage of automated tests by starting
script development very early in the development life cycle. The Company's
research and development staff originates, produces and tests many of the
Company's prototype products. The research and development department consults
with the Company's sales and marketing staff and utilizes the feedback from
customer support and training to ensure the satisfaction of its current
customers. The Company also licenses technology from vendors to be embedded in
its product for resale or to be resold as products by the Company.
7
The Company's primary research and development group is located at
corporate headquarters in Lexington, Massachusetts. The Company also has
development operations in Austria and Northern California. The majority of the
Northern California employees joined the Company as part of the December 1998
acquisitions of Eventus and B&W (see Note 2 to the Consolidated Financial
Statements). As of February 28, 1999, the Company had approximately 85
employees in research and development. The Company intends to continue making
significant investments in research and development to develop new products,
expand the capabilities of its Web application testing products and to
internationalize the Company's products.
COMPETITION
The market for software quality management tools is new, intensely
competitive, rapidly evolving and subject to rapid technological change. The
Company's competitors offer a variety of products and services to address this
market. The Company currently encounters direct competition from a number of
public and private companies such as Mercury Interactive Corporation, Rational
Software Corporation and Compuware Corporation. In addition, the possible
entrance of new competitors may intensify competition in the software quality
management market. Many of the Company's current and possible future
competitors have significantly greater financial, technical, marketing and other
resources than does the Company, and many have well established relationships
with current and potential customers of the Company. It is also possible that
alliances among competitors may emerge and rapidly acquire significant market
share. The Company also expects that competition will increase as a result of
software industry consolidations. Increased competition may result in price
reductions, reduced gross margins and loss of market share, any of which would
materially adversely affect the Company's business, operating results and
financial condition. There can be no assurance that the Company will be able to
compete effectively against current and future competitors.
The Company believes that the principal competitive factors affecting its
market include product features and functionalities such as flexibility,
scalability, ease-of-integration, ease-of-implementation, ease-of-use, quality,
performance, price and total cost of ownership; customer service and support;
company reputation and financial viability; and effectiveness of sales and
marketing efforts. Although the Company believes that it currently competes
effectively with respect to such factors, there can be no assurance that the
Company will be able to maintain its competitive position against current and
potential competitors.
PROPRIETARY TECHNOLOGY
The Company primarily relies upon a combination of trademark, copyright and
trade secret laws and employee and third-party non-disclosure agreements to
protect its proprietary rights in its products. The Company has one patent, but
there can be no assurance that this patent would be upheld if challenged. There
can be no assurance that the Company's competitors will not independently
develop technologies that are substantially equivalent or superior to the
Company's technology. There can also be no assurance that the measures taken by
the Company to protect its proprietary rights will be adequate to prevent
misappropriation of the technology or independent development by others of
similar technology. In addition, the laws of various countries in which the
Company's products may be sold may not protect the Company's products and
intellectual property rights to the same extent as the laws of the United
States. There can be
8
no assurance that third parties will not assert intellectual property
infringement claims against the Company or that any such claims will not require
the Company to enter into royalty arrangements or result in costly litigation.
The Company is not aware of any patent infringement charge or any violation of
other proprietary rights claimed by any third party relating to the Company or
the Company's products. However, the computer software market is characterized
by frequent and substantial intellectual property litigation. Intellectual
property litigation is complex and expensive, and the outcome of such litigation
is difficult to predict. The Company believes that, due to the rapid pace of
technological innovation for software quality management products, the Company's
ability to establish and maintain a position of technology leadership in the
industry is dependent more upon the skills of its development personnel than
upon the legal protections afforded its existing technology.
EMPLOYEES
As of February 28, 1999, the Company had approximately 295 full-time
employees with 85 in research and development, 120 in sales and marketing, 50 in
services, and 40 in finance and administration. All but approximately 35
employees are based in the United States. The Company's employees are not
represented by any collective bargaining organizations and the Company has never
experienced any work stoppages. The Company considers its relations with its
employees to be good.
ITEM 2. PROPERTIES
The Company's corporate headquarters are located in Lexington,
Massachusetts, where the Company leases approximately 52,500 square feet under a
lease that expires in October 2007. The Company is obligated to lease an
additional 15,000 square feet at its corporate headquarters beginning July 1,
1999. The Company's field sales and support operations occupy leased facilities
in eleven locations throughout the United States and in four locations in Canada
and Europe. Remote product research and development facilities are located in
Campbell, California; San Francisco, California; and Linz, Austria. The Company
believes that its current facilities are sufficient for its current operations
and that those facilities will continue to provide adequate space for operations
in the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
The Company is currently not involved in any material legal proceeding.
The Company may, from time to time, be involved in ordinary routine litigation
incidental to its business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
9
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
MARKET PRICE FOR COMMON STOCK
The following table sets forth, for the periods indicated, the high and low
closing prices of the Company's Common Stock as reported on the Nasdaq National
Market System. The Company's Common Stock is traded under the Nasdaq symbol:
SEGU. These prices do not include retail markups, markdowns, or commissions.
YEAR ENDED DECEMBER 31, 1998: HIGH LOW
---- ---
First Quarter $15.000 $ 9.875
Second Quarter $16.063 $12.250
Third Quarter $18.875 $13.875
Fourth Quarter $24.625 $12.750
YEAR ENDED DECEMBER 31, 1997: HIGH LOW
---- ---
First Quarter $18.250 $ 7.500
Second Quarter $15.125 $ 8.625
Third Quarter $13.750 $ 7.625
Fourth Quarter $12.500 $ 7.750
On March 31, 1999, the closing price reported on the Nasdaq National
Market System for the Common Stock was $9.625. The market price of the
Company's Common Stock has fluctuated significantly and is subject to
significant fluctuations in the future.
HOLDERS OF RECORD
As of March 31, 1999, there were approximately 98 holders of record of the
Company's Common Stock and 8,993,540 shares of Common Stock outstanding. The
Company estimates that as of March 31, 1999, there were approximately 2,286
beneficial stockholders.
DIVIDEND POLICY
The Company has never paid cash dividends on the Common Stock and does not
anticipate paying such dividends in the foreseeable future. The Company intends
to retain future earnings for use in the Company's business. The payment of any
future dividends will be determined by the Board of Directors in light of
conditions then existing, including the Company's financial condition and
requirements, future prospects, restrictions in financing agreements, business
conditions and other factors deemed relevant by the Board of Directors.
RECENT SALES OF UNREGISTERED SECURITIES
On December 3, 1998, the Company issued an aggregate of 312,990 shares of
Common Stock to the then current stockholders of Eventus in connection with the
Company's acquisition of all the capital stock of Eventus. The Company issued
the shares of
10
Common Stock to the then current stockholders of Eventus in a private placement
in reliance on Rule 506 of Regulation D promulgated under the Securities Act of
1933 ("Regulation D").
On December 31, 1998, the Company issued an aggregate of 224,809 shares of
Common Stock to the stockholder of B&W in connection with the Company's
acquisition of all the capital stock of B&W. The Company issued the shares of
Common Stock to the stockholder of B&W in a private placement in reliance on
Rule 506 of Regulation D.
USE OF PROCEEDS FROM REGISTERED SECURITIES
The Company completed the initial public offering (IPO) of its Common Stock
in April 1996. The IPO was made pursuant to a Registration Statement on Form S-
1, filed with the Securities and Exchange Commission pursuant to Rule 462(b)
under the Securities Act of 1933 (Commission File No. 333-1488), which was
declared effective as of March 28, 1996. The IPO commenced on April 2, 1996 and
terminated shortly thereafter after the sale into the public market of all of
the registered shares of Common Stock.
The 3,162,500 shares of Common Stock sold by the Company and selling
security holders in the IPO were offered for sale in the United States by a
syndicate of underwriters represented by Alex. Brown & Sons Incorporated, Adams,
Harkness & Hill, Inc., and Soundview Financial Group, Inc.
The Company registered an aggregate of 2,412,500 shares of Common Stock
(including 412,500 shares issued upon the exercise of the underwriters'
overallotment options) for sale in the IPO at a per share price of $18.00 for an
aggregate offering price of approximately $43.4 million. All of such shares
were registered for the Company's account. Selling security holders registered
an aggregate of 750,000 shares of Common Stock for sale in the IPO at a per
share price of $18.00 for an aggregate offering price of $13.5 million. All of
such shares were registered for the selling security holders' accounts. As
stated above, all of such shares were sold shortly after the commencement of the
offering.
In connection with the IPO, the Company incurred the following expenses:
Underwriting discounts and commissions $3,039,750
Expenses paid to underwriters 10,999
Other direct expenses 847,281
----------
Total expenses $3,898,030
==========
After deducting the expenses set forth above, the Company received
approximately $39.5 million in net proceeds of the IPO.
For the year ended December 31, 1998, the Company used approximately $2.6
million for the purchase of property and equipment, approximately $1.7 million
for repayment of indebtedness including interest ($883,000 and $385,000 for
principal and interest,
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respectively, on the SQLBench notes and approximately $395,000 on Eventus debt),
$950,000 for guaranteed royalties, $480,000 for a non-recurring engineering and
initial license fee, approximately $195,000 for employee severance payments, and
approximately $5.5 million for working capital. The remaining $28.1 million was
invested in temporary investments, mainly consisting of government agency paper
and commercial paper.
No payments were made to directors, officers, or persons owning 10 percent
or more of the Common Stock of the Company.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with
the Consolidated Financial Statements and the Notes thereto and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this Annual Report on Form 10-K.
All financial data below has been restated to give retroactive effect to
the Company's December 1998 acquisitions of Eventus Software, Inc. and Black &
White Software, Inc., using the pooling-of-interests method of accounting.
12
YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(in thousands, except per share data)
STATEMENT OF OPERATIONS DATA:
Revenue:
Software $26,249 $ 19,662 $16,551 $11,544 $ 7,012
Services 14,599 7,977 5,411 2,627 1,253
Royalties - - - 129 335
------- -------- ------- ------- -------
Total revenue 40,848 27,639 21,962 14,300 8,600
------- -------- ------- ------- -------
Cost of revenue:
Cost of software 2,972 3,673 2,807 1,537 1,029
Cost of services 6,119 2,641 1,721 1,194 601
Cost of royalties - - - 30 80
------- -------- ------- ------- -------
Total cost of revenue 9,091 6,314 4,528 2,761 1,710
------- -------- ------- ------- -------
Gross margin 31,757 21,325 17,434 11,539 6,890
Operating expenses:
Sales and marketing 20,764 14,071 10,073 6,710 3,356
Research and development 8,571 7,084 5,043 2,781 1,946
General and administrative 4,500 3,933 2,950 1,709 1,284
Non-recurring charges 2,198/(1)/ 9,813/(2)/ - 449 -
------- -------- ------- ------- -------
Total operating expenses 36,033 34,901 18,066 11,649 6,586
------- -------- ------- ------- -------
Income (loss) from operations (4,276) (13,576) (632) (110) 304
Litigation settlement - - (744) - -
Other income (expense), net 1,521 2,155 1,540 (23) (15)
------- -------- ------- ------- -------
Income (loss) before provision for income taxes (2,755) (11,421) 164 (133) 289
Provision for income taxes 140 56 20 3 9
------- -------- ------- ------- -------
Net income (loss) $(2,895) $(11,477) $ 144 $ (136) $ 280
======= ======== ======= ======= =======
Net income (loss) per common share - basic $ (0.34) $ (1.48) $ 0.03 $ (0.08) $ 0.16
======= ======== ======= ======= =======
Net income (loss) per common share - diluted $ (0.34) $ (1.48) $ 0.02 $ (0.08) $ 0.07
======= ======== ======= ======= =======
Weighted average common shares
outstanding - basic 8,626 7,761 5,639 1,777 1,753
------- -------- ------- ------- -------
Weighted average common shares
outstanding - diluted 8,626 7,761 7,980 1,777 4,227
------- -------- ------- ------- -------
DECEMBER 31,
-------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(in thousands)
BALANCE SHEET DATA:
Cash and cash equivalents $16,096 $ 23,393 $ 7,541 $ 588 $ 987
Working capital (deficit) 30,904 33,693 40,308 (56) 1,473
Total assets 48,951 47,681 49,983 5,352 4,571
Long-term obligations 883 3,777 245 - 654
Total stockholders' equity 35,213 33,966 42,353 1,370 1,882
/(1)/ Non-recurring charges represent $1.5 million of transaction costs
associated with the acquisitions of Eventus Software, Inc. and Black & White
Software, Inc. and $667,000 associated with write-offs of a non-recurring
engineering fee and guaranteed royalties.
/(2)/ Non-recurring charges include a charge of $9.1 million for purchased
research and development in process and $718,000 for severance charges.
13
There were no cash dividends declared per common share for any of the years
shown above.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The Company develops, markets and supports software products, and provides
related professional services, for the management and testing of e-business
applications. The Company's products are used by webmasters, quality assurance
professionals and software developers to improve software quality, reduce
development costs, manage the vast and growing number of application components,
and shorten the time required to develop and deploy these mission-critical
applications. The Company's products provide a solution designed to assemble,
model, deploy, monitor and analyze electronic commerce ("e-commerce") systems as
well as to provide automated functional and load testing of applications
deployed on the World Wide Web and on client/server systems.
In December 1998, the Company acquired Eventus Software, Inc. ("Eventus")
and Black & White Software, Inc. ("B&W") in two separate transactions. Founded
in September 1996 and based in California, Eventus' principal product manages
the assembly and deployment of web applications. Eventus had approximately 20
employees at the time of acquisition. The Company acquired Eventus to expand its
product offerings to include end-to-end enterprise web content management.
