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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
[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: 0-24081
EVOLVING SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 84-1010843
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
9777 Mt. Pyramid Ct., Englewood, 80112
Colorado (Zip Code)
(Address of principal executive
offices)
(303) 802-1000
(Registrant's telephone number)
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, par value $0.001 per share
(Title of class)
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 to this Form 10-K. [_]
The approximate aggregate market value of the Common Stock held by non-
affiliates of the registrant, based upon the last sale price of the Common
Stock reported on the National Association of Securities Dealers Automated
Quotation National Market System was $5.34 as of March 18, 1999.
The number of shares of Common Stock outstanding was 12,081,792 as of March
18, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III (Items 10, 11, 12 and 13) is
incorporated by reference to portions of the registrant's definitive proxy
statement for the 1999 Annual Meeting of Stockholders which will be filed with
the Securities and Exchange Commission within 120 days after the close of the
1998 year.
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EVOLVING SYSTEMS, INC.
Annual Report on Form 10-K
December 31, 1998
Table of Contents
Page
----
PART I
Item 1 Business................................................... 3
Item 2 Properties................................................. 15
Item 3 Legal Proceedings.......................................... 15
Item 4 Submission of Matters to a Vote of Security Holders........ 15
PART II
Market for Registrant's Common Equity and Related
Item 5 Stockholder Matters........................................ 16
Item 6 Selected Financial Data.................................... 17
Management's Discussion and Analysis of Financial Condition
Item 7 and Results of Operations.................................. 18
Item 8 Consolidated Financial Statements and Supplementary Data... 25
Changes in and Disagreements with Accountants on Accounting
Item 9 and Financial Disclosure................................... 26
PART III
Item 10 Directors and Executive Officers of the Registrant......... 27
Item 11 Executive Compensation..................................... 27
Security Ownership of Certain Beneficial Owners and
Item 12 Management................................................. 27
Item 13 Certain Relationships and Related Transactions............. 27
PART IV
Exhibits, Financial Statement Schedules and Reports on Form
Item 14 8-K........................................................ 28
2
Except for the historical information contained herein, the following
discussion contains forward-looking statements that involve risks and
uncertainties. The Company's actual results could differ materially from those
discussed here. Factors that could cause or contribute to such differences
include, but are not limited to, those discussed in this section, in the
sections entitled "Management's Discussion And Analysis Of Financial Condition
And Results of Operations" and "Risk Factors."
PART I
Item 1. Business
Introduction
Evolving Systems is a leading provider of selected software solutions and
services that enable telecommunications companies to address the technical
challenges to their Operational Support Systems (OSS) and Network Elements (NE)
created by the industry's rapidly changing technology, competitive pressures
and regulatory environment. The Company has significant technical expertise and
business acumen in several different areas.
From its inception in 1985 through 1996, the Company has focused on providing
custom software development services to a limited number of telecommunications
companies. Beginning in 1996, the Company made a strategic decision to expand
its focus to include development of Local Number Portability (LNP) software
products. The Company is using its technical strengths to position itself as
both a leading custom software developer as well as a provider of next-
generation (NextGen) OSS and NE applications.
The Company's (LNP) software solution, enabling carriers to meet the
requirement that customers retain their local phone numbers when changing
service providers, has been selected for use by two of the five Regional Bell
Operating Companies (RBOCs) and two leading local and long distance carriers.
The Company believes that the implementation of LNP will require significant
changes in a broad range of carriers' software and systems that perform mission
critical functions such as ordering, provisioning, service assurance and
billing, collectively known as OSS.
The Company developed and continues to maintain the software currently in use
by all Number Portability Administration Centers (NPACs) in the United States
and Canada. The software receives ported telephone number information as
changes occur, and distributes the data to all subscribing carriers in the
region. The software is provided under contract to IMS Corporation, formerly a
division of Lockheed Martin.
The Company provides a wide range of custom solutions to incumbent local
exchange carriers (ILECs) and competitive local exchange carriers (CLECs) for
the provisioning and fulfillment of customer orders. These solutions focus on
the flow-through provisioning of Advanced Intelligent Network (AIN) services
within a carrier's network environment.
The Company developed and continues to maintain and enhance wireless data
network elements which are owned and marketed by Lucent Technologies (Lucent).
3
INDUSTRY BACKGROUND
The Telecommunications Industry
Historically, telecommunications carriers have operated in a highly regulated
environment, with local and long distance telephone service providers operating
as near monopolies with little competition. More recently, however, the U.S.
and many foreign governments have begun to deregulate the telecommunications
industry in order to reduce prices and improve telecommunications services
through increased competition.
Deregulation and the widespread adoption of new telecommunications
technologies, such as fiber optics, packet-data networks, digital wireless
telephony and Internet-based services, have significantly increased the number
of telecommunications carriers and created an increasingly competitive market.
New entrants to the telecommunications service market include CLECs, alternate
access providers, internet service providers (ISPs) and wireless service
providers. To be competitive in this new environment, telecommunications
service providers are seeking to rapidly enter new markets by offering new or
differentiated services in a cost-effective manner. These new carriers must
build their OSS and NE infrastructure to quickly introduce and support these
services.
Competition and Deregulation
The U.S. long distance market was opened to competition beginning in the
early 1970s. More recently, the Telecommunications Act of 1996 provides for the
introduction of competition in local telephone service, allowing long distance,
wireless and other carriers to enter local telephone markets. The Act, among
other things, requires RBOCs and other ILECs to offer LNP, which allows
customers to retain their local phone numbers regardless of the carrier
providing local telephone service. The Act also requires that carriers unbundle
local services and facilities, which requires an interface to be made available
to their new competitors for ordering, service provisioning and billing
systems.
Similar initiatives to deregulate local telephone service have been adopted
or are being considered in a number of foreign markets, including Australia,
Belgium, Canada, Germany, Holland, France, Hong Kong and the United Kingdom.
Recent adoption of the World Trade Organization agreement on basic
telecommunications services may accelerate this trend. For example, the
Canadian Radio-Television & Telecommunications Commission (the "CRTC") issued a
report in 1995 in which LNP was identified as the critical catalyst to
encourage competition among local telephone carriers. In 1997, the CRTC issued
Decision 97-8, under which all service providers would gain equal access to
local markets, providing impetus for the implementation of LNP throughout
Canada.
These new competitive and regulatory pressures have created significant
technological challenges for existing and new carriers. Existing carriers must
develop new systems that are interoperable with their legacy systems to enable
them to respond to increasing competitive challenges. In addition, new entrants
to local telephone markets require solutions that do not depend on an existing
OSS infrastructure and that can be deployed quickly and cost-effectively. Thus,
the Company believes that carriers' OSS are evolving from back-office legacy
systems to strategic business systems that play an increasingly important role
in enhancing competitiveness as well as enabling compliance with the
requirements of the Act.
Operational Support Systems
Operational Support Systems (OSS) encompass a broad array of software and
systems that perform critical functions for telecommunications carriers,
including ordering, provisioning, service assurance and billing. Ordering
systems allow carriers to collect customer information, retrieve current
service information, capture and validate new service requests, verify the
availability of selected services and transmit completed orders to one or more
provisioning OSS. Carriers use provisioning systems to install services for new
customers and to change or add services for existing customers. Service
assurance systems allow carriers to perform the testing, monitoring and
reporting necessary to maintain network availability and feed operational data
to other business systems. Carriers use billing systems to collate, manage and
report billing information.
4
Historically, as existing carriers have added new services, such as wireless
or Internet-based services, they have developed multiple, distinct OSS. These
legacy, proprietary OSS have typically been mainframe-based systems that in
many cases utilize incompatible software and technologies, making communication
among systems difficult. These OSS are further strained by the many incremental
changes that have been made in order to accommodate new technologies, such as
client/server technology and advancements in data networking, and the
proliferation of value-added services, such as call waiting, call forwarding
and voice mail. Despite these difficulties, carriers are unable to completely
replace existing OSS due to the large investments and vast amounts of
historical data contained in these systems. As a result, carriers continue to
make incremental modifications to these OSS, further increasing their
complexity and interoperability difficulties.
LNP Challenges to Current OSS
The LNP requirements of the Act pose significant technological challenges to
existing carriers' OSS, which are already strained by the changes caused by
increasing competition, new technologies and the introduction of value-added
services. LNP invalidates a fundamental design assumption of many existing OSS,
which is the association between a customer's telephone number and the
geographic location of a carrier's particular physical switch. Provisioning
systems now must be able to receive and distribute on a real-time basis certain
customer data in order to assure proper call handling, routing and completion.
If the LNP data from ported numbers are not properly distributed to all
involved carriers, any call to and from that number will not be routed
correctly, causing service problems for customers. Moreover, carriers that have
not implemented LNP may incur substantial call termination or "dip" charges if
they direct calls to regions where LNP has been mandated.
After altering provisioning systems, carriers must then implement changes
throughout many of their other OSS. These OSS are "hard-coded" in that each
telephone number corresponds to a physical switch for the ordering, service
assurance and billing systems. The implementation of LNP also requires new
systems to pool, allocate and assign telephone numbers. Changes will be
required to existing billing systems, which currently associate a telephone
number with a fixed geographic location. As a result of these challenges, the
Company believes a significant market opportunity exists for providing
solutions to carriers that must address these OSS problems.
New Technologies and Experience
New Network Technologies. The wireless carriers continue to deploy networks
using new technologies such as Code Division Multiple Access (CDMA), Time
Division Multiple Access (TDMA) and Global Services for Mobile (GSM). They
require the ability to transfer packet data using these protocols and this
environment creates a continuing opportunity for the Company.
IP Telephony. Historically, telephone companies built separate network
infrastructures to offer new technology options requiring technology-specific
OSS to support these unique networks. The isolated networks separate voice from
data traffic and force the customers to maintain multiple subscriptions with
the carrier. Network technology options that combine network traffic are
developing today at an ever-increasing pace due to the heavy investments in
research and development. CLECs and ISPs are developing convergent networks
that combine voice and data on the same network. Virtual Private Networks (VPN)
is one technology that is rapidly being accepted to combine the voice and data
networks. The VPN technology digitizes voice into packets for transfer on data
networks. This is sometimes called next generation or "NextGen" telephony.
Experienced and Reliable Implementation Provider. To provide necessary
support services for these changes in the industry, the company believes
carriers will need vendors with significant communications software, OSS, and
NE related domain expertise. Because of competitive pressure and short time
frames, these carriers will look for solutions, including integration, and not
just products. ILECs need such vendors in order to integrate their multiple
legacy systems. CLECs and ISPs that do not have the personnel with the required
expertise will need vendors to provide such services and expertise.
5
Evolving Systems Strategy
Recognizing the opportunity created by the ongoing deregulation of local
telephone service, the Company has capitalized on its historic strength as a
leading architect and developer of solutions for technically challenging OSS
requirements. The Company positions itself as a leading provider of next
generation OSS solutions for the telecommunications industry. The Company's
heritage of custom development for service activation, wireless technology and
LNP provides a base of domain expertise necessary to continue its leadership
position in the industry. Account Managers and Service Directors utilize this
knowledge to develop new business with existing customers and to attract new
customers needing our technological expertise.
The Company believes that developing long-term business relationships with
its customers gives it a competitive edge. Specifically, these relationships
are created and sustained by repeatedly delivering solutions to the customer
that satisfy its needs. The Company believes that over time, its growing
knowledge of customers' systems and needs help the Company in providing new
solutions. Additionally, as the customer realizes that the Company reliably
delivers solutions as promised, they are more likely to choose the Company for
their next solution requirement over a competitor.
The Company intends to continue to provide custom solutions to its large
customers. These solutions sustain the relationship with these customers and
provide the Company with deep technological expertise in emerging telephony
technologies. The Company sales plan focuses on extending these relationships
into new areas with our existing customers. These large customers will also be
pursuing "NextGen" technology applications in their networks and the Company
wishes to be their first choice solution.
The Company expects to combine its heritage for custom services with product
components to offer NextGen solutions tailored to each carrier. The Company's
Emerging Technologies unit is currently negotiating contracts for joint
development of new products with partners. The Company plans to build, and/or
partner with strategic alliances to build a full suite of solutions integrating
its domain expertise, product components, custom development, integration and
support services with strategic partners in several business areas. Coupling
this approach with an expanded sales force, targeted focus on new products and
expanded services offerings, the Company plans to expand its customer base in
several areas:
Product--The Company packages specific custom development activities into
products. These products are designed for integration into the customer's
environment through adapters. The Company uses an end-to-end process for
managing product lifecycles. The Company's products are licensed under
perpetual licenses and may be licensed separately or bundled as a complete
solution. The Company provides a 90-day warranty against defects, 24x7 help
desk support and problem resolution as part of the warranty and offers extended
warranty support services on an optional annual support agreement.