Founded in 1992, B&W marketed a wide range of products, internally and
externally developed, for application development and productivity enhancement,
including tools for creating object-oriented client/server applications and
building applications with dynamic graphics and visual animation for graphical
user interfaces. B&W had approximately 40 employees at the time of the
acquisition. During 1998, B&W began to focus its efforts on products that
diagnose and monitor communications between distributed application objects. The
Company acquired B&W to expand its product offerings to include delivering
comprehensive management, monitoring and testing of object level transactions
for e-business applications using the Common Object Request Broker Architecture
(CORBA) as well as to expand its customer base. Both acquisitions were accounted
for using the pooling-of-interests method and, accordingly, the historical
consolidated financial statements of the Company prior to the acquisitions
presented herein have been restated to include the financial position, results
of operations and cash flows of Eventus and B&W (see Note 2 to the Consolidated
Financial Statements).
In 1997, the Company began to focus on load testing through an OEM/reseller
arrangement with a third party software vendor. On December 30, 1997, the
Company acquired both the third party software vendor and the developer of the
product, SQLBench International, Inc. and ARC - Dr. Ambichl & Dr. Reindl
Communication GmbH (formerly named ARC Dr. Ambichl & Dr. Reindl OEG), hereafter
referred to as "SQLBench". The acquisition was accounted for using the purchase
method and, accordingly, the operating results of SQLBench are included in the
Company's consolidated financial statements since the date of acquisition.
RESULTS OF OPERATIONS
14
The following table sets forth, for the periods indicated, the percentage
of total revenue represented by certain items reflected in the Company's
consolidated statements of operations:
Year ended December 31,
---------------------------------
1998 1997 1996
---- ---- ----
Revenue:
Software 64.3 % 71.1 % 75.4
Services 35.7 28.9 24.6
----- ----- -----
Total revenue 100.0 100.0 100.0
Cost of revenue:
Cost of software 7.3 13.3 12.8
Cost of services 15.0 9.5 7.8
----- ----- -----
Total cost of revenue 22.3 22.8 20.6
Gross margin 77.7 77.2 79.4
Operating expenses:
Sales and marketing 50.8 50.9 45.9
Research and development 21.0 25.6 23.0
General and administrative 11.0 14.2 13.4
Non-recurring charges 5.4 35.6 -
----- ----- -----
Total operating expenses 88.2 126.3 82.3
----- ----- -----
Loss from operations (10.5) (49.1) (2.9)
Litigation settlement - - (3.4)
Other income, net 3.7 7.8 7.0
----- ----- -----
Income (loss) before provision for income taxes (6.8) (41.3) 0.7
Provision for income taxes 0.3 0.2 0.1
----- ----- -----
Net income (loss) (7.1) % (41.5) % 0.6 %
===== ===== =====
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
SOFTWARE REVENUE
Software revenue consists of revenue from the granting of perpetual
licenses to use the Company's products. The Company sells its licenses through
its direct sales force, telesales, international distributors and channel
partners. Software revenue increased 34% to $26.2 million in 1998 compared to
$19.7 million in 1997. The increase is primarily the result of increased unit
shipments, particularly resulting from the direct domestic sales force. These
increased unit shipments were due to continued demand for the Company's products
from existing customers and due to first-time buyers; the introduction of new
and upgraded products; increased market acceptance of the families of products
including Web application testing and load testing products introduced in 1997;
and the expansion of the Company's worldwide direct sales force. International
product sales accounted for 16% and 10% of total Company product sales in 1998
and 1997, respectively, and increased for the factors noted above.
The mix of software revenue changed from 1997 to 1998. Total e-commerce
software revenue represented 61% and 33% of total software revenue in 1998 and
1997, respectively. The Company's client/server products, its historical core
product line, represented 39% and 67% of
15
total software revenue for the years ended December 31, 1998 and 1997,
respectively. The increase in e-commerce software revenue from year to year was
due to the introduction of SilkTest and SilkPerformer, which target the e-
commerce testing markets, in May 1997 and September 1997, respectively. The Silk
product family in total represented 54% and 19% of total software revenue in
1998 and 1997, respectively. During 1998, Eventus intentionally curtailed
selling certain of its royalty-bearing products, which targeted the e-commerce
testing market, in order to concentrate its efforts on developing and selling
new products. Consequently, e-commerce software revenue in 1998 consisted
primarily of the Silk product family. QA Performer and SilkPerformer, which
target the load testing markets, in total represented 25% and 7% of total
software revenue in 1998 and 1997, respectively.
The rate of continued software revenue growth depends upon the Company's
ability to successfully generate and fill current software license orders,
attract and retain skilled personnel and deliver timely new products and
enhancements. Performance could also be affected by the efforts to integrate
Eventus' and B&W's operations with those of the Company; the success of those
integration efforts; and market acceptance of the new products: SilkControl,
SilkPilot and SilkRealizer.
SERVICES REVENUE
Services revenue consists of revenue from maintenance and training and
consulting. Services revenue increased 83% to $14.6 million in 1998 compared to
$8.0 million in 1997. The increase in service revenue is a result of the growth
in the Company's installed customer base and the increased training and
consulting services performed for these customers. Maintenance revenue increased
28% to $7.2 million in 1998 compared to $5.7 million in 1997. Training and
consulting revenue increased 218% to $7.4 million in 1998 compared to $2.3
million in 1997.
The increase in training and consulting revenue is also due to the
introduction in the second quarter of 1998 of LiveQuality scenario testing
solutions, which consist of a combination of software product and consulting
services. Moreover, one customer accounted for approximately 10% of training and
consulting revenue in 1998. The Company does not expect similar occurrences in
1999 and, consequently, does not expect 1999 services revenue increases, if any,
to be at the rate experienced in 1998.
COST OF SOFTWARE
Cost of software includes documentation, product packaging, product media,
employment costs for processing and distribution, amortization of intangible
assets and royalties due to third parties. These costs decreased 19% to $3.0
million, or 11% of software revenue, in 1998 compared to $3.7 million, or 19% of
software revenue, in 1997.
The decrease in cost of software reflects the Company's intentional
reduction in sales of royalty-bearing products during 1998, resulting in a
decrease of approximately $1.3 million in royalty expense. The decrease is
partially offset by a $600,000 increase in the amortization of intangible assets
primarily related to the SQLBench acquisition and the NRE fee noted below as
well as the cost of upgrading the installed base with new versions of various
products. The Company intends to reduce sales of B&W's royalty-bearing products
in 1999; therefore, the
16
Company expects to continue to decrease royalty expense as a percentage of
software revenue in the future.
In March 1998, the Company entered into an agreement with a vendor whereby
the vendor licensed specific software to the Company for purposes of marketing
and distribution. Under the initial terms of the agreement, the Company paid
$780,000 in 1998, which represented a non-refundable non-recurring engineering
and initial license fee ("NRE") of $480,000 and guaranteed royalties of
$300,000. Under this agreement, an additional $200,000 for guaranteed royalties
was to be paid by September 30, 1998.
In October 1998, the parties amended this agreement as follows: (i) the
remaining payment for guaranteed royalties was removed, (ii) the Company
committed to spend $200,000 on defined marketing activities during the initial
18-month term and each subsequent one-year term of the agreement, and (iii) the
Company agreed to make guaranteed, annual royalty payments beginning on October
1, 1999 of $300,000 for each one-year term of the agreement. The agreement
terminates on September 30, 2001, unless earlier voluntarily terminated by the
Company at the conclusion of any current one-year term.
The NRE fee was being amortized into cost of software revenue on a
straight-line basis over its estimated life of two years, and the royalty
expense was being recognized as cost of software revenue based upon sales of the
related products. For the year ended December 31, 1998, amortization expense and
royalty expense related to this agreement was approximately $180,000 and
$10,000, respectively.
Based on minimal sales of the licensed products and management's decision
in the first quarter of 1999 to cease selling the licensed products related to
the above agreement in order to focus efforts on the EBMS products, the Company
wrote off the remaining balances of the NRE and prepaid royalties, $300,000 and
approximately $290,000, respectively, as non-recurring charges as of December
31, 1998.
In December 1998, the Company entered into a five-year agreement with a
vendor which provides for future royalty payments to the vendor of 10% of net
revenues achieved on sales of the Company's products to the vendor's customer
base. Under the terms of the agreement, the Company paid a guaranteed, non-
refundable minimum royalty of $650,000 in December 1998. As of December 31,
1998, other current assets included approximately $220,000, and other long-term
assets included approximately $430,000 related to the guaranteed royalties.
Future royalty expense will be recognized as cost of software revenue based upon
qualified sales of the Company's products.
To the extent that revenue from related products does not support the
guaranteed royalties described above, the Company could be required to
accelerate amortization of these prepaid royalties. The amortization of the
prepaid royalties may cause the cost of software to increase as a percentage of
revenue in the future.
COST OF SERVICES
17
Cost of services consists principally of salaries and benefits for the
Company's customer technical support staff, which provides services under
maintenance contracts, and for the Company's training and consulting staff, as
well as third party consulting fees and the cost of materials and facilities
used in training customers. Cost of services increased 132% to $6.1 million, or
42% of services revenue, in 1998 compared to $2.6 million, or 33% of services
revenue, in 1997.
The increase in cost of services is primarily due to the Company's
utilization of third party consultants to assist in Live Quality scenario
testing solutions. The cost of third party consultants is generally higher than
the cost of internal resources. The increases in amount and as a percentage of
service revenue are also the result of increased investment in personnel needed
to support the increased demand for training and consulting services. Headcount
in the training and consulting and technical support groups increased 56% from
December 31, 1997 to December 31, 1998. The Company expects to continue to hire
employees in the services group in order to generate and support worldwide
services revenue and to provide ongoing quality customer support to the
Company's increasing installed base. In order to support the growing
international customer base, the Company is opening a technical support center
in Ireland during the third quarter of 1999 and expects to have approximately
20 employees located in Ireland by the end of 1999.
SALES AND MARKETING
Sales and marketing expenses consist primarily of salaries and benefits,
commissions, travel costs and promotional marketing programs. Marketing programs
include advertising, direct mail programs, seminars and trade shows. Sales and
marketing expenses increased 48% to $20.8 million, or 51% of total revenue, in
1998 compared to $14.1 million, or 51% of total revenue, in 1997. The principal
reasons for the absolute dollar increase in sales and marketing expenses were
increased headcount, increases in commissions as a result of higher revenue
levels and increases in related travel costs.
The Company expects to continue the growth of its worldwide sales and
marketing organization during 1999. The continued growth depends upon the
Company's ability to attract and retain highly skilled technical, managerial and
sales personnel. There can be no assurance that related increased expenditures
will result in increased revenue or improvement in the effectiveness of the
sales organization.
RESEARCH AND DEVELOPMENT
Research and development expenses consist primarily of salaries and
benefits and facility costs. To date, all of the Company's internal costs for
research and development have been charged to operations as incurred since
amounts of software development costs qualifying for capitalization have been
insignificant. Research and development expenses increased 21% to $8.6 million,
or 21% of total revenue, in 1998 compared to $7.1 million, or 26% of total
revenue, in 1997. The increase in absolute dollars in research and development
expenses is mainly attributable to the operations of the Austria facility, which
was only reflected in the Company's operating results from the beginning of
1998. Additionally, the increase is due to increased headcount. Research and
development headcount, including that of the Austrian facility, increased
18
approximately 10% from December 31, 1997 to December 31, 1998. The decrease in
research and development as a percentage of total revenue is primarily due to
the increase in total revenue. The Company intends to continue to make
significant investments in research and development to develop new products and
to expand the capabilities of its Web application testing products.
During 1998, the Company introduced several new products including
SilkControl (a web content management product), Eventus' principal product;
SilkPilot (a CORBA-based distributed object testing product), a B&W product; and
SilkRealizer (for scenario testing and modeling).
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of salaries and
benefits for executive, finance, information technology, human resource and
administrative personnel, professional fees, system support costs and other
general corporate expenses. General and administrative expenses increased 14% to
$4.5 million, or 11% of total revenue, in 1998 compared to $3.9 million, or 14%
of total revenue, in 1997. The increase in absolute dollars in general and
administrative expenses is attributable to increased headcount and related
recruitment fees. General and administrative headcount increased 28% from
December 31, 1997 to December 31, 1998. The decrease as a percentage of total
revenue is primarily due to the increase in total revenue. The Company
anticipates that general and administrative expenses will increase in 1999 to
support the Company's expanding business.
NON-RECURRING CHARGES
In the fourth quarter of 1998, the Company recorded a charge of $1.5
million related to the Eventus and B&W acquisitions (see Note 2 to the
Consolidated Financial Statements). This charge consisted primarily of
investment banking, legal, accounting and other professional fees.
In the fourth quarter of 1998, the Company recorded a charge of
approximately $590,000 associated with write-offs of the NRE fee and guaranteed
royalties related to the March 1998 software license agreement (see Cost of
Software above and Note 3 to the Consolidated Financial Statements).
In the fourth quarter of 1997, the Company recorded a charge of $9.1
million related to the write-off of purchased research and development in
process in conjunction with the SQLBench acquisition and $718,000, consisting of
severance and accelerated vesting of options related to the resignation of the
Company's former President and Chief Executive Officer.
During the first quarter of 1999, the Company began to execute a
restructuring plan to consolidate its marketing, product development and
administrative operations in order to achieve cost efficiencies through the
elimination of redundant functions. The Company realigned its marketing and
product development operations to redirect focus on its strongest product lines
and better integrate the efforts of certain product development teams. The
Company expects to recognize a one-time charge of approximately $1.0 million
during the first quarter of 1999 related to the restructuring plan. The
restructuring charge includes approximately $830,000 for severance and other
employee-related costs of the terminated staff and approximately $190,000 for
facility-
19
related costs, including the accrual of estimated lease obligations associated
with the closure of excess office facilities.