Custom Software--The Company provides custom software development services
spanning the complete system development lifecycle from feasibility and
requirements planning through development and production rollout. By offering
these custom development services on a selective basis to leading
telecommunications service providers for over a decade, the Company has
developed a broad-based telecommunications domain expertise that it believes
provides it with a competitive advantage.
Product Integration--The Company's proprietary Product Integration Review
(PIR) process defines customer requirements associated with the installation
and integration of the Company's software products. The Company's PIR produces
a set of documents that describe the project deliverables, installation
process, any legacy system interfaces and software development requirements, as
well as the project timeline and milestones. The Company believes its PIR
positions itself for successful customer relationships and creates
opportunities for additional product sales or services engagements.
Systems Integration--The Company provides a range of systems integration
services, including system design, database and network design, network
configuration and other system-development areas of expertise. The Company also
provides systems integration services for third-party software products. The
Company has strategic partnerships in place to perform these services for
leading infrastructure providers. As an example, the
6
Company has a relationship with InConcert, Inc., a Xerox New Enterprise
Company, to integrate its workflow product for carriers.
Customer Support--The Company provides a broad array of customer support
services, including 24x7 help desk support, problem resolution, software
maintenance and scheduled software upgrades, complete training and
documentation for products and services, and quality assurance. The Company's
typical software maintenance agreement has a 12-month term.
Evolving Systems Business Structure
The Company is organized into five main business units that build on its core
competencies and domain expertise to form an end-to-end solution for each
customer's specific requirements. The business units combine domain expertise
with product components and professional services to create next generation OSS
solutions for the carrier. Each of the five business units is described below:
LNP Business Unit. The Company's current LNP products enable carriers to
accommodate customer requests to change service providers while retaining the
same phone number, and to exchange call routing data to carriers' networks via
the NPAC. The Company currently offers three LNP products, which were released
beginning in the first half of 1997. The Company's LNP products are licensed
under perpetual licenses and may be licensed separately or bundled as a
complete solution.
Customers typically engage the Company to provide installation, integration
and testing of the LNP products in connection with these licenses. Such
services are provided for additional fees, depending upon the mix of products
licensed and the complexity of the customer's system. Customers also rely on
the Company for ongoing support and enhancement of the solution. General
software upgrades and enhancements for all products are planned.
The Company has announced its intention to operate OrderPath(R) in a service
bureau environment. Smaller customers that do not wish to incur the capital
expense of an in-house solution can now choose to subscribe with the Company
for use of the OrderPath(R) product. The Customer will be charged a monthly
subscription fee and a separate fee per transaction.
NPAC Business Unit. The Company developed and continues to maintain the
software currently in use by all NPAC's in the United States and Canada. The
software receives ported telephone number information as changes occur and
distributes the data to all subscribing carriers in the region. The software is
provided under contract to IMS (Lockheed Martin).
Wireless Technology Business Unit. This business unit provides custom
software products for Lucent, a leading equipment supplier. The infrastructure
products enable Cellular Digital Packet Data (CDPD), CDMA, and Over-the-Air-
Service Provisioning (OTASP) in wireless network environments. The Company
provides full lifecycle support for these products including the initial
development and ongoing maintenance releases. The Wireless Technologies
business unit maintains a service bureau offering for the billing of wireless
data. The PilotPlus offering is available to wireless carriers on a service
bureau or license basis for the rating of packet-oriented data.
Service Activation and Fulfillment Business Unit. The Service Activation
business unit provides a wide range of custom solutions to ILECs and CLECs for
the provisioning and fulfillment of customer orders. The solutions focus on the
flow-through provisioning of Advanced Intelligent Network (AIN) services within
a carrier's network environment. The Company is investigating the viability of
packaging components of the solution developed in the Service Activation
business unit for sale as products to the general marketplace. The products
would provide interfaces to available order management OSS and network elements
for seamless integration.
Emerging Technology Business Unit. The Emerging Technologies unit is
responsible for the capture and incubation of new ideas that surface throughout
the Company. The unit uses a standardized development
7
process to refine the concept, define a value proposition and obtain funding
for the project. Emphasis is given to projects that provide multiple
applications.
For the first project, the Company has signed a joint development and
distribution agreement with EHPT, formerly known as Ericsson Hewlett-Packard
Telecommunications, a European OSS vendor. The Emerging Technology unit is
developing a platform to bridge the protocols and call models of incompatible
networks. The first application creates a path between the Public Switched
Telephone Network (PSTN) and various packet-based Internet Protocol (IP)
networks. The call agent manager solution allows VPN carriers to access
existing PSTN infrastructure. Delivery of the solution is expected to begin in
the third quarter of 1999.
In conjunction with the call agent manager development, the two companies are
jointly working to tailor their existing PSTN-oriented solutions to the VPN
marketplace. The result will be an integrated bundle of core OSS elements
designed to enable rapid deployment of a NextGen infrastructure. The Company
intends to distribute and integrate the solution components as part of their
product portfolio to ISPs and CLECs. The Company believes that the suite
offering will provide these new carriers with a timely solution for critical
OSS components and a path to tightly integrate their environment over time.
Marketing and Sales
The primary objectives of the Company's marketing efforts are to build
Evolving Systems' image, generate market awareness and produce qualified leads.
The Company's marketing efforts include direct sales to targeted accounts,
participation in selected trade shows, a strong website presence, print and
electronic advertising and story placement in telecom industry trade media,
presentations at industry conferences and forums, press releases to the
industry, and certain other marketing initiatives.
The Company's sales activities are conducted through a direct sales force and
the services support organization, both of which are complemented by other
sales channels. The Company intends to rely on resellers and alternate channels
to further penetrate the LNP market. The Company also assigns a dedicated
account and business manager to each major customer to ensure that both the
sales relationship and the business relationship are managed well. The sales
closing cycle can be quite long in the telecom business due to both the
complexity of products and integration issues that make major systems decisions
difficult. Typically, the sales cycle takes three months to one year.
The alternate channels, such as strategic distribution partners, help to
identify and qualify leads. The Company plans to increase the focus on
resellers and alternate sales channels in 1999 to further penetrate the LNP
market. The Company believes that a limited window of opportunity exists to
capture a share of these customers. The Company's marketing and sales efforts
have been focused primarily on facility-based local exchange, interexchange and
wireless service providers in the United States, and this group has comprised
the majority of the Company's customers. In 1999, the Company will continue
efforts among these markets and expand its focus to include non-facilities-
based service providers, ISPs and VPNs with additional product and service
offerings beyond LNP.
The Company believes that significant demand for new OSS products and
services exists outside of the U.S. due to increased deregulation and resulting
competition. The Company intends to expand it sales and marketing efforts
internationally through a series of partnerships with specific third-party
systems integrators and software suppliers, as well as the extension of its
relationships with existing customers as they expand into international
markets.
Research and Development
The Company's research and development efforts are focused on identifying
market requirements and performing design and development functions. These
activities follow the Company's product development process that governs the
product lifecycle from concept through product launch and subsequent retirement
from the marketplace, all through the use of cross-functional teams. This
process provides the Company's senior management with a series of decision
milestones that allows the evaluation of ongoing projects on a regular basis.
Normally, the Company does not fund significant development efforts without
first having a customer to buy the resulting product.
8
Competition
The market for telecommunications software is intensely competitive and is
subject to rapid technological change, evolving industry standards and
regulatory developments. The Company faces continuous demand for improved
product performance, new product features and reduced prices, as well as
intense pressure to accelerate the release of new products and product
enhancements. The Company's existing and potential competitors include many
large domestic and international companies, including certain customers of the
Company that have substantially greater financial, manufacturing,
technological, marketing, distribution and other resources, larger installed
customer bases and longer-standing relationships with telecommunication
customers than the Company. Although the Company concentrates on providing
software and services for the telecommunications industry, the market for
telecommunications software is extremely large and the Company currently holds
only a very small portion of the market share.
The principal competitors of the Company's LNP products include Telcordia
(formerly known as Bellcore), Lucent, Nortel and Tekelec. The Company believes
that competitors to its other products will include Cisco, Telcordia and
Lucent. The Company expects competition to increase in the future from existing
suppliers and from other companies that may enter the Company's existing or
future markets with solutions which may be less costly, provide higher
performance or additional features or be introduced earlier than the Company's
solutions.
Many telecommunications companies have large internal development
organizations which develop software solutions and provide services similar to
the Company's products and services. In addition, customers who have purchased
custom software solutions from the Company are not precluded from competing
with the Company. ILECs that have implemented LNP solutions are well suited to
provide LNP services for smaller CLECs within their regions.
The Company believes that its ability to compete successfully depends on a
wide range of internal and externally controlled factors. The Company plans to
compete by providing quality solutions that are tailored specifically to the
customer. The Company is organized to provide core products and complimentary
services that provide a total solution for the application area. The Company
then creates a long-term relationship with the customer by providing ongoing
support, extensions of the original solution, and new related solutions.
Intellectual Property
The Company relies on a combination of copyright, trademark and trade secret
laws, as well as confidentiality agreements and licensing arrangements, to
establish and protect its proprietary right. The Company presently has no
patents, but has patent applications pending in the U.S. on elements of its
three LNP products: NumberManager, OrderPath and NodeMaster.
Employees
As of December 31, 1998, the Company employed 277 people, of which 74% were
involved in service provision, consulting practices and product development. In
addition, 3% were involved in research and development, 4% in marketing and
sales, and 20% in general administration.
9
RISK FACTORS
Fluctuations in Quarterly Results of Operations
The Company's operating results have fluctuated significantly in the past and
are likely to continue to fluctuate significantly in the future. Fluctuations
in operating results may result in volatility in the price of the Company's
Common Stock. These quarterly fluctuations may result from a number of factors,
including the magnitude, timing and signing of new contracts; the Company's
rate of progress under such contracts; the timing of customer and market
acceptance of the Company's products and service offerings; actual or
anticipated changes in government laws and regulations related to the
telecommunications market or judicial or administrative actions with respect to
such laws or regulations; the nature and pace of enforcement of the Act;
product lifecycles; the mix of products and services sold; changes in demand
for the Company's products and services; the timing of third-party contractors'
delivery of software and hardware; budgeting cycles of the Company's customers;
changes in the renewal rate of support agreements; the timing and amount of
expenditures made by the Company for research and development and sales,
general and administrative expenses; competition by existing and emerging
competitors in the telecommunications software markets; the Company's success
in developing and marketing new products, controlling cost, attracting and
retaining qualified personnel and expanding its sales and marketing programs;
regional office expansion; software defects and other product quality problems;
changes in the Company's strategy; the extent of industry consolidation and
general economic conditions. A significant portion of the Company's revenue has
been and is expected to continue to be derived from a small number of
customers. Accordingly, the loss of any significant customer, delays in
delivery or acceptance of any of the Company's products or delays in the
performance of services could have a material adverse effect on the Company's
business, financial condition and results of operations.
The Company's expense levels are based in significant part on its
expectations regarding future revenue. The Company's revenue is difficult to
forecast because the market for the Company's products and services is rapidly
evolving, and the Company's sales cycle and the size and timing of significant
contracts vary substantially among customers. Accordingly, the Company may be
unable to adjust spending in a timely manner to compensate for any unexpected
shortfall in revenue.
Based on all of the foregoing, the Company believes that future revenue,
expenses and operating results are likely to vary significantly from quarter to
quarter. As a result, quarter-to-quarter comparisons of operating results are
not necessarily meaningful or indicative of future performance. Furthermore,
the Company believes it is likely that in some future quarter the Company's
operating results will be below the expectations of public market analysts or
investors. In such event, or in the event that adverse conditions prevail, or
are perceived to prevail, with respect to the Company's business or generally,
the market price of the Company's Common Stock would likely be materially
adversely affected.
Dependence Upon Telecommunications Industry; Regulatory Uncertainties
The market for the Company's products was created and has primarily been
driven by the adoption of regulations under the Act requiring RBOCs to
implement LNP as a condition to being permitted to provide long distance
services. Therefore any changes to such regulations, or the adoption of new
regulations by federal or state regulatory authorities under the Act, or any
legal challenges to the Act, could have a material adverse effect upon the
market for the Company's products and services. Although the Act was designed
to expand competition in the telecommunications industry, the realization of
the objectives of the Act is subject to many uncertainties, including judicial
and administrative proceedings designed to define rights and obligations
pursuant to the Act, actions or inactions by ILECs and other carriers that
affect the pace at which the changes contemplated by the Act occur, resolution
of questions concerning which parties will finance such changes and other
regulatory, economic and political factors.
The Company is aware of certain challenges to the validity of the Act and the
local telephone competition rules adopted by the Federal Communications
Commission ("FCC") to implement the Act. Recently, challenges by wireless
carriers resulted in the FCC delaying implementation of the Act with respect to
wireless
10
carriers until March 28, 2001. These delays have had, and continue to have, an
impact on the Company's revenue from its LNP products and services. Additional
delays in the deadlines imposed by the Act or the FCC, or any invalidation,
repeal or modification in the requirements imposed by the Act or the FCC, could
have a material adverse effect on the Company's business, financial condition
and results of operations. Moreover, customers may require, or the Company
otherwise may deem it necessary or advisable, that the Company modify its
products or services to address actual or anticipated changes in the regulatory
environment. Any other delay in implementation of the Act, or other regulatory
changes, could materially adversely affect the Company's business, financial
condition and results of operations.
Reliance on Significant Customers
Historically, a substantial portion of the Company's revenue has been derived
from a limited number of customers. During the years ending December 31, 1996,
1997 and 1998, the Company recognized approximately 73%, 89% and 87% of total
revenue from five, six and six customers, respectively, all in the
telecommunications industry. The Company expects to continue to depend on large
contracts with a small number of significant customers, which can cause its
revenue and earnings to fluctuate between quarters based on the timing of
contracts and installation of the Company's products by these customers. None
of the Company's major customers has any obligation to purchase additional
products or services. Consequently, the failure by the Company to maintain
existing relationships or develop relationships with significant new customers
would have a material adverse effect on the Company's business, financial
condition and results of operations. Additionally, business or marketplace
consolidations affecting one or more of the Company's major customers has
caused delays in customer contracts and could result in the loss of that
customer, which also could have a material adverse effect on the Company's
business, financial condition and results of operations.
Lengthy Implementation Process; Customer Acceptance of Company Solutions
Implementation of the Company's solutions is a relatively complex and lengthy
process that involves significant allocation of resources by the Company in
order to adapt and customize such solutions for each customer's unique
environment. Moreover, certain of the Company's customers may require rapid
deployment of the Company's software solutions, resulting in pressure on the
Company to meet demanding delivery and implementation schedules. Delays in
implementation may result in customer dissatisfaction and/or damage to the
Company's reputation and could have a material adverse effect on the Company's
business, financial condition and results of operations.
The majority of the Company's existing contracts provide for acceptance
testing by the customer before the contract is considered complete.
Unanticipated difficulties or delays in the customer acceptance process could
result in higher costs and delayed payments. Moreover, if the Company fails to
satisfy acceptance criteria within prescribed times, the customer may be
entitled to cancel its contract and receive a refund of all or a portion of
amounts previously paid or other amounts as liquidated damages, which could
exceed related contract revenue and which could result in a future charge to
earnings. Any failure or delay in achieving final acceptance of the Company's
software and services could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations".
Lengthy Sales Cycle
The Company's software products and services are generally used by large
telecommunications service providers for enterprise-wide, mission-critical
purposes, involving significant capital expenditures and lengthy implementation
plans. Prospective customers typically commit significant resources to the
technical evaluation of the Company's products and services and require the
Company to expend substantial time, effort and money providing education
regarding the Company's solutions. This evaluation process often results in an
extensive and lengthy sales cycle, typically ranging between three and 12
months, making it difficult for the Company to forecast the timing and
magnitude of sales contracts. Delays associated with customers' internal
approval and
11
contracting procedures, procurement practices, and testing and acceptance
process are common. For example, customers' budgetary constraints and internal
acceptance reviews may cause potential customers to delay or forego a purchase.
The delay or failure to complete one or more large contracts could have a
material adverse effect on the Company's business, financial condition or
results of operations and cause the Company's operating results to vary
significantly from quarter to quarter.
Fixed-Price Contracts
The Company historically derived a majority of its revenue from contracts
that were billed on a timeand-materials basis. Beginning in mid-1996, a
majority of the Company's revenue has been derived from contracts that were
billed on a fixed-price basis. The Company in the past has incurred budget
overruns on certain fixed-price contracts, resulting in lower than anticipated
margins, and there can be no assurance that the Company will not incur such
budget overruns in the future. If the Company incurs such budget overruns, the
Company's gross margins and results of operations may be materially adversely
affected. To the extent that the Company continues to provide custom software
development or consulting services, it anticipates that customers will continue
to request that the Company provide software and implementation services as a
total solution on a fixed-price basis. These contracts specify certain
obligations and deliverables to be met by the Company regardless of actual
costs incurred by the Company. There can be no assurance that the Company can
successfully complete these contracts on budget, and the Company's inability to
do so could have a material adverse effect on its business, financial condition
and results of operations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations".
Rapid Technological Change; Risks Associates with New Versions and New
Products; Risks of Software Defects
The market for the Company's products and services is subject to rapid
technological changes, evolving industry standards, changes in carrier
requirements and preferences and frequent new product introductions and
enhancements. The introduction of products that incorporate new technologies
and emergence of new industry standards can render existing products obsolete
and unmarketable. To compete successfully, the Company must continue to design,
develop and sell enhancements to existing products and new products that
provide higher levels of performance and reliability in a timely manner, take
advantage of technological advancements and changes in industry standards and
respond to new customer requirements. There can be no assurance that the
Company will successfully identify new product opportunities or will achieve
market acceptance of new products brought to market. Products developed by
others may render the Company's products obsolete or noncompetitive. Any
failure by the Company to anticipate or respond adequately to changes in
technology and customer preferences, any failure of the Company's products to
perform satisfactorily or any significant delay in product development or
introductions could have a material adverse effect on its business, financial
condition and results of operations.
The Company intends to issue interim and new releases of its family of
software products periodically. As a result of the complexities inherent in
software development, major new product enhancements and new products can
require long development and testing periods before they are commercially
released. There can be no assurance that delays will not occur in the future.
Competition
The Company's primary markets are intensely competitive and are subject to
rapid technological changes, evolving industry standards and regulatory
developments. The Company faces continuous demand for improved product
performance, new product features and reduced prices, as well as intense
pressure to accelerate the release of new products and product enhancements.
The Company's existing and potential competitors include many large domestic
and international companies, including certain of the Company's customers, that
have substantially greater financial, manufacturing, technological, marketing,
distribution and other resources, larger installed customer bases and longer-
standing relationships with customers than the Company. The Company's principal
competitors in the LNP market include Bell Communications Research, Inc.
("Bellcore"), Lucent, Northern Telecom, Inc. ("Nortel") and Tekelec, Inc.
("Tekelec"). One of the Company's principal customers,
12
Lucent, competes with the Company with respect to certain of the Company's
products and services that it offers in competition with the Company. In
addition, Lockheed has retained rights to the NPAC software developed for
Lockheed by the Company, and Lockheed potentially could compete with the
Company with respect to LNP products and related services. There also can be no
assurance that other customers will not offer competitive products or services
in the future. The Company expects competition to increase in the future from
existing competitors and from other companies that may enter the Company's
existing or future markets with solutions which may be less costly, provide
higher performance or additional features or be introduced earlier than the
Company's solutions. Many telecommunications companies have large internal
development organizations which develop software solutions and provide services
similar to the Company's products and services. Moreover, customers who have
purchased custom software solutions from the Company are not precluded from
competing with the Company.
The Company believes that its ability to compete successfully depends on
numerous factors, both within and outside of its control, including
responsiveness to service providers' needs, quality and reliability of the
Company's and its competitors' products and services, price, project management
capabilities, technical subject matter expertise, quality of customer service
and support, the emergence of new industry standards, the development of
technical innovations, the attraction and retention of qualified personnel,
regulatory changes and general market and economic conditions. A variety of
potential actions by the Company's competitors, including a reduction of
product prices or increased promotion, announcement or accelerated introduction
of new or enhanced products, or cooperative relationships among competitors,
could have a material adverse effect on the Company's business, financial
condition and results of operations. There can be no assurance that the Company
will be able to compete successfully with existing or new competitors or will
properly identify and address the demands of new markets. The failure by the
Company to adapt to emerging market demands, respond to regulatory and
technological changes or compete successfully with existing and new competitors
would have a material adverse effect on the Company's business, financial
condition and results of operations.
The Company's ability to manage future expansion, if any, effectively will
require it to attract train, motivate and manage new employees successfully, to
integrate new management and employees into overall operations and to continue
to improve its operational, financial and management systems. The Company
anticipates that it will need to hire development personnel. Competition for
development and other technical personnel is intense, and there can be no
assurance that the Company will be able to hire additional personnel on a
timely basis, if at all. Because of the complexity of the Company's software
solutions, a significant time lag exists between the hiring date of technical
and sales personnel and the time at which they become fully productive. The
Company has at times experienced and continues to experience difficulty in
recruiting such personnel. Any failure by the Company to hire qualified
personnel on a timely basis could materially adversely affect the Company's
business, financial condition and results of operations.
The Company is continuing its implementation of new financial and project
accounting software packages. The Company's ability to implement these new
systems is likely to place substantial demands on certain of the Company's
managerial resources. In addition, if the Company is unable to implement these
software packages effectively, the Company's ability to accurately forecast and
manage its business may be adversely affected. The Company's failure to manage
any expansion effectively, including any failure to integrate new management
and employees or failure to continue to implement and improve financial,
operational and management controls, systems and procedures, could have a
material adverse effect on the Company's business, financial condition and
results of operations.
Product Liability
The Company's agreements with its customers typically contain provisions
designed to limit the Company's exposure to potential liability for damages
arising out of the use of or defects in the Company's products. The nature and
extent of such limitations, however, tend to vary from customer to customer and
it is possible that such limitations of liability provisions may not be
effective as a result of federal, sate of local laws or ordinances or
unfavorable judicial decisions. In addition, the Company currently has errors
and
13
omissions insurance which, subject to customary exclusions, covers claims
resulting form failure of the Company's software products or services to
perform the function or to serve the purpose intended. To the extent that any
successful product liability claim is not covered by such insurance, the
Company's business, financial condition and results of operations may be
materially adversely affected, particularly since the Company's software
products may be used in critical business applications. Defending such a suit,
regardless of its merits, could involve substantial expense and require the
time and attention of key management personnel, either of which could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company's business reputation could be
adversely affected by product liability claims, regardless of their merit or
the eventual outcome of such claims.
Year 2000 Capability
Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. These date code fields
will need to accept four digit entries to distinguish 21st century dates from
20th century dates. As a result, in less than one year, computer systems and/or
software used by many companies may need to be upgraded to comply with such
"Year 2000" requirements. Significant uncertainty exists in the software
industry concerning the potential effects associated with such compliance.
The Company believes that the purchasing patterns of customers and potential
customers may be significantly affected by Year 2000 issues. Many companies are
expending significant resource to correct or patch their current software
systems for Year 2000 compliance. These expenditures may result in reduced
funds available to purchase software products such as those offered by the
Company. Many potential customers may also defer purchasing Year 2000 compliant
products until they believe it is absolutely necessary, thus resulting in
potentially deferred sales. Conversely, Year 2000 issues may cause other
companies to accelerate purchases, thereby causing an increase in short-term
demand and a consequent decrease in long-term demand for software products.
Additionally, Year 2000 issues could cause a significant number of companies,
including current customers of the Company, to reevaluate their current system
needs and as a result consider switching to other systems or suppliers. This
could have a material adverse effect on the Company's business, financial
condition and results of operations.
The Company currently offers software products that are designed to be Year
2000 compatible, and the Company's current contract with its customers require
that the Company warrant Year 2000 capability. Although the Company has
designated its products to be Year 2000 capable and tests third-party software
that is incorporated with the Company's products, there can be no assurance
that the Company's software products, particularly when such products
incorporated third-party software, contain all necessary date code changes. See
"Liquidity and Capital Resources" section of Item 7 for a more detailed
discussion on Y2K.
Protection of Intellectual Property; Risks of Infringement
The Company's success and ability to compete are dependent to a significant
degree on its proprietary technology. The Company relies on a combination of
copyright, trademark and trade secret laws, as well as confidentiality
agreements and licensing arrangements, to establish and protect its proprietary
rights. The Company presently has no patents, but has patent applications
pending in the U.S. on elements of its three LNP products, NumberManager,
OrderPath and NodeMaster and an internet call processing engine. In addition,
the Company has registered or filed for registration of certain of its
trademarks. Despite these precautions, it may be possible for a third party to
copy or otherwise obtain and use the Company's products or technology without
authorization or to develop similar technology independently through reverse
engineering or other means. In addition, the laws of some foreign countries do
not adequately protect the Company's proprietary rights. There can be no
assurance that the Company's means of protecting its proprietary rights in the
U. S. or abroad will be adequate or that others will not independently develop
technologies that are similar or superior to the Company's technology,
duplicate the Company's technology or design around any patent of the Company.