OTHER INCOME (EXPENSE), NET
Other income (expense), net is comprised primarily of interest income from
cash, cash equivalents and short-term investments. Other income, net decreased
29% to $1.5 million in 1998 compared to $2.2 million in 1997 mainly due to
interest expense associated with the Company's issuance of notes in December
1997 related to the SQLBench acquisition.
PROVISION FOR INCOME TAXES
The Company recorded a provision for foreign and state income taxes of
$140,000 and $20,000 for the years ended December 31, 1998, 1997 and
1996, respectively. There was no tax benefit for losses generated in the U.S.
during 1998 and 1997 due to the uncertainty of realizing such benefits. The
Company did not record a provision for federal income taxes in 1996 due to
utilization of net operating loss carryforwards.
As of December 31, 1998, the Company had federal net operating loss
carryforwards of approximately $14.2 million, of which $9.6 million relates to
deductions attributable to stock options state net operating loss carryforwards
of approximately $11.9 million, of which at least $2.6 million is subject to
annual limitations on utilization; and $779,000 of federal and $230,000 of state
tax credit carryforwards available for income tax purposes. These carryforwards
generally expire in the years 1999 through 2018 and may be subject to additional
annual limitations as a result of changes in the Company's ownership. The
benefits of stock option deductions included in net operating loss carryforwards
will be credited to additional paid-in capital when realized.
Management of the Company has evaluated the positive and negative evidence
impacting the realizability of its deferred tax assets. Based on the weight of
the available evidence, it is more likely than not that all of the deferred tax
assets will not be realized, and accordingly the deferred tax assets have been
fully reserved. Management re-evaluates the positive and negative evidence on a
quarterly basis.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
SOFTWARE REVENUE
Software revenue increased 19% to $19.7 million in 1997 compared to $16.6
million in 1996. The increase in software revenue is primarily the result of
increased unit shipments, particularly resulting from the direct domestic sales
force. These increased unit shipments were due to an increase in the demand for
automated testing products; the introduction of new and upgraded products;
increased market acceptance of the families of products including Web
application testing and load testing products introduced in 1997; and the
expansion of the Company's sales and marketing activities. International revenue
accounted for 10% and 7% of total product revenue in 1997 and 1996,
respectively.
20
In 1997, the Company introduced a Web application testing product,
SilkTest, and load testing products, SilkPerformer and QA Performer. Revenues
from these three new products represented 15%, 4% and 3% of total product
revenue, respectively.
In addition, the mix of software license revenue changed in 1997. Prior to
1997, the Company had minimal revenue from the e-commerce testing market and no
revenue from the load testing market. Revenues from those markets totaled 33%
and 7% of total product revenue in 1997.
SERVICES REVENUE
Services revenue increased 47% to $8.0 million in 1997 compared to $5.4
million in 1996. The increase in services revenue is principally the result of
the increased volume of maintenance, training and consulting services, primarily
due to the expansion of the installed base of users of the Company's products.
Maintenance revenue increased 61% to $5.7 million in 1997 compared to $3.5
million in 1996. Training and consulting revenue increased 16% to $2.3 million
in 1997 compared to $1.9 million in 1996.
COST OF SOFTWARE
Cost of software increased 31% to $3.7 million, or 19% of software revenue,
in 1997 compared to $2.8 million, or 17% of software revenue, in 1996. The
increase in the cost of software primarily reflects the increased volume of
units sold. The increase is also attributable to royalty expense related to the
sale of the Company's load testing products which were licensed from a third
party until December 30, 1997. The Company acquired the vendor on December 30,
1997, with the royalty agreement being terminated (see Note 2 to the
Consolidated Financial Statements).
COST OF SERVICES
Cost of services increased 53% to $2.6 million, or 33% of service revenue,
in 1997 compared to $1.7 million, or 32% of service revenue, in 1996. The
increase in the cost of services is largely the result of increased headcount.
Cost of services headcount increased 50% from December 31, 1996 to December 31,
1997. The increase is also attributable to costs related to the delivery of
training and consulting services, due to higher demand for such services, such
as travel and equipment rental.
SALES AND MARKETING
Sales and marketing expenses increased 40% to $14.1 million, or 51% of
total revenue, in 1997 compared to $10.1 million, or 46% of total revenue, in
1996. The principal reasons for the increases in sales and marketing expenses
were increased headcount, increases in commissions as a result of higher revenue
levels and increases in promotional marketing programs. Sales and marketing
headcount increased 30% from December 31, 1996 to December 31, 1997. The sales
organization was restructured in the fourth quarter of 1997 to focus on the
Company's e-commerce market initiative.
21
RESEARCH AND DEVELOPMENT
Research and development expenses increased 40% to $7.1 million, or 26% of
total revenue, in 1997 compared to $5.0 million, or 23% of total revenue, in
1996 mainly due to increased headcount. Research and development headcount
increased 30% from December 31, 1996 to December 31, 1997.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 33% to $3.9 million, or 14%
of total revenue, in 1997 compared to $3.0 million, or 13% of total revenue, in
1996. The increase is attributable to increased headcount and increases in
professional fees, system support costs and other general corporate expenses.
NON-RECURRING CHARGES
In the fourth quarter of 1997, the Company recorded a charge of $9.1
million related to the write-off of purchased research and development in
process in conjunction with the SQLBench acquisition and $718,000, consisting of
severance and accelerated vesting of options related to the resignation of the
Company's former President and Chief Executive Officer.
LITIGATION SETTLEMENT
On September 30, 1996, the Company entered into a definitive agreement with
a plaintiff to settle litigation brought against the Company and certain of its
current and former employees. The Company recorded a charge of $744,000 in the
third quarter of fiscal 1996 to cover the settlement and other expenses incurred
in connection therewith.
OTHER INCOME (EXPENSE), NET
Other income (expense), net is comprised primarily of interest income from
cash, cash equivalents and short-term investments. On April 2, 1996, the Company
completed an initial public offering of common stock and received net proceeds
of $39.5 million. Prior to 1997, interest income was partially offset by
interest expense related to the Company's convertible debt. As of December 31,
1996, all of the Company's convertible debt was converted into common stock of
the Company.
PROVISION FOR INCOME TAXES
The Company had a provision for income taxes of $56,000 and $20,000 in 1997
and 1996, respectively, principally for state taxes.
LIQUIDITY AND CAPITAL RESOURCES
22
As of December 31, 1998, the Company's principal sources of liquidity
included cash, cash equivalents and short-term investments totaling $33.4
million.
The Company's operating activities utilized cash of $3.7 million in 1998
compared to providing cash of $1.0 million in 1997. Cash was utilized in 1998
primarily for increases in accounts receivable as a result of the Company's
revenue growth and other current assets, offset by increased accounts payable
and deferred revenue. The increase in other current assets is principally due to
prepaid royalties in 1998 (see Note 3 to the Consolidated Financial Statements).
The Company's investing activities utilized cash of $7.2 million in 1998
compared to providing cash of $13.4 million in 1997. The Company purchased $2.7
million of property and equipment in 1998 compared to $1.4 million in 1997. The
large increase consists primarily of computer equipment and software for new
employees and to support the Company's expanding operations as well as furniture
and fixtures and leasehold improvements for the new corporate headquarters.
Additionally in 1998, the Company paid $480,000 in NRE fees in 1998 (see Note 3
to the Consolidated Financial Statements) and made payments of $883,000 on
acquisition related notes payable. Cash provided from investing activities in
1997 was largely the result of net maturities of short-term investments,
partially offset by $4.5 million related to the SQLBench acquisition.
The Company's financing activities provided cash of $3.7 million and $1.4
million in 1998 and 1997, respectively, primarily due to the issuance of common
stock upon the exercise of stock options. Additionally, in 1998 and 1997,
approximately $990,000 and $510,000 of proceeds, respectively, were received by
Eventus from the issuance of common stock, net of issuance costs.
In August 1998, the Company moved its corporate headquarters to Lexington,
Massachusetts under a lease which expires in October 2007. The annual rental
rate is approximately $2.1 million. The Company has the right to terminate the
lease on September 30, 2004 for a fee of approximately $2.2 million.
The Company will recognize a one-time pre-tax charge of approximately $1.0
million during the first quarter of 1999 related to a restructuring plan. The
restructuring charge includes the following expenses that the Company expects
will be paid out in 1999 and 2000: approximately $830,000 for severance and
other employee-related costs of the terminated staff and approximately $190,000
for facility-related costs, including the accrual of estimated lease obligations
associated with the closure of excess office facilities.
The Company expects to incur approximately $1.4 million in 1999 for an ERP
information system to be implemented during 1999. This amount consists of
approximately $670,000 for the purchase of software, hardware and related
maintenance and approximately $700,000 in consulting and implementation.
The Company expects to open a Technical Support Center in Ireland during
the third quarter of 1999, and to incur infrastructure costs of approximately
$600,000. This expenditure will be partially funded by a grant awarded by the
Ireland Industrial Development Board ("IDB"), of approximately $175,000.
In December 1999, approximately $2.6 million becomes due under the SQLBench
notes.
23
Long-term cash requirements, other than normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, the possible opening of additional international offices, and
the possible acquisition of software products or technologies complementary to
the Company's business.
Assuming there is no significant change in the Company's business, the
Company believes that cash, cash equivalents and short-term investments as well
as cash flows from operations will be sufficient to meet its working capital and
debt requirements through the end of 1999. In the event the Company requires
additional financing, the Company believes it would be able to obtain such
financing; however, there can be no assurance that it would be successful in
doing so, or that it could do so on terms favorable to the Company.
YEAR 2000 ISSUES
The year 2000 presents potential concerns for business and consumer
computing. The consequences of this issue may include systems failures and
business process interruption. It may also include additional business and
competitive differentiation. If the Company, its significant customers, or
suppliers fail to make necessary modifications and conversions on a timely
basis, the year 2000 issue could have a material adverse effect on the Company's
operations. There are two other related issues which could also lead to
incorrect calculations or failures: i) some systems' programming assigns special
meaning to certain dates, such as 9/9/99, and ii) the year 2000 is a leap year.
To address these year 2000 issues with its internal systems, including
information technology (IT) and non-IT systems, the Company initiated a program
designed to deal with the most critical systems, packaged software applications,
first. Year 2000 compliance testing is complete for the Company's internal
software systems. Testing of the internal hardware systems for year 2000
compliance was begun in the first quarter of 1999, and the Company expects the
testing to be complete by June 30, 1999. In addition, the Company began work on
various types of contingency planning to address potential problem areas with
internal systems in the first quarter of 1999. The Company expects the
contingency planning to be complete by June 30, 1999 as well. Although the
assessment is still underway, management currently believes that all material
systems will be compliant by the year 2000 and that the cost to address the
issues will not be more than $100,000 in total. However, this estimate does not
include potential costs related to any customer or other claims or the cost of
internal software and hardware replaced in the normal course of business. The
total cost estimate is based on the current assessment of the projects and is
subject to change as the projects progress. The costs incurred to date related
to these programs are minimal.
The Company has also initiated formal communications with its significant
vendors, mainly of IT packaged applications, to determine the extent to which
the Company is vulnerable to those third parties' failure to remedy their own
year 2000 issues. The Company has received written assurances of year 2000
compliance from all significant vendors. Most of the vendors under existing
contracts with the Company are under no contractual obligation to provide such
information to the Company. The Company is taking steps with respect to new
vendor agreements to ensure that the vendors' products and internal systems are
year 2000 compliant. The Company does not believe it has any mission-critical
suppliers of products or services.
24
The Company also assesses the capability of its products to handle the year
2000. To assist customers in evaluating their year 2000 issues, the Company has
a description on its website which indicates the capability of Segue's products
to handle the year 2000. All Segue products are year 2000 compliant. However,
the assessment of whether a complete system will operate correctly depends on
the BIOS capability and software design and integration, and for many end-users
this will include BIOS and software provided by companies other than Segue.
The Company anticipates that substantial litigation may be brought against
vendors, including the Company, of all component products of systems that are
unable to properly manage data related to year 2000. The Company's agreements
with customers typically contain provisions designed to limit the Company's
liability for such claims. It is possible, however, that these measures will not
provide protection from liability claims, as a result of existing or future
federal, state or local laws or ordinances or unfavorable judicial decisions.
Any such claims, with or without merit, could result in a material adverse
effect on the Company's business, financial condition and results of operations,
including increased warranty costs, customer satisfaction issues and potential
lawsuits.
Based on currently available information, management does not believe that
the year 2000 matters discussed above related to internal systems or products
sold to customers will have a material adverse impact on the Company's financial
condition or overall trends in results of operations; however, it is uncertain
to what extent the Company may be affected by such matters. In addition, there
can be no assurance that the failure to ensure year 2000 capability by a
supplier or another third party would not have a material adverse effect on the
Company.
CERTAIN FACTORS AFFECTING FUTURE OPERATING RESULTS
Statements made or incorporated in this Form 10-K include a number of
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. Forward-
looking statements include, without limitation, statements containing the words
"anticipates", "believes", "expects", "intends", "future" and words of similar
import which express management's belief, expectations or intentions regarding
the Company's future performance. The Company's actual results could differ
materially from those set forth in the forward-looking statements. Certain
factors that might cause such a difference are discussed below.