Moreover, litigation may be necessary in the future to enforce the Company's
intellectual property rights, to
14
determine the validity and scope of the proprietary rights of others or to
defend against claims of infringement
or invalidity. Such litigation could result in substantial costs and diversion
of management time and resources
and could have a material adverse effect on the Company's business, financial
condition and results of operations.
Possible Volatility of Stock Price
The trading price of the Company's Common Stock has been and may continue to
be subject to wide fluctuations in response to quarterly variations in
operating results, announcements of technological innovations or new products
by the Company or its competitors, changes in financial estimates by securities
analysts, the operating and stock price performance of other companies that
investors may deem comparable to the Company, general stock market and economic
considerations and other events or factors. In addition, the stock market has
experienced volatility that has particularly affected the market prices of
equity securities of many technology companies and that often has been
unrelated to the operating performance of such companies. These broad market
fluctuations may adversely affect the trading price of the Company's Common
Stock. As a result of the foregoing factors, there can be no assurance that the
Company's Common Stock will trade at or higher than the initial public offering
price.
Item 2. Properties
The Company leases office space at three locations in the Denver, Colorado
metropolitan area, including two in the Englewood area (Meridian and
Southgate), one in the Boulder area (Louisville) and Santa Maria, California.
The Company also leases sales offices in Dallas, Chicago, Atlanta, San Jose and
Washington, D.C. The Company's leases in the Denver, Colorado metropolitan area
are shown below:
Location Square Footage Lease Expiration
-------- -------------- ----------------
Meridian.................................. 120,281 11/30/2016
Southgate................................. 68,566 12/31/2000
Louisville................................ 10,992 10/31/2002
The Company no longer has operations in its Southgate location and subleases
the Southgate facility for the remainder of its lease commitment.
Item 3. Legal Proceedings
Since June 22, 1998, four securities class action complaints have been filed
against the Company and certain of its current and former officers and
directors in the Federal Court for the District of Colorado that allege
violations of the federal securities laws. The complaints have been
consolidated. The plaintiffs purport to represent a class of persons who
purchased the Company's securities during the period of May 12, 1998 through
July 23, 1998. The complaints allege that the Company and certain of its
officers misled the investing public regarding the financial prospects of the
Company. The Company believes that the allegations are without merit and will
vigorously defend itself. Certain provisions of the Company's Certificate of
Incorporation and indemnification agreements between the Company and its
officers and directors require the Company to indemnify them against judgements
rendered on certain claims. The Company expects to incur significant legal
expenses on its behalf and on behalf of such officers and directors in
connection with this litigation. Although the Company does not believe that it
or any of its current or former officers or directors has engaged in any
wrongdoing, there can be no assurance that this stockholder litigation will be
resolved in the Company's favor. An adverse result, settlement or prolonged
litigation could have a material adverse effect on the Company's business,
financial condition or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
During the fourth quarter of 1998, no matters were submitted to a vote of the
Company's stockholders.
15
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholders Matters
The Company's Common Stock began trading publicly through the NASDAQ National
Market under the symbol "EVOL" on May 12, 1998. Prior to that date, there was
no public market for the Common Stock. The closing price of the Company's
Common Stock as reported on the NASDAQ National Market as of March 18, 1999 was
$ 5 11/32 per share. The following table sets forth for the periods indicated
the high and low closing sale quotations for the Common Stock as reported on
the NASDAQ National Market. The prices reported do not include retail mark-ups,
mark downs or commissions.
High Low
------ -----
For the Fiscal Year Ended December 31, 1998:
Second Quarter, beginning May 12, 1998..................... 20 5/8 8 1/2
Third Quarter.............................................. 12 2 3/8
Fourth Quarter............................................. 5 1 1/2
As of March 18, 1999, there were approximately 206 holders of record of the
Company's Common Stock.
The Company has not declared or paid a cash dividend on its Common Stock. The
Company currently intends to retain any future earnings, if any, to finance the
growth and development of its business and therefore, does not anticipate
paying cash dividends in the foreseeable future.
Use of Initial Public Offering Proceeds
The Company used the net proceeds of its IPO for repayment of its obligations
under the Subordinated Notes and Stockholder Notes, working capital and other
corporate purpose. The respective principal amounts (exclusive of $56,517 in
accrued interest) outstanding under the Subordinated Notes and Stockholder
Notes are $6,792,885 and $5,059,539 and bear interest at the rates of 9% (with
deferred interest accrued at the rate of 12%) and 7.25%, respectively, with
respective maturity dates of June 1, 2004 and January 2, 2006. The Company also
used proceeds to pay prepayment penalties to the holders of the Notes in the
amount of $446,000 net of taxes. The Company also used proceeds to fund the
general business operations including research and development expenses related
to its LNP products. The balance of the proceeds were invested in investment
grade, short-term investments bearing various interest rates.
16
Item 6. Selected Financial Data
The selected financial data set forth below for each of the years in the
five-year period ended December 31, 1998, have been derived from the Company's
consolidated financial statements and should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", the financial statements and the notes thereto and other financial
information included elsewhere in this annual report on Form 10K.
1998 1997 1996 1995 1994
-------- ------- ------- ------- -------
In thousands, except per share amounts
Revenue......................... $ 37,238 42,720 36,918 45,355 33,032
Cost of Revenue................. 27,104 25,224 24,531 26,589 18,181
Sales and Marketing............. 5,739 5,065 2,913 3,405 1,898
General and Administrative...... 8,566 8,635 8,587 7,725 4,321
Research and Development........ 7,197 2,914 641 821 482
Income (loss) from Operations... (11,368) 882 246 6,815 8,150
Other Income (Expense).......... (60) (1,395) (1,422) (689) (136)
Provision for (benefit from)
Income Taxes................... (601) (791) 81 -- --
Net Income (loss) (1)(2)........ (11,273) 278 (1,257) 6,126 8,014
Diluted Earning (loss) Per
Share.......................... (1.43) 0.03 (0.82) 4.00 5.24
Working Capital................. 31,009 5,366 6,390 3,174 4,728
Total Assets.................... 47,479 27,859 24,356 19,203 17,901
Long Term Debt.................. 825 16,465 18,096 6,059 2,610
Shareholder Equity.............. 39,362 1,698 996 9,173 8,859
Dividends Paid.................. 0 0 0 0 0
- --------
(1) Prior to January 6, 1996, the Company was an S corporation for federal and
state income tax purposes, and accordingly, the Company's income was taxed
directly to the Company's stockholders at that time. Net income (loss) for
1996, 1995, and 1994 do not reflect the estimated federal and state income
taxes that would have been payable if the Company had not been an S
corporation prior to January 6, 1996.
(2) Included in net loss for 1998 is an extraordinary loss on early
extinguishment of debt of approximately $446,000, net of $220,000 in income
tax benefit. See Note 3 of Notes to Financial Statements.
17
The following table presents, for the periods indicated, certain items
contained in the Company's statement of operations reflected as a percentage of
total revenue:
Year Ended December 31,
-------------------------
1996 1997 1998
------- ------- -------
Revenue:
License fees and related services................ 2.4% 46.9% 27.3%
Other services................................... 97.6 53.1 72.7
------- ------- -------
Total revenue.................................. 100.0 100.0 100.0
------- ------- -------
Cost of revenue:
License fees and related services................ 1.2 14.8 22.2
Other services................................... 65.2 44.2 50.6
------- ------- -------
Total cost of revenue.......................... 66.4 59.0 72.8
------- ------- -------
Gross margin....................................... 33.6 41.0 27.2
Operating Expenses:
Sales and marketing.............................. 7.9 11.9 15.4
General and administrative....................... 23.3 20.2 23.0
Research and development......................... 1.7 6.8 19.3
------- ------- -------
Total operating expenses....................... 32.9 38.9 57.7
------- ------- -------
Operating Income................................... 0.7 2.1 (30.5)
Other income (expense), net........................ (3.9) (3.3) (0.2)
------- ------- -------
Income (loss) before income taxes.................. (3.2) (1.2) (30.7)
Provision for (benefit from) income taxes.......... 0.2 (1.9) (1.6)
------- ------- -------
Net income (loss) before extraordinary item........ (3.4) 0.7 (29.1)
------- ------- -------
Extraordinary item, net of taxes................... -- -- 1.2
------- ------- -------
Net income (loss).................................. (3.4) 0.7 (30.3)
------- ------- -------
Pro forma provision for (benefit from) income
taxes............................................. (0.8)
-------
Pro forma net income (loss)........................ (2.4)
-------
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
This section contains forward-looking statements which involve risks and
uncertainties. The Company's actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those set forth in this section and in the section entitled "Risk
Factors."
Introduction
Evolving Systems, Inc., in it's 13th year of operation, began its first year
as a publicly traded company on May 12, 1998. The Company's core business is
designing and integrating software systems for the telecommunications industry.
Software projects are bid at either a fixed price or as time and materials
custom software projects. From the Company's inception in 1985 through 1996,
the Company focused on providing custom software development services,
primarily to two large customers. Beginning in 1996, the Company broadened its
focus to include proprietary software products in response to declining demand
from key customers for custom software development services that reflected the
changing industry patterns for software procurement. In addition, the Company
aggressively sought new customers for its custom software development business.
The Company had an excellent market for its LNP products in 1997 as a result
of the mandated requirements for LNP capabilities in the Telecommunications Act
of 1996. Revenues from license fees and
18
related services were over $20,000,000 in 1997. Other services of the business
also increased due to considerable integration support needed to implement LNP.
This market demand did not carry forward into 1998 for those LNP products. The
Company refocused its LNP products sales efforts to other market segments such
as wireless and CLECs but these segments are much smaller than the wire line
portion of the telecommunications market. The end result has been a substantial
decline in license fee and related services in 1998 when compared to 1997.
Revenue Recognition
The Company recognizes revenue in accordance with the provisions of Statement
of Position 97-2, "Software Revenue Recognition". The Company derives revenue
from license fees and services under the terms of both fixed- price and time-
and-materials contracts. License fees and related services revenue during 1996
consisted of fees from non-LNP software products. Subsequent to 1996, license
fees and related services revenue consists of revenue from contracts involving
the Company's LNP software products and related services. Other services
revenue consists of revenue from custom programming, systems integration of
third party products, annual maintenance contracts and training.
License fees and related services revenue is generated from fixed price
contracts that provide for both licenses and services and is generally
recognized using the percentage-of-completion method of accounting. The
percentage of completion for each contract is determined based on the ratio of
direct labor hours incurred to total estimated direct labor hours. Amounts
billed in advance of services being performed are recorded as unearned revenue.
Unbilled work in- progress represents revenue earned but not yet billable under
the terms of the fixed-price contracts and all such amounts are expected to be
billed and collected during the succeeding 12 months.
Services revenue provided under fixed price contracts is generally recognized
using the percentage-of-completion method of accounting described above.
Revenue from other services provided pursuant to time-and-materials contracts
is recognized as the services are performed.
Annual maintenance revenue is recorded as deferred revenue and is recognized
ratably over the service period, which is generally 12 months. Revenue from
training services is recognized as the training services are performed. When
maintenance or training services are bundled with the original license fee
arrangement, their fair value is deferred and recognized during the period such
services are provided. The Company may encounter budget and schedule overruns
on fixed-price contracts caused by increased material, labor or overhead costs.
Adjustments to cost estimates are made in the periods in which the facts
requiring such revisions become known. Estimated losses, should they occur,
would be recorded in the period in which current estimates of total contract
revenue and contract cost indicate a loss.
19
RESULTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1998
COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
Revenue. Total revenue decreased 13% from $42.7 million in 1997 to $37.2
million in 1998. License fees and related services revenue declined 49% because
the demand for LNP systems declined as the wire line portion of the
telecommunications industry substantially completed implementation of LNP in
1998. Other services revenue, consisting primarily of custom system development
revenue, increased 19% from $22.7 million in 1997 to $27.0 million in 1998 as
the Company focused on other services to counteract the software revenue
shortfall. As a percentage of revenue, license fees and related services
revenue declined from 47% in 1997 to 27% in 1998. Other services revenue
increased from 53% in 1997 to 73% in 1998.
Cost of Revenue. Cost of revenue consists primarily of personnel costs,
equipment depreciation, facilities costs and the cost of third party software.
Cost of license fees and related services increased by $1.9 million, or 30%
even though the related revenue declined by 49% for the year ended December 31,
1998 as the Company incurred considerable labor expenses due to
underutilization of personnel assigned to LNP projects. As a result, the gross
margin on license fees and related services declined to 19% for the year ended
December 31, 1998 compared to 68% for the year ended December 31, 1997. In the
fourth quarter of 1998, the Company recorded $302,000 in additional costs in
connection with a contract for which all revenue had previously been recorded.
The cost of revenue for other services decreased .2% in 1998 even though
revenue increased 19%. The gross margin for other services improved from 17% to
30% for the years ending December 31, 1997 and December 31, 1998, respectively,
as staff utilization rates improved.
Sales and Marketing. Sales and marketing expenses consist primarily of
compensation costs (including commissions), travel expenses, field sales office
expenses and marketing communication expenses. Sales and marketing expenses
increased by $295,000, or 6%, to $5.4 million for the year ended December 31,
1998 from $5.1 million for the year ended December 31, 1997. The increase was
primarily due to the Company's continued active sales efforts for its next
generation products.
In October 1998, Mr. Abramson, the CEO of the Company, resigned and was
replaced by Mr. Hallenbeck, the former CEO and co-founder of the Company.
Shortly thereafter, the CFO resigned and was replaced by a new hire from
outside of the Company and several other management changes occurred through
out late 1998. As a result of these management changes the Company incurred an
expense of $378,981 in severance costs.
General and Administrative. General and administrative expenses consist
principally of compensation costs for administration, facilities, finance,
legal, human resources, quality assurance and general management personnel.
General and administrative expenses increased to 23% of revenue from 20% of
revenue for the years ending December 31, 1998 and December 31, 1997,
respectively. The increase in cost was attributable to turnover in staffing at
all levels of the Company resulting in increased severance and recruiting
costs. In absolute dollars, general and administrative expense remained flat
from 1997 to 1998.
Research and Development. Research and development expenses consist primarily
of compensation costs, equipment and software development tools. Research and
development expenses increased 147%, or $4.3 million in the year ended December
31, 1998, from $2.9 million in the year ended December 31, 1997. As a
percentage of revenue, research and development increased from 7% in 1997 to
19% in 1998. This increase resulted from the Company's continued commitment to
the development of next generation software products as well as significant
research and development cost being recorded as cost of sales in 1997.
Other Income (expense), Net. Other expense, net of other income, includes
interest expense on the Company's debt financing and capital leases and
interest income on cash. The net expense declined 96% from $1.4 million in the
year ended December 31,1997, to $60,000 in the year ended December 31, 1998 as
a result of debt being retired from the proceeds of the initial public offering
of common stock in the second quarter of 1998, and the increase in interest
income as a result of investing those proceeds.
20
Extraordinary Item. The Company recorded an extraordinary item of $445,702
net of taxes relating to early retirement penalties and the write off of
capitalized debt issue costs resulting from the repayment of debt associated
with completion of the Company initial public offering. The Company recorded a
tax benefit of $220,000 relating to the extraordinary item. A similar charge
was not recorded in 1997.
Provision for (benefit from) Income Taxes. The Company has recorded a
partial valuation allowance against its carryforward tax benefits to the extent
that it believes that it is more likely than not all of such benefits will not
be realized in the foreseeable future. The Company's assessment of this
valuation allowance was made using all available evidence, both positive and
negative. In particular, the Company considered both its historical results and
its projections of profitability for only reasonably foreseeable future
periods. The Company's realization of its recorded net deferred tax assets is
dependent on future taxable income and therefore, the Company is not assured
that such benefits will be realized.
RESULTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1997
COMPARED TO THE YEAR ENDED DECEMBER 31, 1996
Revenue. Total revenue increased $5.8 million, or 16% to $42.7 million in the
year ended December 31, 1997 from $36.9 million in the year ended December 31,
1996. License fees and related services revenue increased by $19.1 million, or
2,171% to $20.0 million in the year ended December 31, 1997 from $882,000 in
the year ended December 31, 1996, reflecting the Company's progress in
introducing the initial LNP products. Other services revenue, a majority of
which was attributable to custom development projects for the Company's
telecommunications customers, decreased by $13.3 million, or 37% to $22.7
million in the year ended December 31, 1997 from $36.0 million for the year
ended December 31, 1996, reflecting the Company's expanded focus in 1997 on
both standard software products as well as custom development projects. License
fees and related services revenue as a percentage of total revenue increased to
47% for the year ended December 31, 1997 from 2% for the year ended December
31, 1996.
Cost of Revenue. Cost of license fees and related services increased by $5.9
million, or 1,309%, to $6.3 million for the year ended December 31, 1997 from
$450,000 for the year ended December 31, 1996. As a percentage of revenue, cost
of license fees and related services increased to 15% for the year ended
December 31, 1997, from 1% for the year ended December 31, 1996. These
increased costs reflected the Company's expanded focus to include standard
software products and associated integration services. Cost of other services
decreased $5.2 million, or 22%, to $18.9 million for the year ended December
31, 1997 compared to $24.1 million for the year ended December 31, 1996. As a
percentage of total revenue, cost of other services decreased to 44% for the
year ended December 31, 1997 from 65% for the year ended December 31, 1996. The
absolute amount of other services costs decreased in connection with the
reduction in the Company's lease commitments, increased productivity of Company
personnel and a shift of personnel from custom development projects to provide
necessary integration services for the Company's standard software products.
Sales and Marketing. Sales and marketing expenses increased by $2.2 million,
or 74%, to $5.1 million in the year ended December 31, 1997 from $2.9 million
in the year ended December 31, 1996. As a percentage of revenue, sales and
marketing expenses increased to 12% in the year ended December 31, 1997 from 8%
in the year ended December 31, 1996. This increase was attributable to the
Company's expansion of its direct sales force by 12 persons to 16 persons to
support sales of the Company's new standard software products and an increase
in the Company's marketing activities.
General and Administrative. General and administrative expenses totaled $8.6
million in the years ended December 31, 1997 and 1996. As a percentage of
revenue, general and administrative expenses decreased to 20% in the year ended
December 31, 1997 from 23% in the year ended December 31, 1996. On a percentage
basis, this decrease reflected increased revenue. In late 1996 and in 1997, the
Company implemented cost and headcount controls and made additional investments
to improve the Company's operational, financial, management information and
software development processes.
21
Research and Development. Research and development expenses increased by $2.3
million, or 355%, to $2.9 million in the year ended December 31, 1997 from
$641,000 in the year ended December 31, 1996. As a percentage of revenue,
research and development expenses increased to 7% in the year ended December
31, 1997 from 2% in the year ended December 31, 1996. The increased cost
resulted from additional staffing and associated costs in connection with the
Company's strategic commitment to the development of next generation software
product offerings. In addition, significant research and development expenses
were recorded as cost of revenue in the year ended December 31, 1997. This
resulted from the Company entering into a license with a major customer prior
to the completion of the development effort. No research and development
expenses were recorded as cost of revenue in the year ended December 31, 1996.
Other Income (expense), Net. Other income (expense), net, includes interest
expense on the Company's debt financing and capital lease obligations and
interest income on cash. Other expense, net of other income, totaled $1.4
million in both of the years ended December 31, 1997 and 1996. As a percentage
of revenue, other expense declined to 3% in the year ended December 31, 1997
from 4% in the year ended December 31, 1996, reflecting increased revenue in
1997.
Provision for (benefit from) Income Taxes. The Company recorded an income tax
benefit in the year ended December 31, 1997 of $792,000 which resulted
primarily from the Company's pretax loss coupled with significant research and
development tax credits generated during this period. The change from the
provision for income taxes recorded in 1996 was a result of such research and
development tax credits and the effect of converting to taxable status in 1996.
Prior to January 6, 1996, the Company operated as an S corporation for tax
purposes and did not pay taxes at the corporate level. On a pro forma basis,
assuming the Company had been a taxable entity since its inception, the income
tax benefit would have been approximately $298,000 for the year ended December
31, 1996, resulting in an effective income tax rate of 25%. The pro forma rate
was lower than the federal statutory rate primarily because of a permanent
difference associated with the conversion to a C corporation for tax purposes
and the cancellation of certain indebtedness.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically financed its operations through a combination of
cash flow from operations and borrowings. On May 12, 1998, the Company
completed its initial public offering of common stock and subsequently repaid
most outstanding borrowings. At December 31, 1998, the Company's principal
sources of liquidity included $11.7 million in cash and cash equivalents, $6.9
million in short term investments, a $10.0 million secured bank line of credit
and an equipment term loan agreement, which expire in September 1999. As of
December 31, 1998, the Company had no outstanding balance under the line of
credit and a $250,000 balance outstanding under the equipment term loan
agreement. The Company is required under the credit line to comply with certain
financial covenants regarding tangible net worth, performance ratios relating
to profitability, debt, asset performance, and working capital. At December 31,
1998, the Company was not in compliance with such covenants, however, waivers
have been subsequently obtained.
At December 31, 1997, the Company had senior promissory notes payable to
stockholders in the amount of $6.8 million bearing semi-annual interest
payments at a rate of 9% beginning April 1996, and principal repayments of $1.6
million due semi-annually beginning in 2000. The Company also had notes payable
to stockholders in the amount of $5.1 million bearing annual interest payments
of 7.25%, with the principal due in 2006. Following the Company's initial
public offering in May, 1998, these notes and accrued interest obligations were
retired.
Net cash used in operating activities was $14.4 million in the year ended
December 31, 1998 compared to a positive contribution of $3.7 million in the
year ended December 31, 1997. The main contributors to the usage of cash by
operations in the year ended December 31, 1998 were funding expenses related to
the $11.3 million operating loss, an increase in unbilled work-in-process by
$2.5 million due to achievement of billable milestones and a decline in
customer deposits and unearned revenue by $3.0 million, primarily the result of
the completion of several large LNP projects.
22
Net cash used in investing activities during the year ended December 31, 1998
and December 31, 1997 was $9.1 million and $2.9 million respectively in the
area of equipment and facilities to support operations, as well as purchases of
$6.8 million in short-term investments from the proceeds of the Company's
public offering.
Financing activities provided $34.0 million in cash in the year ended
December 31, 1998 compared to using $2.8 million in the year ended December 31,
1997. The Company's initial public offering generated approximately $48 million
and all outstanding debt of the Company except for capital lease obligations
was repaid during 1998.
The Company believes that its current cash and short-term investments,
together with anticipated cash flow from operations and its existing credit
facilities and the net proceeds from the initial public offering will be
sufficient to meet its working capital and capital expenditure requirements for
at least the next twelve months. Thereafter, the Company may require additional
funds to support such activity through public or private equity financing or
from other sources. There can be no assurance that additional financing will be
available at all or that if available, such financing will be obtainable on
terms favorable to the Company and would not be dilutive.
Impact of Inflation. Inflation has not had a significant effect on the
Company's operations during the past three years ended December 31, 1998.
Impact of the Year 2000 Issue. Many currently installed computer systems and
software products are coded to accept only two digit entries in the date code
field. These date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates. As a result, computer
systems and/or software used by many companies may need to be upgraded to
comply with such Year 2000 requirements. Significant uncertainty exists in the
software industry concerning the potential effects associated with such
compliance.
The Company is impacted by the Year 2000 in three areas: as a developer and
supplier of telecommunications software, in its internal operations, and the
buying decisions of the Company's customers, which could result in either a
positive or negative impact on the Company's revenue.
The Company has formed a Year 2000 project team to assess its state of
readiness with respect to Year 2000 issues and to implement corrective actions
and contingency plans. This project team is in the process of inventorying
items that will be affected by Year 2000 compliance, assigning priorities to
identified items, assessing the Year 2000 compliance of items determined to be
material to the Company, repairing or replacing materials items that are found
not be Year 2000 compliant, testing Company developed software and third party
provided software, and designing contingency plans. The Company expects the
Year 2000 projects to be successfully completed during the remainder of 1999.
The following graph should be used as an approximate guide of the Company's
activities to date in regard to this problem.
PHASE: Awareness Assessment Renovation Validation Implementation
Products and Services ___________________________
Third Party Suppliers __________________________
Customers ________________
Evolving Systems Internal:
IT-Software _____________________________________________
IT-Hardware _______________________
Non-IT Hardware ______________________________________________
Suppliers ____________________________________________
The Company is currently performing Year 2000 compliance assessment and
testing using its own personnel, and there are no plans to hire third party
consultants to assist with Year 2000 compliance activities.
23
Products: The Company currently offers software products that are designed to
be Year 2000 compliant and the Company's current contracts with its customers
require that the Company warrant Year 2000 capability. Although the Company has
designed its products to be Year 2000 capable and has tested third-party
software that is incorporated with the Company's products, there can be no
assurance that the Company's software products, particularly when such products
incorporate third-party software, contain all necessary date code changes. The
Company is continuing its review of its products to ensure compliance and
anticipates ongoing testing of its products through the third quarter of 1999
as new releases of the Company's products are made available to the Company's
customers. The Company's primary products subject to Year 2000 issues are the
Company's Local Number Portability products. Testing of these products was
conducted in early 1998, and additional testing is ongoing.
Custom Software and Services: The Company provides custom software and
related services for a number of customers. These customers have engaged the
Company to perform Year 2000 compliance tests on such software and services.