The Company's quarterly results may fluctuate. Segue's quarterly revenue
and operating results are difficult to predict and may fluctuate significantly
from quarter to quarter. If Segue's quarterly revenue or operating results fall
below the expectations of investors or public market analysts, the price of its
common stock could fall substantially. The Company's quarterly revenue may
fluctuate significantly for several reasons, including: the timing of
introductions of new products or product enhancements by Segue or its
competitors; personnel changes; the size and timing of individual orders;
software bugs or other product quality problems; competition and pricing;
customer order deferrals in anticipation of new products or product
enhancements; demand for Segue's products is difficult to predict for reasons
discussed below; changes in operating expenses; product mix; and general
economic conditions. A substantial portion of the Company's operating expenses
are related to personnel, facilities and marketing programs. The level of
spending for such expenses cannot be adjusted quickly and is based, in
significant part, on
25
expectations of future revenues. If actual revenue levels are below management's
expectations, results of operations are likely to be adversely affected. In
addition, the Company does not typically experience order backlog. Furthermore,
the Company has often recognized a substantial portion of its revenues in the
last month of a quarter, with these revenues frequently concentrated in the last
weeks or days of a quarter. As a result, product revenues in any quarter are
substantially dependent on orders booked and shipped in the latter part of that
quarter, and revenues for any future quarter are not predictable with any
significant degree of accuracy. For these reasons, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as indications of future performance.
The Company may not be profitable in the future. Since Segue began
operations, it has generally experienced losses. Losses have resulted in an
accumulated deficit of approximately $18.0 million as of December 31, 1998.
Segue had net income of $144,000 in 1996, a net loss of $11.5 million in 1997,
which includes a charge of $9.1 million for purchased research and development
in process and $718,000 for severance charges and a net loss of $2.9 million in
1998, which includes a charge of $1.5 million related to the Eventus and B&W
acquisitions and a charge of $667,000 related to the write-offs of an NRE fee
and guaranteed royalties. While the Company has experienced revenue growth in
recent periods, continued growth at the same rate is not sustainable and is not
necessarily indicative of future operating results. Failure to sustain or
increase profitability may adversely affect the market price of the Company's
Common Stock.
The Company has recently shifted its focus from general software testing to
e-business testing. In 1997, the Company began to develop and acquire technology
to provide automated software testing for Web-enabled software applications,
including its acquisition of SQLBench in December 1997. These developments
allowed the Company to extend its testing capabilities beyond distributed
client/server applications with GUI front ends. Because e-business scenario
testing is more complicated than general software testing, the Company may
experience issues with its product quality. In the second quarter of 1998, Segue
introduced "LiveQuality", an e-business scenario testing solution. In the fourth
quarter of 1998, the Company acquired Eventus Software, Inc. and Black & White
Software, Inc., which provided the Company with other technologies to expand its
current line of e-business testing products. The Company's shift from a general
software testing company to an e-business testing company during the past year
has resulted in significant changes in (i) Segue's organizational structure,
(ii) management personnel, (iii) product mix, and (iv) sales approach. If the
Company fails to effectively manage these changes, or make other changes which
may be needed in connection with such shift to an e-business testing company,
the Company's business, operating results and financial condition may be
materially adversely affected.
The development of a market for the Company's products is uncertain. The
market for automated software testing products is relatively new and
undeveloped. Marketing and sales techniques in the automated software testing
marketplace, as well as the bases for competition, are not well established.
There can be no assurance as to the extent that a significant market for
automated software testing products will develop or the extent to which the
Company's products will be accepted in that market. Although the Company
believes that the current trend toward increased use of automated software
testing will continue, a majority of software testing is still carried out
manually, and there can be no assurance that the automated software testing
market will enjoy continued growth.
26
The commercial market for products and services designed for use on the
Internet, Intranet and Extranet has only recently begun to develop. The success
of the Company's products focused on e-commerce and Internet applications will
depend on the growth of the market and on the Company's ability to continue to
enhance its products to work with all of the prevalent technologies driving
Internet applications. There can be no assurance that Segue will be able to
effectively adapt its products to the prevalent technologies being used on e-
commerce applications or to successfully compete in the market for Internet-
related products and services. As is typical for new and rapidly evolving
industries, demand for recently introduced products is highly uncertain.
The Company may have difficulty managing its growth. The Company has been
experiencing a period of rapid growth, including increases in the number of
orders, customers and employees. The Company's rapid growth has placed, and may
continue to place, strains on its management, operations and systems. To manage
future growth effectively, Segue must expand, improve and effectively utilize
its operational, management, marketing, sales and financial systems as
necessitated by changes in its business. The Company is implementing an ERP
information system and opening a Technical Support Center in Ireland in 1999,
both of which could be disruptive. Additionally, as part in the restructuring
plan in the first quarter of 1999, the Company has significantly changed the
sales management team and consolidated the position of Senior Vice President of
Research and Development with the position of Senior Vice President and General
Manager of the executive management team. In conjunction with these management
changes, the Company also changed the structure of its internal organization by
adding product divisions which relate to its e-business testing products. The
Company also refocused its sales and marketing approach to focus on e-commerce
applications. There can be no assurance that the Company will be able to
effectively manage such changes and such changes are likely to be disruptive.
The Company may be subject to risks associated with its recent acquisitions
and future acquisitions. In the fourth quarter of 1998, Segue acquired Eventus
Software, Inc. and Black & White Software, Inc. in two separate transactions.
The Company's product range and customer base have increased in the recent past
due in part to these acquisitions. These acquisitions provided the Company with
technologies to expand its current line of e-business testing products. There
can be no assurance that the integration of all of the acquired technologies
will be successful or will not result in unforeseen difficulties which may
absorb significant management attention.
In the future, the Company may acquire additional businesses or product
lines. The recently completed acquisitions, or any future acquisition, may not
produce the revenue, earnings or business synergies that it anticipated, and an
acquired product, service or technology might not perform as expected. Prior to
completing an acquisition, however, it is difficult to determine if such
benefits can actually be realized. The process of integrating acquired companies
into the Company's business may also result in unforeseen difficulties.
Unforeseen operating difficulties may absorb significant management attention,
which the Company might otherwise devote to its existing business. Also, the
process may require significant financial resources that the Company might
otherwise allocate to other activities, including the ongoing development or
expansion of its existing operations. The integration of the acquisitions of
Eventus Software, Inc. and Black & White Software, Inc. will take longer than
originally expected.
27
If the Company pursues a future acquisition, its management could spend a
significant amount of time and effort in identifying and completing the
acquisition. To pay for a future acquisition, the Company might use capital
stock or cash. Alternatively, Segue might borrow money from a bank or other
lender. If the Company uses capital stock as it did with its recent
acquisitions, the Company's stockholders would experience dilution of their
ownership interests. If the Company uses cash or debt financing, its financial
liquidity will be reduced.
The Company has recently changed its sales approach and restructured its
sales teams. As part of the shift in the Company's business to e-business
testing, the Company has recently begun to focus its marketing and sales efforts
with a solution sales approach. The Company's direct sales force focuses on
large enterprise and strategic sales in an effort to provide as many solutions
as a particular client needs. To faciliate the solution sales approach, the
Company restructured its direct sales force into teams of one strategic sales
representative and one technical support engineer. The Company has also recently
hired additional sales personnel and worked to integrate sales personnel from
Eventus and Black & White. There can be no assurance that this sales approach
will result in greater revenues. Because the Company's sales force focuses on
making larger sales, its sales cycle may increase. Larger purchases will take
longer than smaller sales because customers will generally take more time to
decide on whether to make larger purchases. A longer sales cycle reduces the
Company's ability to forecast revenue levels. Any delay or loss in sales of the
Company's products could have a material adverse effect on its business,
operating results and financial condition, and could cause its operating results
to vary significantly from quarter to quarter.
The Company's performance will depend in part on the growth and commercial
acceptance of the Internet. The Company's future success will depend
substantially upon the widespread adoption of the Internet as a primary medium
for commerce and business applications. If the Internet does not become a viable
and substantial commercial medium, the Company's business, operating results and
financial condition will be materially adversely affected. The Internet has
experienced, and is expected to continue to experience, significant user and
traffic growth, which has, at times, caused user frustration with slow access
and download times. The Internet infrastructure may not be able to support the
demands placed on it by continued growth. Moreover, critical issues concerning
the commercial use of the Internet, such as security, reliability, cost,
accessibility and quality of service, remain unresolved and may negatively
affect the growth of Internet use or the attractiveness of commerce and business
communication on the Internet. In addition, the Internet could lose its
viability due to delays in the development or adoption of new standards and
protocols to handle increased activity or due to increased government regulation
and taxation of Internet commerce.
The Company faces significant competition from other software companies.
The market for software quality management tools is new, intensely competitive
and subject to rapid technological change. The Company expects competition to
intensify in the future. The Company currently encounters competition from a
number of public and private companies including Mercury Interactive
Corporation, Rational Software Corporation and Compuware Corporation. Many of
Segue's current and potential competitors have longer operating histories,
greater name recognition, larger installed customer bases, and significantly
greater financial, technical and marketing resources than it does and,
therefore, may be able to respond more
28
quickly than the Company to new or changing opportunities, technologies,
standards or customer requirements or may be able to devote greater resources to
the promotion and sale of their products than the Company. The Company may also
face increased competition from the recent consolidation of several companies in
the automated software quality market. An increase in competition could result
in price reductions and loss of market share. Such competition and any resulting
reduction in profitability could have a material adverse effect on the Company's
business, operating results and financial condition.
The Company's business could be adversely affected if its products contain
errors. Software products as complex as the Company's products may contain
undetected errors or "bugs"," which result in product failures. The occurrence
of errors could result in loss of or delay in revenue, loss of market share,
failure to achieve market acceptance, diversion of development resources, injury
to the Company's reputation, or damage to its efforts to build brand awareness,
any of which could have a material adverse effect on the Company's business,
operating results and financial condition.
The Company's future success will depend on its ability to enhance existing
products and develop new products. To be competitive, the Company must develop
and introduce product enhancements and new products that which increase its
customers' ability to test their systems. If the Company fails to develop and
introduce new products and enhancements successfully and on a timely basis, it
could have a material adverse effect on the Company's business, operating
results and financial condition. The emerging nature of the automated software
testing and e-commerce testing markets requires that Segue continually improve
the performance, features and reliability of its products, particularly in
response to competitive offerings and evolving customer needs. The Company must
also introduce enhancements to existing products as quickly as possible and
prior to the introduction of competing products. The Company has acquired, and
may in the future acquire, technologies to provide it with the tools to
introduce new products or to enhance current products. The success of such
acquisitions will depend in part on the Company's ability to effectively
integrate the technologies.
The Company must hire and retain skilled personnel in a tight labor market.
Qualified personnel are in great demand throughout the software industry. The
Company's success depends in large part upon its ability to attract, train,
motivate and retain highly skilled employees, particularly sales and marketing
personnel, software engineers and other senior personnel. There is intense
competition for sales personnel in the Company's business, and there can be no
assurance that Segue will be successful in attracting, integrating, motivating
and retaining new sales personnel. The failure of the Company to attract and
retain the highly skilled personnel that are integral to its direct sales,
product development, service and support teams may limit the rate at which the
Company can generate sales and develop new products or product enhancements.
This could have a material adverse effect on the Company's business, operating
results and financial condition.
The Company faces many risks associated with international business
activities. The Company derived approximately 16% of its total product sales
from international customers in 1998. The international market for software
products is highly competitive and the Company expects to face substantial
competition in this market from established and emerging companies. Segue faces
many risks associated with international business activities including currency
29
fluctuations, imposition of government controls, export license requirements,
restrictions on the export of critical technology, political and economic
instability, tailoring of products to local requirements, trade restrictions,
changes in tariffs and taxes, difficulties in staffing and managing
international operations, longer accounts receivable payment cycles and the
burdens of complying with a wide variety of foreign laws and regulations. To the
extent that the Company is unable to expand international sales in a timely and
cost-effective manner, the Company's business could be materially adversely
affected.
The Company may be affected by unexpected Year 2000 problems. Many existing
computer systems and software products do not properly recognize dates after
December 31, 1999. This "Year 2000" problem could result in miscalculations,
data corruption, system failures or disruptions of operations. The Company is
subject to potential Year 2000 problems affecting its products, its internal
systems and the systems of its vendors and distributors, any of which could have
a material adverse effect on the Company's business, operating results and
financial condition.
In addition, there can be no assurance that Year 2000 errors or defects
will not be discovered in the Company's internal software systems and, if such
errors or defects are discovered, there can be no assurance that the costs of
making such systems Year 2000 compliant will not be material.
Year 2000 errors or defects in the internal systems maintained by the
Company's vendors or distributors could require Segue to incur significant
unanticipated expenses to remedy any problems or replace affected vendors and
could reduce the Company's revenue from its indirect distribution channel.
The Company may be subject to risks associated with its channel partner
program. Although the Company has not historically sold significant amounts of
its products through indirect channels, the Company intends to continue to
develop channel sales as part of its business strategy. Recently Segue has added
significant resources to expand its channel sales, including dedicating sales
personnel to increase sales through current channel partners and developing
relationships with other potential channel partners. There can be no assurance
that the Company's greater efforts will result in an increase in revenues.
Furthermore, the Company may be subject to certain distinct risks associated
with channel sales. The Company licenses its products to channel partners at a
discount and such partners re-license the products to end-users. The Company's
agreements with its channel partners are non-exclusive and provide the channel
partners with 60-day price protection. Because the Company's channel partners
generally order products after they have received purchase orders, there is no
requirement that the Company repurchase any product. The Company typically does
not grant its channel partners a contractual right to return software products.