The Company has successfully completed Year 2000 tests on several software
solutions. The Company expects to continue performing Year 2000 tests for such
customers through June 1999. The Company's relationship with its customers and
the Company's exposure to liability may be impacted if the Company fails to
adequately address Year 2000 issues in its products and/or custom software
solutions. This could have a material adverse effect on the Company's business,
results of operation and financial condition.
Customers: The Company offers software products and services to
telecommunications carriers and telecommunication companies. Currently, the
Company is assisting several of these customers in the evaluation of their
software and systems to be compliant with Year 2000 requirements. As these
companies products and services are largely dependent on integrated software
and hardware networks as described above, there can be no assurance that
assessment and remediation will have been completed by all such customers
within the appropriate timeframe. As a result, the Company's business with
these customers could be negatively or positively influenced by these customers
financial and operational results and consequent decisions regarding the
purchase of the Company's products and services. Such a disruption of buying
patterns could cause a material adverse effect on the Company's business,
results of operations and financial condition. The Company is currently
assessing the Year 2000 readiness of its key customers.
Evolving Systems' Internal Operations:
IT--Software: The Company utilizes off-the-shelf and custom software
developed internally and by third parties. The Company's ERP (enterprise
resource planning) systems as well as its internal communication software have
been replaced within the past three years by new systems that are certified by
their vendors to be date code compliant. Another non-compliant subsystem is
scheduled to be replaced in early 1999. All such upgrades were undertaken to
increase efficiency and effectiveness of the Company's operations and were not
approved primarily for the reasons of date code compliance. The Company has
initiated correspondence with suppliers and is continuing to review what
actions will be required to make all software systems used internally Year 2000
compliant as well as to mitigate its vulnerability to problems with the systems
used by its suppliers and other third parties. To the extent the Company does
not receive adequate responses by March 31, 1999, the Company will develop
contingency plans. To the extent that such software and systems do not comply
with Year 2000 requirements, or that the Company's contingency plans are not
effective, there can be no assurance that potential systems interruptions or
the cost necessary to update such software will not have a material adverse
effect on the Company's business, financial condition and results of
operations.
IT--Hardware: The Company utilizes off-the-shelf hardware in its processing
and network operations. Such equipment either has been certified to be date
code compliant or correspondence with suppliers is in progress to validate such
condition.
Non-IT--Hardware: The Company will initiate correspondence with suppliers to
review what actions will be required to make all embedded systems date code
compliant in the facilities it occupies. The costs associated with such actions
is not expected to have a material effect on the Company's business, results
operations or financial condition.
24
EVOLVING SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Index to Financial Statements
Report of PricewaterhouseCoopers LLP..................................... F-2
Report of Deloitte & Touche LLP.......................................... F-3
Balance Sheets at December 31, 1997 and 1998............................. F-4
Statements of Operations for the years ended December 31, 1996, 1997 and
1998.................................................................... F-5
Statements of Changes in Stockholders' Equity for the years ended
December 31, 1996, 1997 and 1998........................................ F-6
Statement of Cash Flows for the years ended December 31, 1996, 1997 and
1998.................................................................... F-7
Notes to Financial Statements............................................ F-8
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Stockholders of Evolving Systems, Inc.
In our opinion, the accompanying balance sheets and related statements of
operations, of changes in stockholders' equity and of cash flows present
fairly, in all material respects, the financial position of Evolving Systems,
Inc. at December 31, 1998 and 1997, and the results of its operations and its
cash flows for the years then ended, 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.
PricewaterhouseCoopers LLP
Broomfield, Colorado
March 26, 1999
F-2
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Evolving Systems, Inc.
We have audited the accompanying statements of operations, changes in
stockholders' equity and cash flows of Evolving Systems, Inc. for the year
ended December 31, 1996. 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 audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provide a reasonable basis
for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, results of operations and cash flows of Evolving Systems, Inc. for
the year ended as of December 31, 1996 and the in conformity with generally
accepted accounting principles.
Deloitte & Touche LLP
Denver, Colorado
March 4, 1997, except for the fifth and sixth sentences
of the third paragraph of Note 1, as to
which the date is February 10, 1998.
F-3
EVOLVING SYSTEMS, INC.
BALANCE SHEETS
December 31, December 31,
1997 1998
------------ ------------
Assets
Current assets:
Cash and cash equivalents.......................... $ 1,170,659 $11,706,563
Short term investments............................. 130,987 6,949,604
Contract receivables, net of allowance of $520,000
and $308,110 at December 31, 1997 and 1998,
respectively...................................... 13,343,939 14,239,396
Unbilled work in-progress.......................... 840,992 3,374,469
Deferred tax assets................................ 1,276,282 --
Prepaid and other current assets................... 1,077,374 2,031,228
----------- -----------
Total current assets............................. 17,840,233 38,301,260
Property and equipment, net.......................... 9,802,630 7,630,899
Deferred tax assets.................................. -- 1,547,007
Other assets......................................... 216,636 --
----------- -----------
$27,859,499 $47,479,166
----------- -----------
Liabilities and Stockholder's Equity
Current liabilities:
Current portion of long-term obligations........... $ 3,177,637 $ 1,211,294
Accounts payable and accrued liabilities........... 3,242,359 3,001,707
Unearned revenue and customer deposits............. 6,054,421 3,078,741
----------- -----------
Total current liabilities........................ 12,474,417 7,291,742
Long-term obligations, including related parties..... 13,287,012 824,968
Deferred income taxes................................ 400,493 --
Commitments and contingencies (Notes 3 and 7)........
Stockholders' equity:
Preferred stock, $.001 par value: 2,000,000 shares
authorized, no shares issued...................... -- --
Series A preferred stock, $.001 par value: 8,160
shares authorized, issued and outstanding as of
December 31, 1997: liquidation preference of
$6,250 per share.................................. 8 --
Common stock, $.001 par value: 4,930,000 non-voting
shares authorized; 1,620,760 non-voting issued and
outstanding as of December 31, 1997: 25,000,000
voting shares authorized; 11,888,021 voting shares
issued and outstanding as of December 31, 1998.... 1,621 11,888
Additional paid-in capital........................... 2,423,060 50,703,085
Deferred compensation................................ (992,188) (344,469)
Retained earnings (accumulated deficit).............. 265,076 (11,008,048)
----------- -----------
Total stockholders' equity....................... 1,697,577 39,362,456
----------- -----------
$27,859,499 $47,479,166
=========== ===========
The accompanying notes are an integral part of these financial statements.
F-4
EVOLVING SYSTEMS, INC.
STATEMENTS OF OPERATIONS
Year Ended December 31,
--------------------------------------
1996 1997 1998
----------- ----------- ------------
Revenue:
License fees and related services.... $ 882,500 $20,033,964 $ 10,183,533
Other services....................... 36,035,564 22,686,329 27,054,063
----------- ----------- ------------
Total revenue...................... 36,918,064 42,720,293 37,237,596
Cost of revenue:
License fees and related services.... 450,000 6,338,475 8,270,718
Other services....................... 24,081,340 18,885,428 18,833,172
----------- ----------- ------------
Total cost of revenue.............. 24,531,340 25,223,903 27,103,890
----------- ----------- ------------
Gross margin......................... 12,386,724 17,496,390 10,133,706
Operating expenses:
Sales and marketing.................. 2,912,720 5,064,654 5,738,827
General and administrative........... 8,587,126 8,635,424 8,565,620
Research and development............. 641,114 2,914,312 7,197,309
----------- ----------- ------------
Total operating expenses........... 12,140,960 16,614,390 21,501,756
----------- ----------- ------------
Income (loss) from operations.......... 245,764 882,000 (11,368,050)
Other income (expense):
Interest income...................... 77,778 175,384 935,053
Interest expense, including related
party interest of $523,189, $989,378
and $ 0 for the years ended December
31, 1996, 1997 and 1998............. (1,499,534) (1,570,535) (994,989)
----------- ----------- ------------
Total.............................. (1,421,756) (1,395,151) ( 59,936)
----------- ----------- ------------
Loss before income taxes............... (1,175,992) (513,151) (11,427,986)
Provision for (benefit from) income
taxes................................. 81,349 (791,650) (600,564)
----------- ----------- ------------
Income (loss) before extraordinary
item.................................. (1,257,341) 278,499 (10,827,422)
----------- ----------- ------------
Extraordinary item, net of taxes....... -- -- 445,702
----------- ----------- ------------
Net income (loss)...................... $(1,257,341) $ 278,499 $(11,273,124)
----------- ----------- ------------
Income (loss) per common share before
extraordinary item.................... $ (0.82) $ .18 $ (1.37)
Extraordinary item..................... -- -- (0.06)
----------- ----------- ------------
Net income (loss) per common share..... $ (0.82) $ . 18 $ (1.43)
Weighted average common shares out-
standing.............................. 1,533,004 1,557,236 7,887,000
Diluted income (loss) per common share
before
extraordinary item.................... $ (0.82) $ .03 $ (1.37)
Extraordinary item..................... -- -- (0.06)
----------- ----------- ------------
Diluted net income (loss) per common
share................................. $ (0.82) $ . 03 $ (1.43)
Diluted weighted average common shares
outstanding........................... 1,533,004 8,222,312 7,887,000
Pro forma (unaudited) (Note 5):
Income (loss) before income taxes.... $(1,175,992)
Provision for (benefit from) income
taxes............................... (297,886)
-----------
Net income......................... $ (878,106)
-----------
The accompanying notes are an integral part of these financial statements.
F-5
EVOLVING SYSTEMS, INC.
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Series A
Preferred $.01 Par $.001 Par
Stock Common Stock Common Stock Additional Retained Total
-------------- --------------- ------------------ Paid-in Deferred Earnings Stockholder's
Shares Amount Shares Amount Shares Amount Capital Compensation (Deficit) Equity
------ ------ ------- ------ ---------- ------- ----------- ------------ ------------ -------------
Balance,
December 31,
1995........... 10,200 102 9,173,329 9,173,431
Distributions to
stockholders... (7,257,623) (7,257,623)
Reclassification
of
undistributed
earnings upon
conversion from
non- taxable to
taxable
status......... 670,862 (670,862)
Recapitalization.. 8,160 8 (10,200) (102) 1,530,000 1,530 (510) (926)
Other........... 5,786 6 10,693 10,699
Forgiveness of
shareholder
interest....... 326,587 326,587
Net loss........ (1,257,341) (1,257,341)
------ ----- ------- ----- ---------- ------- ----------- ---------- ------------ -----------
Balance,
December 31,
1996........... 8,160 8 -- -- 1,535,786 1,536 1,007,632 (13,423) 995,753
Stock option
exercises...... 84,974 85 67,894 67,979
Deferred
compensation
related to
stock options.. 1,347,534 (1,347,534)
Amortization of
deferred
compensation... 355,346 355,346
Net income...... 278,499 278,499
------ ----- ------- ----- ---------- ------- ----------- ---------- ------------ -----------
Balance,
December 31,
1997........... 8,160 8 -- -- 1,620,760 1,621 2,423,060 (992,188) 265,076 1,697,577
Issuance of
shares in
initial public
offering, net,
and conversion
of preferred
stock.......... (8,160) (8) 9,918,000 9,918 47,946,839 47,956,749
Stock option
exercises...... 283,118 283 226,211 226,494
Compensation
related to
stock options.. 65,421 -- 65,421
Amortization of
deferred
compensation... (231,056) 647,719 416,663
Common Stock
issued pursuant
to the Employee
Stock Purchase
Plan........... 66,143 66 272,610 272,676
Net loss........ (11,273,124) (11,273,124)
------ ----- ------- ----- ---------- ------- ----------- ---------- ------------ -----------
Balance,
December 31,
1998........... -- $ -- -- $ -- 11,888,021 $11,888 $50,703,085 $ (344,469) $(11,008,048) $39,362,456
====== ===== ======= ===== ========== ======= =========== ========== ============ ===========
The accompanying notes are an integral part of these financial statements.
F-6
EVOLVING SYSTEMS, INC.
STATEMENTS OF CASH FLOWS
Year Ended December 31,
-------------------------------------
1996 1997 1998
----------- ---------- ------------
Operating activities:
Net income (loss)...................... $(1,257,341) $ 278,499 $(11,273,124)
Adjustments to reconcile net income
(loss) to net cash provided by (used
in) operating activities:
Provision for uncollectible contract
receivables.......................... 577,000 456,600 (211,890)
Amortization of deferred
compensation......................... -- 355,346 416,663
Depreciation and amortization......... 3,527,436 4,004,225 4,379,307
Loss on disposal of property and
equipment............................ 121,166 159,304 132,984
Non-cash interest expense............. 668,222 -- --
Provision for (benefit from) deferred
income taxes......................... 81,349 (957,138) (671,218)
Change in operating assets and
liabilities:
Contract receivables.................. (3,832,181) (4,237,934) (683,567)
Unbilled work in-progress............. 770,027 (73,135) (2,533,477)
Prepaid and other assets.............. (235,609) (609,014) (737,218)
Accounts payable and accrued
liabilities.......................... 879,965 (1,113,448) (240,652)
Unearned revenue and customer
deposits............................. 170,544 5,388,594 (2,975,680)
----------- ---------- ------------
Net cash provided by (used in)
operating activities............... 1,470,578 3,651,899 (14,397,872)
----------- ---------- ------------
Investing activities:
Purchases of property and equipment.... (3,106,525) (2,966,966) (2,300,743)
Proceeds from sale of property and
equipment............................. 936,858 45,346 25,604
Change in short term investments....... 52,860 25,688 (6,818,617)
----------- ---------- ------------
Net cash used in investing
activities......................... (2,116,807) (2,895,932) (9,093,756)
----------- ---------- ------------
Financing activities:
Proceeds from long-term obligations.... 10,811,904 200,000 --
Repayments of long-term obligations.... (7,686,322) (3,037,403) (14,428,387)
Borrowings from line of credit......... -- -- 6,686,000
Repayments of line of credit........... -- -- (6,686,000)
Distributions to stockholders.......... (573,998) -- --
Warrants issued........................ 4,853 -- --
Repurchase of common stock............. (43) -- --
Proceeds from issuance of common stock,
net................................... 4,671 67,979 48,455,919
----------- ---------- ------------
Net cash provided by (used in)
financing activities............... 2,561,065 (2,769,424) 34,027,532
----------- ---------- ------------
Net increase (decrease) in cash and
cash equivalents...................... 1,914,836 (2,013,457) 10,535,904
Cash and cash equivalents at beginning
of period............................. 1,269,280 3,184,116 1,170,659
----------- ---------- ------------
Cash and cash equivalents at end of
period................................ $ 3,184,116 $1,170,659 $ 11,706,563
=========== ========== ============
Supplemental disclosure of other cash
and non-cash investing and financing
transactions
Interest paid.......................... 805,707 1,566,184 920,450
Income taxes paid...................... 65,471 289,867
Assets acquired under capital lease.... 1,946,597 1,205,714 86,839
Distribution to stockholders in the
form of notes......................... 6,683,625 -- --
Constructive dividend to stockholders
and related contribution of capital... 670,862
Accrued interest payable converted into
note payable.......................... 341,635 -- --
Accrued interest payable contributed to
equity................................ 326,587 -- --
Collection of stockholder note
receivable through reduction of
stockholder note payable.............. 58,374 -- --
Warrants issued as consideration for
accrued interest payable converted to
stockholder notes payable............. 1,218 -- --
The accompanying notes are an integral part of these financial statements.
F-7
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS
1. Organization and Summary of Significant Accounting Policies
Organization
The Company designs, develops, markets and supports OSS products for the
telecommunications industry and provides a broad range of both fixed price and
time and materials custom software solutions. The Company provides these
systems and software products through a combination of its own proprietary
software integrated with software packages purchased from other companies to
form complete software solutions for its customers.
Recapitalization and Merger of the Company
Effective January 1996, Evolving Systems, Inc. ("Old ESI") merged into ESI
Merger Corporation ("the Merger"), a Delaware corporation, which previously had
no operations. Simultaneously, ESI Merger Corporation changed its name to
Evolving Systems, Inc. Pursuant to the Merger agreement, each share of Old ESI
common stock outstanding as of January 10, 1996 was converted into .8 shares of
the Company's Series A Preferred Stock and 100 shares of the Company's non-
voting common stock. As part of the recapitalization, the Company became a
taxable entity and as of that date had $670,862 of earnings which had not been
distributed to its shareholders. Consequently, for financial statement
purposes, these undistributed earnings were reclassified to additional paid-in
capital under the assumption of a constructive dividend to the shareholders
followed by a contribution to the Company's capital.
Initial Public Offering and Reverse Stock Split
In May 1998, the Company completed an initial public offering ("IPO"). Of the
5.3 million shares of common stock sold to the public at $14.00 per share, the
Company issued 3.8 million shares and selling shareholders sold 1.5 million
shares. The Company realized approximately $48 million from the offering after
deducting expenses of the offering of approximately $5.2 million. In connection
with the IPO, all outstanding shares of Series A Preferred Stock converted into
6,120,000 shares of common stock. In addition a one-for-two reverse stock split
of the Company's common stock was effected on February 10, 1998. All common
stock share and per share information and all preferred stock conversion rates
presented in these financial statements have been restated for all periods
presented to reflect the reverse stock split.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements as
well as the reported amounts of revenue and expenses during the reporting
period. Significant estimates have been made by management with respect to the
collectibility of accounts receivable and the estimates to complete long-term
contracts. Actual results could differ from these estimates.
Revenue Recognition
For contracts entered into subsequent to January 1, 1998, the Company
recognizes revenue in accordance with the provisions of Statement of Position
97-2, "Software Revenue Recognition". The Company derives revenue from license
fees and services under the terms of both fixed price and time and materials
contracts. License fees and related services revenue during 1996 consisted of
fees from non-LNP software products. Subsequent to 1996, license fees and
related services revenue consists of revenue from contracts involving the
Company's LNP software products and related services. Other services revenue
consists of revenue from custom programming, systems integration of third party
products, annual maintenance contracts and training.
F-8
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
License fees and related services revenue is generated from fixed price
contracts that provide for both licenses and services and is generally
recognized using the percentage-of-completion method of accounting. The
percentage of completion for each contract is determined based on the ratio of
direct labor hours incurred to total estimated direct labor hours. Amounts
billed in advance of services being performed are recorded as unearned revenue.
Unbilled work in-progress represents revenue earned but not yet billable under
the terms of the fixed price contracts and all such amounts are expected to be
billed and collected during the succeeding 12 months.
Services revenue provided under fixed price contracts is generally recognized
using the percentage-of-completion method of accounting described above.
Revenue from other services provided pursuant to time-and-materials contracts
is recognized as the services are performed.
Annual maintenance revenue is recorded as deferred revenue and is recognized
ratably over the service period, which is generally 12 months. Revenue from
training services is recognized as the training services are performed. When
maintenance or training services are bundled with the original license fee
arrangement, their fair value is deferred and recognized during the periods
such services are provided.
The Company may encounter budget and schedule overruns on fixed price
contracts caused by increased material, labor or overhead costs. Adjustments to
cost estimates are made in the periods in which the facts requiring such
revisions become known. Estimated losses, if any, are recorded in the period in
which current estimates of total contract revenue and contract costs indicate a
loss.
For contracts entered into prior to January 1, 1998, the Company recognized
revenue in accordance with Statement of Position 91-1, "Software Revenue
Recognition." The Company's revenue recognition was substantively the same as
that discussed above.
Software Research and Development Costs
Expenditures for software research and development are expensed as incurred.
Such costs are required to be expensed until the point that technological
feasibility of the product is established after which time such costs are
capitalized until general availability of the product. The period between
achieving technological feasibility and the general availability of such
software has historically been short. Consequently, costs otherwise
capitalizable after technological feasibility is achieved are expensed because
they are insignificant.
Cash and Cash Equivalents
All highly liquid investments and investments with a maturity of three months
or less when purchased are considered to be cash equivalents. All cash
equivalents are carried at cost, which approximates fair value. Short-term
investments consist of high grade commercial paper, maturing within one year.
Such short-term investments are classified as held-to-maturity and accordingly
carried at amortized cost.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations
of credit risk consist primarily of cash and cash equivalents, short term
investments and accounts receivable. The Company has cash investment policies
that limit investments to investment grade securities and certificates of
deposit. The Company performs ongoing evaluations of its customers' financial
condition and, generally, requires no collateral from its customers. During the
years ending December 31, 1996, 1997 and 1998, the Company recognized
approximately 73%, 89% and 87% of total revenue from five, six and six
customers, respectively, all in the telecommunications industry. As of December
31, 1997 and 1998, these customers accounted for 85% and 92% of contract
receivables, respectively.
F-9
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Fair Value of Financial Instruments
For certain of the Company's financial instruments, including cash and cash
equivalents, certificates of deposit, contract receivables, accounts payable
and accrued expenses, management believes that the carrying amounts approximate
fair value due to their short maturities. Additionally, based on borrowing
rates currently available to the Company for debt agreements with similar terms
and average maturities, management believes the carrying amount of the notes
payable to the bank approximates fair market value. For the notes payable to
stockholders and the senior subordinated promissory notes, the Company
estimated the fair value below using rates offered for similar instruments with
similar maturities.
December 31, 1997
-----------------
Carrying amount......................................... $11,885,744
Estimated fair value.................................... $11,403,514
Property and Equipment
Property and equipment are stated at cost and are depreciated over their
estimated useful lives, generally four to seven years or the lease term, if
shorter, using the straight-line method. Leasehold improvements are stated at
cost and are depreciated over the life of the leases using the straight-line
method.
Stock-based Compensation
The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" ("APB No. 25"), in accounting for stock based
compensation arrangements. The Company has included the pro-forma disclosures
required under SFAS No. 123 in Note 4.
Income Taxes
Deferred tax assets and liabilities are recorded for the estimated future tax
effects of temporary differences between the tax bases of assets and
liabilities and amounts reported in the accompanying balance sheets, as well as
operating loss and tax credit carryforwards. Deferred tax assets may be reduced
by a valuation allowance if based on the weight of available evidence it is
more likely than not that these benefits will not be realized.
Reclassifications
Certain amounts in the 1996 and 1997 financial statements have been
reclassified to conform to the 1998 presentation.
Earnings Per Common Share
The FASB issued SFAS No. 128 in February of 1997. This pronouncement
establishes new standards for computing and presenting earnings per share
("EPS") on a basis that is more comparable to international standards and
provides the presentation of basic and diluted EPS. Basic EPS is computed by
dividing net income by the weighted average number of shares outstanding during
the period. Diluted EPS is computed using the weighted average number of shares
outstanding plus all dilutive potential common shares outstanding.
F-10
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The following is the reconciliation of the numerators and denominators of the
basic and diluted EPS computations for the years ended December 31:
1996 1997 1998
----------- ---------- ------------
Basic Earnings Per Share
Net income (loss)...................... $(1,257,341) $ 278,499 $(11,273,124)
----------- ---------- ------------
Basic weighted average common shares
outstanding........................... 1,533,004 1,557,236 7,887,000
Basic earnings per common share........ $ (.82) $ .18 $ (1.43)
----------- ---------- ------------
Diluted Earnings per Share
Net income (loss)...................... $(1,257,341) $ 278,499 $(11,273,124)
----------- ---------- ------------
Basic weighted average number of shares
outstanding........................... 1,533,004 1,557,236 7,887,000
Effect of Dilutive Securities
Options and warrants................... -- 545,076 --
Conversion of preferred shares......... -- 6,120,000 --
----------- ---------- ------------
Diluted weighted average common shares
outstanding........................... 1,533,004 8,222,312 7,887,000
----------- ---------- ------------
Diluted earnings per share............. $ (.82) $ .03 $ (1.43)
=========== ========== ============
All options and warrants for 1996 and 1998 were excluded from computation of
diluted EPS because of their anti-dilutive effect on the net loss per share.
2. Balance Sheet Components
Certain balance sheet components are as follows:
December 31,
--------------------------
1997 1998
------------ ------------
Property and equipment:
Computer equipment and purchased software.... $ 17,372,371 $ 18,614,794
Furniture, fixtures and leasehold
improvements................................ 3,861,952 4,228,237
------------ ------------
21,234,323 22,843,031
Less accumulated depreciation.................. (11,431,693) (15,212,132)
------------ ------------
$ 9,802,630 $ 7,630,899
============ ============
Included in property and equipment at December 31, 1997 and 1998 are assets
under capital lease of $10,564,928 and $10,308,106, respectively. Related
accumulated depreciation is $6,243,846 and $8,239,850 as of December 31, 1997
and 1998, respectively.
Accounts payable and accrued liabilities:
Accounts payable.................................... 1,547,532 616,217
Accrued compensation and related expenses........... 943,591 725,949
Other............................................... 751,236 1,659,541
---------- ----------
$3,242,359 $3,001,707
========== ==========
F-11
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
3. Long-term Obligations, Including Related Party Obligations and Commitments
Long-term obligations, including capitalized lease obligations, consist of
the following:
December 31,
------------------------
1997 1998
----------- -----------
Notes payable to a bank under line of credit and
term debt facility............................. $ 783,333 $ 250,000
Notes payable to stockholders................... 5,092,859 --
Senior subordinated promissory notes payable to
stockholders................................... 6,792,885 --
Capital lease obligations....................... 3,795,572 1,786,262
----------- -----------
Total......................................... 16,464,649 2,036,262
Less current portion............................ (3,177,637) (1,211,294)
----------- -----------
Long-term portion............................... $13,287,012 $ 824,968
=========== ===========
Line of Credit and Notes Payable to Bank
Under a borrowing arrangement with a bank, the Company has a revolving line
of credit with $10,000,000 of maximum available credit at December 31, 1998
which bears interest at the bank's prime rate plus .25% (8.0% at December 31,
1998). The line of credit is collateralized by substantially all assets of the
Company. Borrowings outstanding under the line of credit at December 31, 1997
and 1998 were $200,000 and $ 0 respectively. Letters of credit under the
agreement totaling $664,216 were outstanding at December 31, 1997 and 1998,
respectively.