When approved by management, however, the Company has accepted returns of
certain software products and has provided an allowance for the specified
products. Segue selects its channel partners based on the partner's financial
viability, product expertise and market focus. In order for the Company's
strategy to broaden market penetration through its channel partner program to be
successful, the Company must increase its unit sales to offset the discount the
Company is providing to its channel partners. There can be no assurance that the
Company will succeed in the development of these channels. Moreover, selling
through indirect channels may limit the Company's contact with the end users of
its products. As a result, the Company's ability to accurately forecast sales,
evaluate customer satisfaction and recognize emerging customer requirements may
be hindered and its ability to develop and maintain customer goodwill may be
limited. Furthermore, the Company's existing
30
or future channel partners may choose to devote greater resources to marketing
and supporting the products of other companies. In addition, Segue will need to
resolve potential conflicts among its sales force and channel partners.
The Company could be subject to product liability claims. In selling its
products, the Company relies primarily on "shrink wrap" licenses that contain,
among other things, provisions protecting against the unauthorized use, copying
and transfer of the licensed program and limiting the Company's exposure to
potential product liability claims. However, these licenses are not signed by
the licensees and the provisions of these licenses, including the provisions
limiting the Company's exposure to product liability claims, may therefore be
unenforceable under the laws of certain jurisdictions. The Company's products
may be used on applications that are critical to the operations of its
customers' businesses. Any failure in a customer's application could result in a
claim for substantial damages against the Company, regardless of the Company's
responsibility for such failure. Although the Company maintains general
liability insurance, including coverage for errors and omissions, there can be
no assurance that such coverage will continue to be available on reasonable
terms or will be available in amounts sufficient to cover one or more large
claims, or that the insurer will not disclaim coverage as to any future claim.
The Company's success depends on its ability to protect its proprietary
technology. The Company's success depends to a significant degree upon the
protection of its software and other proprietary technology. The unauthorized
reproduction or other misappropriation of the Company's proprietary technology
could enable third parties to benefit from the Company's technology without
paying Segue for it. This could have a material adverse effect on the Company's
business, operating results and financial condition. Although the Company has
taken steps to protect its proprietary technology, they may be inadequate. The
Company currently relies on a combination of trademark, copyright and trade
secret laws and contractual provisions to protect its proprietary rights in its
products. The Company presently has no registered copyrights. The Company has a
patent but there can be no assurance that the patent would be upheld if
challenged. Moreover, the laws of other countries in which the Company markets
its products may afford little or no effective protection of the Company's
intellectual property. There can be no assurance that the Company's competitors
will not independently develop technologies that are substantially equivalent or
superior to the Company's technology. If the Company resorts to legal
proceedings to enforce its intellectual property rights, the proceedings could
be burdensome and expensive and could involve a high degree of risk. There can
be no assurance that third parties will not assert intellectual property
infringement claims against the Company. If the Company were to discover that
any of its products violated third party proprietary rights, there can be no
assurance that the Company would be able to obtain licenses on commercially
reasonable terms to continue offering the product without substantial
reengineering or that any effort to undertake such reengineering would be
successful.
Any claim of infringement could cause the Company to incur substantial
costs defending against the claim, even if the claim is invalid, and could
distract management from the Company's business. Furthermore, a party making
such a claim could secure a judgment that requires the Company to pay
substantial damages. A judgment could also include an injunction or other court
order that could prevent the Company from selling its products. Any of these
events could have a material adverse effect on the Company's business, operating
results and financial condition.
31
ITEM 7A. QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUNT MARKET RISK
The information required pursuant to this Item 7A is contained in the
Company's Consolidated Financial Statements and notes thereto
included in the Company's Annual Report to Stockholders for the year
ended December 31, 1998 and is incorporated herein by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements required pursuant to this Item 8 are presented
beginning on page F-1 of this Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
32
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 concerning the Company's directors
and officers is incorporated by reference to the information under the heading,
"Election of Directors - Information Regarding the Nominees and Executive
Officers" in the Company's 1999 Proxy Statement.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated by reference to
the Company's 1999 Proxy Statement under the heading, "Compensation of Directors
and Executive Officers".
ITEM 12. SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN BENEFICIAL OWNERS
The information required by this Item 12 is incorporated by reference to
the Company's 1999 Proxy Statement under the heading, "Security Ownership of
Management and Certain Beneficial Owners".
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
33
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this report:
1. Financial Statements. The following financial statements of Segue
Software, Inc. are filed as a part of this report:
Page
----
Table of Contents F-1
Report of Independent Accountants F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997 F-3
Consolidated Statements of Operations for the Years Ended December 31,
1998, 1997 and 1996 F-4
Consolidated Statements of Stockholders' Equity for the Years Ended
December 31, 1998, 1997 and 1996 F-5
Consolidated Statements of Cash Flows for the Years Ended December 31,
1998, 1997 and 1996 F-6
Notes to Consolidated Financial Statements F-7
2. Financial Statement Schedules. All schedules have been omitted because
they are not applicable or the required information is shown in the
financial statements or notes thereto.
3. Exhibits. Documents listed below, except for documents identified by
footnotes, are being filed as exhibits herewith. Documents identified by
footnotes are not being filed herewith and, pursuant to Rule 12b-32 of
the General Rules and Regulations promulgated by the Commission under
the Securities Exchange Act of 1934 (the "Act") reference is made to
such documents as previously filed as exhibits with the Commission. The
Company's file number under the Act is 0-27794.
NUMBER DESCRIPTION OF EXHIBITS
------ -----------------------
3.1 (1) Restated Certificate of Incorporation (Exhibit 3.2 of
Registration Statement on Form S-1 (File No. 333-
1488))
3.2 (1) By-Laws (Exhibit 3.3 of Registration Statement on
Form S-1 (File No. 333-1488))
4.1 (1) Specimen Certificate representing the Common Stock
(Exhibit 4.2 of Registration Statement on Form S-1
(File No. 333-1488))
10.1 (1) 1996 Amended and Restated Incentive and Non-Qualified
Stock Option Plan
10.2 (1) 1996 Employee Stock Purchase Plan
34
10.7 (1) Form of Shareholder Rights Agreement, dated as of February 8,
1996, entered into between the Registrant and certain of its
stockholders (Exhibit 10.9 of Registration Statement on Form S-1
(File No. 333-1488))
10.8 (1) Form of Indemnification Agreement between the Registrant and its
directors and officers (Exhibit 10.10 of Registration Statement
on Form S-1 (File No. 333-1488))
10.10 (2) Agreement and Plan of Merger by and among the Registrant, SGE
Merger Corp. and SQLBench International, Inc. and the
Stockholders of SQLBench International, Inc. dated as of December
30, 1997
10.11 (2) Asset Purchase Agreement by and among the Registrant, ARC - Dr.
Ambichl & Dr. Reindl Communication GmbH and the Stockholders of
ARC - Dr. Ambichl & Dr. Reindl Communication GmbH dated as of
December 30, 1997
10.12 (2) Segue Software, Inc. Special Termination and Vesting Plan adopted
February 5, 1997
10.14 (3) Sublease Agreement dated March 31, 1998 by and between MediaOne
of Delaware, Inc. and the Registrant
10.15 (4) 1998 Employee Stock Option Plan
10.16 (5) Agreement and Plan of Merger by and among the Registrant, SSI
Merger Corp. and Eventus Software, Inc. and the Stockholders of
Eventus Software, Inc. dated as of December 3, 1998
10.17 (6) Agreement and Plan of Merger by and among the Registrant, SBW
Merger Corp. and Black & White Software, Inc. ("B&W"), and the
Stockholders of B&W and beneficial owners of the outstanding
capital stock of B&W dated as of December 31, 1998
*21.1 Subsidiaries of the Registrant
*23.1 Consent of PricewaterhouseCoopers LLP
*27.1 Financial Data Schedules
(1) Incorporated by reference to identically numbered exhibits (unless
otherwise indicated) filed in response to Item 16(a), "Exhibits", of the
Registrant's Registration Statement on Form S-1, as amended (File No. 333-
1488), which was declared effective on March 28, 1996.
(2) Incorporated by reference to the exhibits filed with the Registrant's
Annual Report on Form 10-K for the year ended December 31, 1997.
35
(3) Incorporated by reference to the exhibits filed with the
Registrant's Quarterly Report on Form 10-Q dated August 14, 1998.
(4) Incorporated by reference to the exhibit filed with the
Registrant's Registration Statement on Form S-8 dated December
17, 1998.
(5) Incorporated by reference to the exhibits filed with the
Registrant's Report on Form 8-K dated December 17, 1998.
(6) Incorporated by reference to the exhibits filed with the
Registrant's Report on Form 8-K dated January 14, 1999.
* Filed herewith.
(b) Reports on Form 8-K
On December 17, 1998, the Company filed a Report under Item 5 on Form
8-K.
36
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) 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 on this 15th day of
April 1999.
SEGUE SOFTWARE, INC.
By: /s/ STEPHEN B. BUTLER
----------------------
Stephen B. Butler, President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.
Signature Titles Date
- --------- ------ ----
/s/ STEPHEN B. BUTLER President, Chief Executive Officer April 15, 1999
- --------------------- and Director (Principal Executive
Stephen B. Butler Officer)
/s/ CARL D. BLANDINO Chief Financial Officer April 15, 1999
- --------------------- and Senior V. P. of Administration
Carl D. Blandino (Principal Financial Officer and
Principal Accounting Officer)
/s/ JAMES H. SIMONS Chairman of the Board April 15, 1999
- ---------------------
James H. Simons
/s/ LEONARD E. BAUM Director April 15, 1999
- ---------------------
Leonard E. Baum
/s/ RONALD D. FISHER Director April 15, 1999
- ---------------------
Ronald D. Fisher
/s/ JOHN R. LEVINE Director April 15, 1999
- ---------------------
John R. Levine
/s/ HOWARD L. MORGAN Director April 15, 1999
- ---------------------
Howard L. Morgan
37
SEGUE SOFTWARE, INC.
CONSOLIDATED FINANCIAL STATEMENTS
TABLE OF CONTENTS
Page
----
Report of Independent Accountants F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997 F-3
Consolidated Statements of Operations for the Years Ended
December 31, 1998, 1997 and 1996 F-4
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 1998, 1997 and 1996 F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1998, 1997 and 1996 F-6
Notes to Consolidated Financial Statements F-7
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Stockholders of Segue Software, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and cash
flows present fairly, in all material respects, the financial position of Segue
Software, Inc. (the "Company") at December 31, 1998 and 1997, and the results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with generally accepted auditing standards, which require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Boston, Massachusetts
April 15, 1999
F-2
SEGUE SOFTWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31,
---------------------------------
1998 1997
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 16,096 $ 23,393
Short-term investments 17,335 14,385
Accounts receivable, net of allowances of $608 and 8,823 5,234
$454
Other current assets 1,505 619
-------- --------
Total current assets 43,759 43,631
Property and equipment, net 3,560 2,400
Other assets 1,632 1,650
-------- --------
Total assets $ 48,951 $ 47,681
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Notes payable - current portion $ 2,983 $ 1,600
Accounts payable 2,464 1,777
Accrued compensation and benefits 1,389 1,244
Accrued royalties 377 631
Other accrued expenses 1,346 1,269
Deferred revenue 4,296 3,417
-------- --------
Total current liabilities 12,855 9,938
Notes payable 883 3,532
Other long-term liabilities - 245
Commitments and contingencies (Note 10)
Stockholders' equity:
Preferred stock, par value $.01 per share;
non-cumulative; 5,000 shares authorized; no shares
issued and outstanding - -
Common stock, par value $.01 per share; 30,000 shares
authorized; 8,912 and 8,109 shares issued and
outstanding 89 81
Additional paid-in capital 53,190 49,141
Unearned compensation (20) (105)
Accumulated deficit (18,046) (15,151)
-------- --------
Total stockholders' equity 35,213 33,966
-------- --------
Total liabilities and stockholders' equity $ 48,951 $ 47,681
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
F-3
SEGUE SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
-------------------------------------------
1998 1997 1996
------------ -------------- --------------
Revenue:
Software $26,249 $ 19,662 $16,551
Services 14,599 7,977 5,411
------- -------- -------
Total revenue 40,848 27,639 21,962
------- -------- -------
Cost of revenue:
Cost of software 2,972 3,673 2,807
Cost of services 6,119 2,641 1,721
------- -------- -------
Total cost of revenue 9,091 6,314 4,528
------- -------- -------
Gross margin 31,757 21,325 17,434
Operating expenses:
Sales and marketing 20,764 14,071 10,073
Research and development 8,571 7,084 5,043
General and administrative 4,500 3,933 2,950
Non-recurring charges 2,198 9,813 -
------- -------- -------
Total operating expenses 36,033 34,901 18,066
------- -------- -------
Loss from operations (4,276) (13,576) (632)
Litigation settlement - - (744)
Interest expense (449) (31) (44)
Interest income 1,970 2,186 1,584
------- -------- -------
Income (loss) before provision for income taxes (2,755) (11,421) 164
Provision for income taxes 140 56 20
------- -------- -------
Net income (loss) $(2,895) $(11,477) $ 144
======= ======== =======
Net income (loss) per common share - basic $(0.34) $(1.48) $0.03
Net income (loss) per common share - diluted $(0.34) $(1.48) $0.02
Weighted average common shares outstanding - basic 8,626 7,761 5,639
Weighted average common shares outstanding - diluted 8,626 7,761 7,980
The accompanying notes are an integral part of the consolidated financial
statements.
F-4
SEGUE SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS)
Preferred Stock Common Stock Additional
--------------- ------------ Paid-in Unearned
Shares Par value Shares Par value Capital Compensation
------- ---------- ------ ---------- ------------ ------------
Balance at December 31, 1995 2,292 $ 4,338 1,811 $ 730 $ 120
Change in par value (4,315) (712) 5,027
Return of capital - B&W (70)
Issuance of common stock
under option plan 125 1 127 1 442
Conversion of preferred stock
to common stock (2,417) (24) 2,416 24
Conversion of debt to common stock 654 7 647
Issuance of common stock,
net of issuance costs 2,611 26 39,650
Compensation cost related to stock options 575 $ (575)
Amortization of unearned compensation 135
Net income
---------- ----------- --------- ---------- ------- ----------
Balance at December 31, 1996 - - 7,619 76 46,391 (440)
Return of capital - B&W (49)
Issuance of common stock
under stock plans 291 3 924
Issuance of common stock,
net of issuance costs 55 1 513
Issuance of restricted common stock for acquisition 144 1 1,031
Compensation cost related to stock options 523
Stock options cancelled and amortization of
unearned compensation (192) 335
Net loss
--------- ----------- -------- ---------- ------- ----------
Balance at December 31, 1997 - - 8,109 81 49,141 (105)
Return of capital - B&W (15)
Issuance of common stock
under stock plans 753 8 3,088
Issuance of common stock,
net of issuance costs 50 - 989
Stock options cancelled and
amortization of unearned compensation (57) 85
Compensation cost related to stock options and
warrants 44
Net loss
--------- ----------- -------- --------- ------- ----------
Balance at December 31, 1998 - $ - 8,912 $ 89 $53,190 $ (20)
========= =========== ======== ========= ======= ==========
Total
Accumulated Stockholders'
Deficit Equity
---------------- --------------
Balance at December 31, 1995 $ (3,818) $ 1,370
Change in par value -
Return of capital - B&W (70)
Issuance of common stock
under option plan 444
Conversion of preferred stock
to common stock -
Conversion of debt to common stock 654
Issuance of common stock,
net of issuance costs 39,676
Compensation cost related to stock options -
Amortization of unearned compensation 135
Net income 144 144
---------------- --------------
Balance at December 31, 1996 (3,674) 42,353
Return of capital - B&W (49)
Issuance of common stock
under stock plans 927
Issuance of common stock,
net of issuance costs 514
Issuance of restricted common stock for acquisition 1,032
Compensation cost related to stock options 523
Stock options cancelled and amortization of
unearned compensation 143
Net loss (11,477) (11,477)
----------------- --------------
Balance at December 31, 1997 (15,151) 33,966
Return of capital - B&W (15)
Issuance of common stock
under stock plans 3,096
Issuance of common stock,
net of issuance costs 989
Stock options cancelled and
amortization of unearned compensation 28
Compensation cost related to stock options and
warrants 44
Net loss (2,895) (2,895)
--------------- --------------
Balance at December 31, 1998 $ (18,046) $ 35,213
================ ==============
The accompanying notes are an integral part of the consolidated financial
statements.
F-5
SEGUE SOFTWARE, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
-------- -------- --------
Cash flows from operating activities:
Net income (loss) $ (2,895) $ (11,477) $ 144
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Charge for purchased research and development in process - 9,095 339
Depreciation and amortization 2,322 1,342 774
Loss on disposal of property and equipment 4 4 16
Noncash compensation charges 10 666 135
Write off of other assets 378 - -
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable (3,589) (618) (1,378)
Other current assets (886) 590 (382)
Other assets (433) - -
Accounts payable 687 616 356
Accrued expenses, royalties, compensation and benefits (215) 1 1,186
Deferred revenue 879 812 1,058
-------- --------- --------
Net cash provided by (used in) operating activities (3,738) 1,031 2,248
-------- --------- --------
Cash flows from investing activities:
Additions to property and equipment (2,678) (1,401) (1,474)
Additions to other assets (735) (368) -
Acquisition of businesses - (4,499) -
Payments of notes payable for acquisition (883) - -
Maturities of short-term investments 16,200 57,725 17,500
Purchases of short-term investments (19,150) (38,018) (51,592)
-------- --------- --------
Net cash provided by (used in) investing activities (7,246) 13,439 (35,566)
-------- --------- --------
Cash flows from financing activities:
Net proceeds from initial public offering of common stock - - 39,527
Proceeds from issuance of common stock, net 989 514 -
Proceeds from issuance of notes payable 110 299 435
Payments of notes payable (493) (308) (66)
Proceeds from exercise of stock options and stock purchase plan 3,096 926 445
Return of capital to shareholders (15) (49) (70)
-------- --------- --------
Net cash provided by financing activities 3,687 1,382 40,271
-------- --------- --------
Net increase (decrease) in cash and cash equivalents (7,297) 15,852 6,953
Cash and cash equivalents at beginning of year 23,393 7,541 588
-------- --------- --------
Cash and cash equivalents at end of year $ 16,096 $ 23,393 $ 7,541
======== ========= ========
Supplemental disclosure of noncash investing and financing transactions:
Conversion of convertible debt into common stock $ 654
Issuance of common stock in exchange for notes receivable $ 117
Issuance of common stock and notes for assets $ 389
Issuance of notes payable for acquisition $ 4,415
Issuance of restricted common stock for acquisition $ 1,032
Cash paid during the year for interest $ 419 $ 58 $ 47
The accompanying notes are an integral part of the consolidated financial
statements.
F-6
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Segue Software, Inc. and its subsidiaries (hereafter, collectively, "Segue"
or the "Company") develop, market and support software products, and provide
related professional services, for the management and testing of e-business
applications. The Company's products are used by webmasters, quality assurance
professionals and software developers to improve software quality, reduce
development costs, manage the growing number of application components, and
shorten the time required to develop and deploy these mission critical
applications. The Company's products provide a solution designed to assemble,
model, deploy, monitor and analyze electronic commerce ("e-commerce") systems as
well as to provide automated functional and load testing of applications
deployed on the World Wide Web and on client/server systems.
BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION
As described in Note 2, in December 1998, the Company acquired Eventus
Software, Inc. ("Eventus") and Black and White Software, Inc. ("B&W"). Both
acquisitions were accounted for using the pooling-of-interests method and,
accordingly, the historical consolidated financial statements of the Company
prior to the acquisitions presented herein have been restated to include the
financial position, results of operations and cash flows of Eventus and B&W.
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. Intercompany transactions and balances have
been eliminated in consolidation.
REVENUE RECOGNITION
Effective January 1, 1998, the Company adopted Statement of Position 97-2,
"Software Revenue Recognition" ("SOP 97-2"), which provides guidance on applying
generally accepted accounting principles in recognizing revenue on software
transactions. SOP 97-2 requires that revenue allocated to software products,
specified upgrades and enhancements is generally recognized upon delivery of the
related products, upgrades or enhancements. Revenue allocated to post contract
customer support is generally recognized ratably over the term of the support,
and revenue allocated to service elements is generally recognized as the
services are performed.
F-7
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company recognizes revenue from software licenses upon product shipment
and receipt of a signed purchase order or contract, provided that collection is
probable and the other revenue recognition criteria of SOP 97-2 are met. The
Company's products do not require significant modification or customization of
software. The Company recognizes revenue from maintenance ratably and from
training and consulting services as the services are performed.
The Company typically does not grant to its customers a contractual right
to return software products. When approved by management, however, the Company
has accepted returns of certain software products and has provided an allowance
for those specified products. The Company also provides reserves for customer
receivable balances that are considered potentially uncollectible. Included in
accounts receivable allowances are a sales allowance provided for expected
returns and credits and an allowance for bad debts. The Company's accounts
receivable allowances totaled $608,000, $454,000 and $223,000 as of December
31, 1998, 1997 and 1996, respectively. The provisions charged to the statement
of operations totaled $1,033,000, $448,000 and $507,000 in 1998, 1997 and 1996,
respectively, and write-offs against the allowances totaled $879,000, $217,000
and $439,000 in 1998, 1997 and 1996, respectively.
DEFERRED REVENUE
Service revenue (maintenance, training and consulting) which is not yet
earned is included in deferred revenue.
RESEARCH AND DEVELOPMENT AND SOFTWARE DEVELOPMENT COSTS
Research and development expenditures are charged to operations as
incurred. Software development costs subsequent to the establishment of
technological feasibility are capitalized and amortized to cost of software.
Based on the Company's product development process, technological feasibility is
established upon completion of a working model. Costs incurred by the Company
between completion of the working model and the point at which the product is
ready for general release have been insignificant.
INCOME TAXES
The Company accounts for income taxes using the asset and liability method,
pursuant to which deferred income taxes are recognized based on temporary
differences between the financial statement and tax bases of assets and
liabilities using enacted tax rates in effect for the year in which the
temporary differences are expected to reverse. Valuation allowances are
provided if, based upon the weight of available evidence, it is more likely than
not that some or all of the deferred tax assets will not be realized.
F-8
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company does not provide for U.S. income taxes on the undistributed
earnings of foreign subsidiaries, which the Company considers to be permanent
investments.
CURRENCY TRANSLATION
Assets and liabilities of the Company's foreign operations are translated
into U.S. dollars at the exchange rate in effect at the balance sheet date, and
revenues and expenses are translated using the average rates in effect during
the period. The resultant translation adjustments, which to date have been
insignificant, are reflected as a separate component of stockholders' equity on
the consolidated balance sheet. Foreign currency transaction gains and losses
are included in results of operations.
NET INCOME (LOSS) PER SHARE
Basic earnings per share ("EPS") is based upon the weighted average number
of common shares outstanding during the period. Diluted EPS is based upon the
weighted average number of common and common equivalent shares outstanding
during the period. Common stock equivalent shares are included in the Diluted
EPS calculation where the effect of their inclusion would be dilutive. Common
equivalent shares result from the assumed exercise of outstanding stock options
and warrants, the proceeds of which are then assumed to have been used to
repurchase outstanding common stock using the treasury stock method.
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company considers all highly liquid investments purchased with
maturities of three months or less to be cash equivalents. Investments with
maturities greater than three months but less than twelve months are considered
to be short-term investments. Cash equivalents and short-term investments
consist primarily of commercial paper (approximately $35.2 million at December
31, 1998). The Company has classified its securities as "available for sale" and
reports them at fair value, with unrealized gains and losses excluded from
earnings and reported as an adjustment to stockholders' equity. As of December
31, 1998 and 1997, unrealized gains and losses on securities were not material.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost and depreciated on a straight-
line basis over their estimated useful lives, generally three to five years.
Leasehold improvements are amortized over the shorter of the assets' useful
lives or the term of the related leases. Expenditures for major improvements
which substantially increase the useful lives of assets are capitalized. Repair
and maintenance costs are expensed as incurred.
F-9
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Upon retirement or sale, the cost of the assets disposed and the related
accumulated depreciation and amortization are removed from the accounts and any
resulting gain or loss is included in the determination of net income or loss.
COMPLETED TECHNOLOGY AND OTHER ASSETS
Completed technology is included in other assets and is carried at cost
less accumulated amortization, which is being provided on a straight-line basis
over a period of three years, its estimated useful life (see Note 2).
Long-lived assets to be held and used are recorded at cost. Management
reviews long-lived assets, including intangible assets, for impairment whenever
events or changes in circumstances indicate the carrying amount of such assets
may not be recoverable. Recoverability of these assets is assessed using a
number of factors including operating results, business plans, budgets, and
economic projections and undiscounted cash flows. In addition, the Company's
evaluation considers non-financial data such as market trends, product
development cycles and changes in management's market emphasis.
CONCENTRATION OF CREDIT RISK
The Company places its excess cash in cash equivalents and short-term
investments, primarily consisting of commercial paper. There are no significant
concentrations in any one issuer of debt securities. The Company places its
cash, cash equivalents and investments with financial institutions with high
credit standing. The Company has not experienced any significant losses on its
cash, cash equivalents and short-term investments to date. The Company believes
credit risk with respect to investments of commercial paper are minimal due to
the duration of such investments, which are generally less than 6 months.
The Company sells its products principally through a worldwide direct sales
force and through distributors outside of the United States to customers in a
broad range of industries. The Company provides credit, in the normal course of
business, to various types and sizes of companies located throughout North
America and Europe and does not require collateral or other security. The
Company maintains reserves for potential credit losses.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain estimates and
assumptions. These estimates and assumptions 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 revenue and
expenses during the reported periods. The most significant estimates included
in these financial statements are the valuation of accounts receivable and long-
term assets, including intangibles and deferred tax assets.
RECLASSIFICATION
F-10
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Certain prior year amounts have been reclassified to conform to the current
year presentation.
COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130").
SFAS 130 requires the reporting of comprehensive income in addition to net
income from operations. Comprehensive income is a more inclusive reporting
methodology that includes disclosure of certain financial information that
historically has not been recognized in the calculation of net income. The
adoption of SFAS 130 had no impact on the Company's net income or stockholders'
equity. For the years ended December 31, 1998, 1997 and 1996, comprehensive
income (loss) equaled net income (loss).
SEGMENT REPORTING
In 1998, the Company adopted Statement of Financial Accounting Standards
No. 131, "Disclosure about Segments of an Enterprise and Related Information"
("SFAS 131"), which changes the manner in which public companies report
information about their operating segments. SFAS 131, which is based on the
management approach to segment reporting, requires disclosures about products
and services, major customers, and geographic areas. The adoption of SFAS 131
did not affect the Company's results of operations or financial position, but
did affect the disclosure of segment information (see Note 13).
2. BUSINESS COMBINATIONS
On December 31, 1998, the Company acquired all of the outstanding capital
stock of B&W in exchange for 224,809 shares of the Company's common stock and
the conversion of all B&W outstanding common stock options into options to
purchase 41,870 shares of the Company's common stock. This acquisition was
accounted for using the pooling-of-interests method and, accordingly, the
historical consolidated financial statements of the Company prior to the
acquisition presented herein have been restated to reflect the financial
position, results of operations and cash flows of B&W. Founded in 1992 as a
California S Corporation, B&W supplied a wide range of products for application
development and productivity enhancement, including tools for creating object-
oriented client/server applications and building applications with dynamic
graphics and visual animation for graphical user interface. During 1998, B&W
began to focus its efforts on products that diagnose and monitor communications
between distributed application objects. B&W had approximately 40 employees at
the time of the acquisition.
On December 3, 1998, the Company acquired all of the outstanding capital
stock of Eventus in exchange for 312,990 shares of the Company's common stock
and the conversion of all Eventus outstanding common stock options and warrants
into options and warrants to purchase 31,951 shares of the Company's common
stock. This acquisition was accounted for using the pooling-of-interests
method and, accordingly, the historical consolidated financial statements of the
Company prior to the acquisition presented herein have been restated to reflect
the financial position, results of operations and cash flows of Eventus. Founded
in September 1996 and based in California, Eventus' principal product manages
the assembly and deployment of web applications.
Eventus
F-11
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
had approximately 20 employees at the time of acquisition.
The following information presents certain statement of operations data (in
thousands) of Segue, Eventus and B&W for the periods prior to the acquisitions.
Year Ended December 31,
---------------------------------------
1998 1997 1996
---- ---- ----
Revenue:
Segue $36,167 $ 21,794 $16,973
Eventus 789 2,197 1,033
B&W 3,892 3,648 3,956
------- -------- -------
Total revenue $40,848 $ 27,639 $21,962
======= ======== =======
Net income (loss):
Segue $(1,109) $ (9,588) $ 641
Eventus (2,358) (730) (503)
B&W 572 (1,159) 6
------- -------- -------
Net income (loss) $(2,895) $(11,477) $ 144
======= ======== =======
Acquisition costs of $1.5 million, consisting primarily of investment
banking, legal, accounting and other professional fees, were charged to
operations in the fourth quarter of 1998. Prior to the mergers, there were no
intercompany transactions between Segue, Eventus, and B&W.
On December 30, 1997, the Company acquired both SQLBench International,
Inc. and ARC - Dr. Ambichl & Dr. Reindl Communication GmbH (formerly named ARC
Dr. Ambichl & Dr. Reindl OEG), privately-held developers of Web-based load
testing technology (hereafter referred to as "SQLBench"). Since the acquisition
of each company was contingent upon both companies being acquired, the
transaction was accounted for as a single business combination using the
purchase method. Accordingly, the operating results of SQLBench are included in
the Company's consolidated financial statements from the date of acquisition.
The combined purchase had an aggregate consideration of approximately $10.1
million, including transaction costs, and consisted of approximately $4.4
million in cash paid from the Company's existing cash balances, $4.4 million in
notes payable and the issuance of 144,000 restricted shares of the Company's
common stock with a fair value of $1.0 million. The purchase price was allocated
to $1.0 million of completed technology, which is being amortized over three
years, and $9.1 million to purchased research and development in process. The
purchased research and development in process of $9.1 million had not reached
technological feasibility, had no alternative future use and was valued using
expected future cash flows, discounted for risks and uncertainties related to
the target markets and the completion of the products. Consequently, at the date
of acquisition, the $9.1 million allocated to purchased research and development
in process was recorded as a non-recurring charge. For the years ended December
31, 1998 and 1997, accumulated amortization related to completed technology was
$336,000 and $0, respectively.
F-12
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. OTHER ASSETS
In March 1998, the Company entered into an agreement with a vendor whereby
the vendor licensed specific software to the Company for purposes of marketing
and distribution. Under the initial terms of the agreement, the Company paid
$780,000 in 1998, which represented a non-refundable non-recurring engineering
and initial license fee ("NRE") of $480,000 and guaranteed royalties of
$300,000. Under this agreement, an additional $200,000 for guaranteed royalties
was to be paid by September 30, 1998. In October 1998, the parties amended this
agreement to, among other things, remove the Company's obligation to make the
remaining payment for guaranteed royalties (see Note 10). The NRE fee was being
amortized into cost of software revenue on a straight-line basis over its
estimated life of two years, and the royalty expense was being recognized as
cost of software revenue based upon sales of the related products. For the year
ended December 31, 1998, amortization expense and royalty expense related to
this agreement was approximately $180,000 and $10,000, respectively.
Based on minimal sales of the licensed products and management's decision
in the first quarter of 1999 to cease selling the licensed products related to
the above agreement in order to focus efforts on the EBMS products, the Company
wrote off the remaining balances of the NRE ($300,000) and prepaid royalties
($290,000) as non-recurring charges as of December 31, 1998. Additionally in the
fourth quarter, the Company wrote off approximately $80,000 of other prepaid
royalties, based on an analysis of their recoverability.
In December 1998, the Company entered into a five-year agreement with a
vendor that provides for future royalty payments to the vendor of 10% of net
revenues achieved on sales of the Company's products to the vendor's customer
base. Under the terms of the agreement, the Company paid a guaranteed, non-
refundable minimum royalty of $650,000 in December 1998. As of December 31,
1998, other current assets included approximately $220,000 and other long-term
assets included approximately $430,000 related to the guaranteed royalties.
Royalty expense will be recognized as cost of software revenue based upon
qualified sales of the Company's products.
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following as of December 31 (in
thousands):
F-13
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1998 1997
---- ----
Computer equipment $ 5,514 $ 3,794
Office equipment 145 64
Furniture and fixtures 962 498
Leasehold improvements 456 124
------- -------
7,077 4,480
Accumulated depreciation and amortization (3,517) (2,080)
------- -------
Total $ 3,560 $ 2,400
======= =======
Depreciation and amortization of property and equipment totaled $1,514,000,
$1,096,000, and $659,000 for the years ended December 31, 1998, 1997 and 1996,
respectively.
5. NOTES PAYABLE
In conjunction with the SQLBench acquisition on December 30, 1997, the
Company issued $4.4 million of notes payable that bear interest at a designated
prime rate (7.75% at December 31, 1998). These notes become subordinated debt
upon the issuance of qualified Senior Debt, as defined by the note agreements.
As of December 31, 1998 and 1997, these notes were not subject to subordination.
Subject to certain acceleration terms set forth below, the notes mature on
December 30, 2002. Interest is payable in arrears semi-annually beginning on
June 30, 1998 and on each December 31 and June 30 thereafter. If the holders of
the notes terminate employment with the Company prior to December 30, 2000, no
interest shall accrue with respect to any period following such termination. In
the event that the note holders are either (i) employed by the Company as of the
dates set forth below or (ii) terminated by the Company without cause or by
reason of death or permanent disability, payments under the notes shall be made
according to the following schedule (in thousands):
Date Amount
---- ------
December 30, 1999 $2,649
December 30, 2000 883
------
Total $3,532
======
At December 31, 1998 and 1997, respectively, $2,649,000 and $883,000 was
recorded as the current portion of long-term debt related to this note.
In February 1997, B&W obtained a $350,000 revolving line of credit
(increased to $500,000 in November 1997) and an $85,000 term note with a bank,
both of which bore interest at the bank's prime rate (7.75% at December 31,
1998) plus 1.50%. At December 31, 1998 and 1997, respectively, $334,000 and
$274,000 was outstanding under these notes. The notes were paid in full in
January 1999.
F-14
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In September 1996, Eventus issued a promissory note for $492,000 in
consideration for assets purchased and certain technology rights received. In
October 1996, Eventus received proceeds of $300,000 in exchange for a promissory
note. The notes, which originally bore interest at 7%, were to mature on July
31, 1997. On June 30, 1997 and September 30, 1997, the maturity dates were
extended and the interest rates were amended to 9.5% and 11.0%, respectively, on
the remaining unpaid principal . As of December 31, 1997, approximately $443,000
was outstanding related to these notes. These notes were paid in full in
December 1998.
6. STOCKHOLDERS' EQUITY
COMMON STOCK
In February 1996, the stockholders of the Company approved the following,
among other matters: (i) the reincorporation of the Company from a California
corporation to a Delaware corporation; (ii) an amendment of the Company's
Certificate of Incorporation to increase the number of authorized shares of
common stock and preferred stock to 30 million shares and 9 million shares,
respectively; (iii) the designation of 4 million shares of such 9 million shares
of preferred stock as Series A preferred stock; and (iv) the changing of the per
share par value of the common stock and preferred stock from no par value to
$.01 par value.
In April 1996, the Company consummated an initial public offering of
3,162,500 shares of the Company's common stock at an initial public offering
price of $18.00 per share. The total shares issued pursuant to the initial
public offering consisted of 2 million shares sold by the Company, 750,000
shares sold by selling shareholders, and an additional 412,500 shares sold by
the Company pursuant to the underwriters' over-allotment option. Proceeds to
the Company, net of underwriters' discount and associated costs of approximately
$860,000, were approximately $39.5 million. Concurrent with the closing of the
offering, all outstanding shares of Series A preferred stock were converted into
common stock. After the consummation of the offering, the Company amended its
Certificate of Incorporation to reduce the number of authorized shares of
preferred stock to 5 million shares and to cancel the Company's existing series
of Series A preferred stock.
Each series of Preferred Stock will have the rights, preferences,
privileges and restrictions, including voting rights, dividend rights,
conversion rights, redemption privileges and liquidation preferences, as shall
be determined by the Company's Board of Directors.
The Company's convertible subordinated notes were converted into
approximately 654,000 shares of common stock during the year ended December 31,
1996 at $1.00 per share.
In conjunction with the SQLBench acquisition in December 1997, the Company
issued approximately 144,000 shares of unregistered restricted stock that by
agreement cannot be sold or otherwise disposed of for two years from the
acquisition date.
F-15
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
STOCK COMPENSATION PLANS
STOCK OPTION PLANS
In June 1998, the Company's 1996 Amended and Restated Incentive and Non-
Qualified Stock Option Plan (the "Option Plan") was amended to increase the
maximum number of shares of common stock available for issuance to 3,250,000
shares. Under the Option Plan, incentive stock options may be granted to any
officer or employee of the Company, and nonqualified stock options may be
granted to any officer, employee, consultant, director or other agent of the
Company.
In November 1998, the Company established the 1998 Employee Stock Option
Plan (the "1998 Option Plan"). The 1998 Option Plan provides for grants of
nonqualified options to purchase up to 1 million shares of the Company's common
stock to employees and consultants of the Company.
All options issued under the Option Plan and the 1998 Option Plan are
granted at the fair market value of the stock on the date of grant, become
exercisable at varying rates, generally over three or four years, as determined
by the Board of Directors, and generally expire 10 years from the date of grant.
With the acquisition of Eventus on December 3, 1998, the Company assumed
836 outstanding stock warrants and 31,115 outstanding stock options (adjusted
for the merger exchange ratio of 0.021378 common Eventus shares for each share
of the Company's common stock) representing all of Eventus' obligations under
its existing stock option plan. The assumed stock options and warrants were
granted to employees, directors, and consultants of Eventus at the fair market
value of the Eventus common stock at the date of grant, as established by the
Eventus Board of Directors, and expire 10 years from the date of grant. Vesting
was established by the Eventus Board of Directors and generally occurs over a
three to five year period. As of December 31, 1998, 98,060 shares (adjusted for
the merger exchange ratio) were authorized under the Eventus stock option plan,
with 57,348 shares available for future grants. No additional stock options or
warrants will be granted under the Eventus plan.
With the acquisition of B&W on December 31, 1998, the Company assumed
41,870 outstanding stock options (adjusted for the merger exchange ratio of
0.112405 common B&W shares for each share of the Company's common stock)
representing all of B&W's obligations under its existing stock option plan. The
assumed stock options were granted to employees of B&W at the fair market value
of the B&W common stock at the date of grant, as established by the B&W Board of
Directors, and expire 10 years from the date of grant. Vesting was established
by the B&W Board of Directors and generally occurs over a four year period, with
50% vesting on the second anniversary of the grant date, and 25% vesting on each
of the third and fourth anniversary of the grant dates. As of December 31, 1998,
56,202 shares (adjusted for the merger exchange ratio)
F-16
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
were authorized under the B&W stock option plan, with 14,332 shares available
for future grants. No additional stock options will be granted under the B&W
plan.
The following table summarizes activity of the Company's option plans since
December 31, 1995. Information with respect to Eventus and B&W stock options has
been retroactively restated to reflect their merger exchange ratios noted above.
Weighted
average
Shares exercise prices
------ ---------------
(in thousands)
Outstanding at December 31, 1995 1,356 $ 2.08
Granted 853 14.74
Exercised (127) 1.54
Canceled (183) 16.54
-----
Outstanding at December 31, 1996 1,899 6.43
Granted 1,202 10.49
Exercised (250) 2.33
Canceled (379) 10.20
-----
Outstanding at December 31, 1997 2,472 8.24
Granted 1,107 17.40
Exercised (711) 3.88
Canceled (468) 12.81
-----
Outstanding at December 31, 1998 2,400 $12.87
=====
As of December 31, 1998, 1997 and 1996, options to purchase 552,000,
906,000 and 645,000 shares, respectively, were exercisable with weighted average
exercise prices of $7.67, $4.90 and $2.46 per share, respectively. As of
December 31, 1998, 782,209 shares were available for future grants under the
Option Plan and the 1998 Option Plan.
For various price ranges, weighted average information for options
outstanding at December 31, 1998 was as follows:
F-17
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Outstanding Options Exercisable Options
------------------------------------------------------ ----------------------------
Weighted average Weighted Weighted
Range of exercise remaining life average average
prices Shares (in years) exercise price Shares exercise price
------ ------ ---------- -------------- ------ --------------
(in thousands) (in thousands)
$ 0.75 - $ 4.21 238 5.65 $ 2.11 204 $ 1.99
8.50 - 9.00 461 8.37 8.98 153 8.98
9.25 - 10.63 401 8.88 9.97 74 9.69
10.75 - 14.00 381 8.70 12.47 82 12.35
14.56 - 19.06 476 9.50 16.83 23 16.17
20.25 - 22.25 443 9.85 21.42 16 22.25
----- ---
$ 0.75 - $22.25 2,400 8.74 $12.87 552 $ 7.67
EMPLOYEE STOCK PURCHASE PLAN
In February 1996, the Company established the Segue Software, Inc. 1996
Employee Stock Purchase Plan (the "ESPP"), under which eligible employees may
purchase up to 100,000 shares of the Company's common stock through payroll
deductions. The shares can be purchased for 85% of the lower of the beginning or
ending fair market value of each six-month segment within the offering period.
Purchases are limited to 10% of an employee's annual compensation. In June 1998,
the ESPP was amended in order to increase the maximum number of shares of common
stock available for issuance from 100,000 to 200,000 shares. As of December 31,
1998, approximately 77,000 shares have been issued under the ESPP.
In October 1995, Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation", ("SFAS 123") was issued. SFAS 123
required the Company to elect either expense recognition under SFAS 123 or its
disclosure-only alternative for stock-based employee compensation. The expense
recognition provision encouraged by SFAS 123 requires fair-value based financial
accounting to recognize compensation expense for employee stock compensation
plans. The Company adopted SFAS 123 in 1997 and elected the disclosure-only
alternative. Had compensation cost for the Company's stock and stock option
plans been determined based on the fair value at the grant dates for awards
under those plans consistent with the methodology of SFAS 123, the Company's net
income (loss) and net income (loss) per share would have been adjusted to the
pro forma amounts indicated below for the years ended December 31, (in
thousands, except per share data):
F-18
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
1998 1997 1996
---- ---- ----
Net income (loss) As reported $(2,895) $(11,477) $ 144
Pro forma $(5,486) $(13,646) $(1,025)
Net income (loss) per common
share - basic As reported $ (0.34) $ (1.48) $ 0.03
Pro forma $ (0.64) $ (1.76) $ (0.18)
Net income (loss) per common
share - diluted As reported $ (0.34) $ (1.48) $ 0.02
Pro forma $ (0.64) $ (1.76) $ (0.13)
For the years ended December 31, 1998, 1997 and 1996, total compensation
cost recognized in pro forma net loss for stock-based employee compensation
awards was $2,591,000, $2,169,000, and $1,169,000, respectively. Since the SFAS
123 method of accounting has not been applied to options granted prior to
January 1, 1995, the resulting compensation cost may not be representative of
that to be expected in future years.
The weighted average fair value of the stock options granted during 1998,
1997 and 1996 was $9.65, $5.74 and $7.72 per share, respectively. For the
computation in accordance with SFAS 123, the fair value of each stock option
grant is estimated on the date of grant using the Black-Scholes option pricing
model with the following weighted average assumptions used for grants in 1998,
1997 and 1996, respectively: risk-free interest rate of 5.0%, 6.1% and 5.9%;
dividend yield of 0%; expected life of five years; and expected volatility of
59%, 59% and 46%. For the computation in accordance with SFAS 123, the fair
value of the employees' purchase rights under the ESPP is estimated using the
Black-Scholes model with the following assumptions for 1998, 1997, and 1996:
risk-free interest rate of 5.5%, 5.3%, and 5.4%, respectively; dividend yield of
0%; expected life of six months; and expected volatility of 60%.
7. NET INCOME (LOSS) PER SHARE
The following table sets forth the computation of basic and diluted net
income (loss) per share (in thousands, except per share data):
F-19
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
1998 1997 1996
---- ---- ----
C>
Net income (loss) $(2,895) $(11,477) $ 144
Plus income impact of assumed conversions:
Interest on convertible debt, net of tax - - 27
------- -------- ------
Net income (loss) plus assumed conversions $(2,895) $(11,477) $ 171
Weighted average shares used in net income (loss)
per share - basic 8,626 7,761 5,639
Effect of dilutive securities:
Employee and director stock options - - 1,180
Preferred stock - - 614
Convertible debt - - 547
------- -------- ------
Dilutive potential common shares - - 2,341
------- -------- ------
Weighted average shares used in net income (loss)
per common share - diluted 8,626 7,761 7,980
======= ======== ======
Net income (loss) per common share - basic $ (0.34) $ (1.48) $ 0.03
======= ======== ======
Net income (loss) per common share - diluted $ (0.34) $ (1.48) $ 0.02
======= ======== ======
Options to purchase approximately 2,400,000 and 2,472,000 shares of common
stock were outstanding for the years ended December 31, 1998 and 1997,
respectively, but were not included in the calculation of diluted net loss per
common share because their inclusion would have been antidilutive. Options to
purchase 24,000 weighted average shares of common stock at an average exercise
price of $21.44 per share were outstanding for the year ended December 31, 1996,
but were not included in the calculation of diluted net income per common share
because the options' exercise prices were greater than the average market price
of the common shares for the period.
8. EMPLOYEE SAVINGS PLAN
The Company maintains two 401(k) plans under which all employees may make
contributions to their respective participant accounts. The Company may, at its
discretion, make matching contributions on behalf of its employees. Employees
must have completed two years of service to be eligible for the Company's
contributions. No matching contributions were made during the years ended
December 31, 1998, 1997 or 1996.
9. INCOME TAXES
Income (loss) before income taxes and the components of the income tax
provision (benefit) are as follows for the years ended December 31, (in
thousands):
F-20
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
1998 1997 1996
---- ---- ----
Income (loss) before income taxes:
United States $(2,949) $(11,421) $ 164
Foreign 194 - -
------- -------- -----
Total income (loss) before income taxes $(2,755) $(11,421) $ 164
======= ======== =====
Provisions for (benefit from) income taxes:
Current: Foreign $ 71 $ - $ -
State 69 56 20
------- -------- -----
Total current tax provision $ 140 $ 56 $ 20
------- -------- -----
Deferred: Federal $ (672) $ (2,637) $ 21
Foreign (26) - -
State (108) (802) 4
Change in valuation allowance 761 3,439 (25)
------- -------- -----
Total deferred tax provision - - -
------- -------- -----
Total tax provision $ 140 $ 56 $ 20
======= ======== =====
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. As of December 31, the
components of the net deferred tax asset are as follows (in thousands):
1998 1997
---- ----
Gross deferred tax assets
-------------------------
Federal and state net operating
loss carryforwards $ 5,432 $ 1,845
Intangible assets 2,604 2,670
Research and experimentation credits 936 1,047
Accounts receivable 198 136
Accrued expenses and deferred
compensation 115 299
Fixed assets 42 52
Valuation allowance (9,327) (6,049)
------- -------
Net deferred tax assets $ - $ -
======= =======
Of the change in valuation allowance of $3,278,000, approximately
$2,517,000 relates to tax return deductions attributable to the exercise of non-
qualifying stock options and disqualifying dispositions of incentive stock
options, and are not benefited through income.
As of December 31, 1998, the Company had federal net operating loss
carryforwards of approximately $14.2 million, of which $9.6 million relates
to deductions attributable to the
F-21
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
exercise of nonqualified stock options and disqualifying dispositions of
incentive stock options; state net operating loss carryforwards of
approximately $11.9 million, of which at least $2.6 million is subject to
annual limitations on utilization; and $779,000 of federal and $230,000 of state
tax credit carryforwards available for income tax purposes. These carryforwards
generally expire in the years 1999 through 2018 and may be subject to additional
annual limitations as a result of changes in the Company's ownership. The
benefits of stock option deductions included in net operating loss carryforwards
will be credited to additional paid-in capital when realized.
Management of the Company has evaluated the positive and negative evidence
impacting the realizability of its deferred tax assets. Based on the weight of
the available evidence, it is more likely than not that all of the deferred tax
assets will not be realized, and accordingly the deferred tax assets have been
fully reserved. Management re-evaluates the positive and negative evidence on a
quarterly basis.
The following schedule reconciles the difference between the federal income
tax rate and the effective income tax rate for the years ended December 31 (in
thousands):
1998 1997 1996
---- ---- ----
U.S. federal statutory tax $(937) $(3,883) $ 55
S Corporation (income) loss taxed
at shareholders' level (194) 456 (2)
State tax provision, net (25) (492) 16
Foreign rate differential 4 - -
Nondeductible acquisition costs 520 30 -
Change in valuation allowance 761 3,439 (25)
Write-off of incomplete technology - 844 -
Other 11 (338) (24)
----- ------- -----
Effective tax $ 140 $ 56 $ 20
===== ======= =====
10. COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
In August 1998, the Company moved its corporate headquarters to Lexington,
Massachusetts under a non-cancelable operating lease that expires in 2007. The
Company has an obligation to provide a security deposit of up to approximately
$2.2 million if the Company's current assets become less than $20 million. The
Company has the right to terminate the lease on September 30, 2004 for a fee of
approximately $2.2 million. The Company also leases certain U.S. and foreign
sales offices and certain equipment under various operating leases with lease
terms ranging from month-to-month up to five years. Certain of these leases
contain renewal options. The agreements generally require the payment of
utilities, real estate taxes, insurance
F-22
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
and repairs. Future minimum payments under the facilities and equipment leases
with non-cancelable terms are as follows as of December 31, 1998 (in thousands):
Amount
1999 ------
2000 $ 2,477
2001 2,465
2002 2,235
2003 2,235
Thereafter 2,162
8,280
Total -------
$19,854
=======
Rent expense for the years ended December 31, 1998, 1997 and 1996 totaled
$1.9 million, $1.3 million and $616,000, respectively.
ROYALTY COMMITMENTS
In March 1998, the Company entered into an agreement with a vendor whereby
the vendor licensed specific software to the Company for purposes of marketing
and distribution (see Note 3). In October 1998, the parties amended this
agreement as follows: (i) the Company committed to spend $200,000 on defined
marketing activities in the initial 18-month term and each subsequent one-year
term of the agreement, and (ii) the Company agreed to make guaranteed, annual
royalty payments beginning on October 1, 1999 of $300,000 for each one-year term
of the agreement. The agreement terminates on September 30, 2001, unless earlier
voluntarily terminated by the Company at the conclusion of any current one-year
term.
In addition, the Company participates in other royalty arrangements with
third parties and expenses such amounts as revenues from the related products
are recognized.
11. NON-RECURRING CHARGES
In the fourth quarter of 1998, the Company recorded a charge of $1.5
million, consisting primarily of investment banking, legal, accounting, and
other professional fees, related to the Eventus and B&W acquisitions and
approximately $667,000 related to the write-offs of an NRE fee and guaranteed
royalties (see Note 3).
In the fourth quarter of 1997, the Company recorded a charge of $9.1
million related to the write-off of purchased research and development in
process in conjunction with the SQLBench acquisition and $718,000 consisting of
severance and accelerated vesting of options related to the resignation of the
Company's former President and Chief Executive Officer. The charge of $718,000
consisted of $195,000 in severance and $523,000 in accelerated vesting of
options for common stock.
F-23
SEGUE SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
12. LITIGATION SETTLEMENT
On September 30, 1996, the Company entered into a definitive agreement
with a plaintiff, a software company located in Cambridge, Massachusetts, to
settle litigation brought against the Company and certain of its current and
former employees. The Company recorded a charge of $744,000 during the year
ended December 31, 1996 to cover the settlement and other expenses incurred in
connection therewith.
13. SEGMENT REPORTING
The following table presents revenue and long-lived asset information by
geographic area as of and for the years ended December 31 (in thousands):
Total Revenue Long Lived Assets
------------- -----------------
1998 1997 1996 1998 1997 1996
---- ---- ---- ---- ---- ----
United States $35,792 $25,413 $20,591 $4,995 $3,906 $2,289
Foreign 5,056 2,226 1,371 197 144 -
------- ------- ------- ------ ------ ------
$40,848 $27,639 $21,962 $5,192 $4,050 $2,289
======= ======= ======= ====== ====== ======
Foreign revenue is based on the country in which the sale originates.
Revenue from no single foreign country was material to the consolidated
revenues of the Company. No customer accounted for 10% or more of total revenue
in 1998, 1997 or 1996.
14 SUBSEQUENT EVENTS (UNAUDITED)
During the first quarter of 1999, the Company began to execute a
restructuring plan to consolidate its marketing, product development and
administrative operations in order to achieve cost efficiencies through the
elimination of redundant functions. The Company realigned its marketing and
product development operations to redirect focus on its strongest product lines
and better integrate the efforts of certain product development teams. The
Company expects to recognize a one-time charge of approximately $1.0 million
during the first quarter of 1999 related to the restructuring plan. The
restructuring charge includes approximately $830,000 for severance and other
employee-related costs of the terminated staff and approximately $190,000 for
facility-related costs, including an accrual of estimate lease obligations
associated with the closure of excess office facilities.
In March 1999, the Company committed to spend approximately $700,000 with a
consulting firm for consulting and implementation work related to the ERP
information system that will be implemented during 1999. In March 1999, the
Company incurred approximately $670,000 for the purchase of software, hardware
and related maintenance on the ERP project.
F-24