The Company also has a term debt facility under the same borrowing
arrangement. Under the term debt facility, which expires September 16, 1999,
the Company can draw up to a maximum of $5,000,000, subject to certain terms
and conditions. Each borrowing under the term debt facility is repayable in 36
monthly installments. The term debt facility bears interest at the bank's prime
rate plus .75% (8.5% at December 31, 1998). The term debt facility is
collateralized by accounts receivable and property and equipment. Subsequent to
year end, the Company modified its borrowing arrangement decreasing the
interest rate to the bank's prime rate.
Under the borrowing arrangement, the Company is limited in its ability to pay
dividends, make investments, incur other indebtedness, or enter into a business
merger. Additionally, the Company must maintain certain financial covenants, in
addition to other restrictive covenants, with which it is not in compliance as
of December 31, 1998, but has received waivers from the bank.
Notes Payable to Stockholders
On January 2, 1996, the Company distributed substantially all previously
undistributed earnings on which stockholders had been taxed in the form of
stockholder notes payable, (the Notes), aggregating $6,683,625. These notes
were unsecured and were due January 2, 2006, with interest payable annually on
December 31, 1998 at 7.25% per annum, and contained prepayment penalties.
Accrued interest of $326,587 payable to stockholders was forgiven and
reclassified into additional paid-in capital in 1996. The notes plus accrued
interest and prepayment penalties were paid at the closing of the Company's
initial public offering of common stock.
Senior Subordinated Promissory Notes Payable to Stockholders
In May 1996, the Company issued Senior Subordinated Promissory Notes to
certain stockholders (the Promissory Notes) for a total of $6,500,000. The
Promissory Notes were unsecured, and the principal was due
F-12
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
in four equal payments beginning on June 1, 2000. Interest was payable
semiannually on December 1 and June 1 at 9% per annum. These notes were retired
with the closing of the Company's initial public offering of common stock. In
connection with the Promissory Notes, the Company issued warrants to purchase
910,633 shares of the Company's common stock at $ .80 per share which expire
May 31, 2003. These warrants were still outstanding at December 31, 1998.
Extraordinary Item
In connection with the early retirement of the Notes and the Promissory
Notes, the Company recorded an extraordinary loss of $445,702, net of $220,000
in tax benefit. The extraordinary loss is comprised of the prepayment penalties
on the Notes and the write-off of capitalized debt issuance costs related to
the Promissory Notes.
Operating Lease Commitments
The Company leases its office and operating facilities and various equipment
under non-cancelable operating leases. Rent expense was $4,156,863, $3,746,954
and $3,804,613 for the years ended December 31, 1996, 1997 and 1998,
respectively. Rent expense is net of sublease rental income of $341,862,
$1,276,419 and $515,638 for the years ending December 31, 1996, 1997, and 1998,
respectively. As of December 31, 1997, a certificate of deposit totaling
$130,987 was pledged as collateral on an office space lease.
In connection with its obligations under certain of its office facility
leases, the Company has letters of credit totaling $664,216 outstanding at
December 31, 1997 and 1998, respectively.
Future minimum non-cancelable commitments under these leases as of December
31, 1998 are as follows:
1999.......................................................... $ 2,982,410
2000.......................................................... 2,718,588
2001.......................................................... 1,513,350
2002.......................................................... 1,420,506
2003.......................................................... 1,290,936
Thereafter.................................................... 10,219,910
-----------
20,145,700
Less: sublease income......................................... 1,879,825
-----------
$18,265,875
===========
Scheduled maturities of debt obligations for the period ending December 31,
1998 are as follows:
Notes Capital Lease
Payable Obligations Total
--------- ------------- -----------
1999.................................. $ 250,000 $1,114,788 $ 1,364,788
2000.................................. -- 727,944 727,944
2001.................................. -- 169,276 169,276
2002.................................. -- -- --
2003.................................. -- -- --
Thereafter............................ -- -- --
--------- ---------- -----------
250,000 2,012,008 2,262,008
Less amounts representing interest.... -- (225,746) (225,746)
--------- ---------- -----------
250,000 1,786,262 2,036,262
Less current maturities............... (250,000) (961,294) (1,211,294)
--------- ---------- -----------
$ -- $ 824,968 $ 824,968
========= ========== ===========
F-13
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
4. Stock Options and Employee Stock Purchase Plan
Stock Options
On January 19, 1996, the Company's board of directors approved a stock option
plan. Under the stock option plan, 3,150,000 shares of the Company's common
stock are reserved for issuance, of which 434,942 shares are available for
grant as of December 31, 1998. The Company has also reserved 910,633 shares of
common stock for the issuance of warrants. Options issued under the stock
option plan shall be at the discretion of the Board of Directors, including the
provisions of each stock option granted, which need not be identical. Options
generally vest over four years and expire no more than ten years from the date
of grant. Certain options were automatically vested upon the effectiveness of
the IPO. On December 30, 1997 the Board of Directors approved the repricing of
all options granted from September 1, 1997 through December 30, 1997 to a new
exercise price of $9.50. On September 25, 1998, 61,734 stock options for non-
officer employees were repriced to $2.75, the fair market value at that date.
On November 5, 1998, 238,250 options for officers were repriced to $2.75, a
price above the fair value at that date but equal to the price set for non-
officer employees. No compensation expense was recorded, as the options were
repriced to an exercise price greater than or equal to fair market.
===
Generally, stock options are granted with an exercise price not less than
fair value of common stock as determined by the Board of Directors at the date
of grant, and accordingly no compensation cost was recognized prior to 1997.
During the year ended December 31, 1997, the Company recorded $1,347,534 as
deferred compensation, representing the excess of the deemed fair value of the
Company's common stock over the exercise price of options granted during 1997.
Such deferred compensation cost is being amortized over the vesting period of
the options. Of the total amount, $355,346 and $416,663 were recognized as
expense during the years ended December 31, 1997 and 1998, respectively. During
1998, the Company reduced deferred compensation by $231,056 for cancelled
options.
Based on calculations using the minimum value and Black-Scholes option-
pricing models, the weighted average grant date fair value of options and
warrants was $0, $1.29 and $1.76 in 1996, 1997 and 1998, respectively. The fair
value has been estimated using the minimum value and Black-Scholes option-
pricing models with the following assumptions used for grants in 1996, 1997 and
1998, respectively: no dividend yield for all periods; an expected life of 3
years for all periods; volatility of 0%, 0% and 104%; and weighted average risk
free interest rates of 6.5%. 6.3% and 4.7%.
The pro forma impact on the Company's net income (loss) and net income (loss)
per share had compensation cost been recorded at the date of grant based on the
method prescribed by SFAS No. 123 is shown below:
Year Ended Year Ended
December 31, 1997 December 31, 1998
----------------- -----------------
Net income (loss):
As reported.......................... $278,499 $(11,273,124)
SFAS No. 123 Pro forma............... $ 89,891 $(11,889,569)
Net income (loss) per common share:
As reported.......................... $ .18 $ (1.43)
SFAS No. 123 Pro forma............... $ .06 $ (1.51)
Diluted net income (loss) per common
share:
As reported.......................... $ .03 $ (1.43)
SFAS No. 123 Pro forma............... $ .01 $ (1.51)
F-14
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The status of total stock options and warrants outstanding and exercisable
under the Plan as of December 31, 1998 follows: Stock Options and
Stock Options and
Stock Options and Warrants Outstanding Warrants Exercisable
------------------------------------------ ------------------------
Weighted Average
Remaining Weighted Weighted
Range of Number Contractual Average Number Average
Exercise Prices of Shares Life (years) Exercise Price of Shares Exercise Price
--------------- --------- ---------------- -------------- --------- --------------
Options................. $0.80 526,307 5.62 $0.80 349,124 $0.80
$2.00--$3.57 1,817,038 9.77 $2.67 33,035 $2.76
$9.50--$10.00 1,606 9.19 $9.86 338 $9.50
--------- ---- ----- ------- -----
2,344,951 8.84 $2.25 382,497 $0.98
--------- ---- ----- ------- -----
Warrants................ $0.80 910,633 4.40 $0.80 910,633 $0.80
Number of Shares
--------------------
Weighted Weighted
Average Options and Average
Exercise Warrants Exercise
Options Warrants Price Exercisable Price
---------- -------- -------- ----------- --------
Options and warrants out-
standing January 1, 1996.. -- -- $-- -- --
Options and warrants
granted................. 897,226 910,633 0.80 -- $--
Less options forfeited... (70,279) -- 0.80
Less options exercised... (2,015) 0.80
---------- ------- ----
Options and warrants out-
standing, December 31,
1996...................... 824,932 910,633 0.80 1,106,482 0.80
Options granted.......... 1,449,439 -- 6.19
Less options forfeited... (301,996) -- 0.93
Less options exercised... (84,974) -- 0.80
---------- ------- ----
Options and warrants out-
standing December 31,
1997...................... 1,887,401 910,633 3.58 1,249,894 0.80
Options granted.......... 2,349,723 4.16
Less options forfeited... (1,609,055) 8.49
Less options exercised... (283,118) 0.80
---------- ------- ----
Options and warrants out-
standing December 31,
1998...................... 2,344,951 910,633 1.85 1,293,130 0.85
========== ======= ====
The following is a summary of stock option activity:
Included in total options and warrants exercisable at December 31, 1996, 1997
and 1998, are 910,633 warrants issued in connection with debt financing (see
Note 3). Subsequent to December 31, 1998, the Company granted options to
purchase 100,064 shares of common stock at a weighted average exercise price of
$5.36 per share.
Employee Stock Purchase Plan
Under the Employee Stock Purchase Plan, the Company is authorized to issue up
to 250,000 shares of common stock to its full-time employees, nearly all of
whom are eligible to participate. Under the terms of the plan, employees may
elect to have up to 15% of their gross salaries withheld by payroll deduction
to purchase the Company's common stock. The purchase price of the stock is 85%
of the lower of market price at the beginning or end of each six-month
participation period. Under the plan employees purchased 66,143 shares in 1998.
The fair value of each stock purchase plan grant was estimated on the date of
grant using the Black-Scholes model with the following assumptions: no dividend
yield for all periods; an expected life of .14 years
F- 15
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
and .5 years (note that the initial purchase period was from May 12, 1998
through June 30, 1998); volatility of 104%; and a risk free interest rate of
5.5%.
5. Income Taxes
Prior to January 6, 1996, the Company elected to be taxed under Subchapter S
of the Internal Revenue Code of 1986, as amended (the "Code"). Accordingly, the
shareholders were responsible for payment of taxes on income earned by the
Company and the Company distributed to shareholders annually an amount equal to
the estimated tax liability arising from operations. On January 6, 1996, the
Company revoked its election to be taxed under Subchapter S of the Code and
elected to be taxed under Subchapter C of the Code. In connection with the
change in status, the Company recorded a deferred tax liability and tax expense
of $379,235. The provision for (benefit from) income taxes consists of the
following:
The provision for (benefit from) income taxes consists of the following:
Year Ended December 31,
----------------------------
1996 1997 1998
------- --------- ---------
Current:
Federal...................................... $ -- $ 165,758 $(156,797)
State........................................ -- (270) 7,451
Deferred:
Federal...................................... 74,152 (953,612) (611,834)
State........................................ 7,197 (3,526) (59,384)
------- --------- ---------
Total...................................... $81,349 $(791,650) $(820,564)
======= ========= =========
Of the total 1998 benefit from income taxes, $220,000 is reflected in the
extraordinary item on the income statement.
Components of the Company's deferred tax assets and liabilities are as
follows as of December 31:
1997 1998
--------- ----------
Deferred tax assets:
Deferred revenue................................... $ 164,995 $ 84,130
Research and development credit carryforwards...... 750,000 1,050,000
Minimum tax credit carryforwards................... 167,279 13,112
Allowance for doubtful accounts.................... 194,008 114,932
Net operating loss carryforwards................... -- 4,284,971
Other.............................................. 59,680 37,897
--------- ----------
Total deferred tax assets........................ 1,335,962 5,585,042
--------- ----------
Deferred tax liabilities:
Accumulated depreciation........................... (460,173) (215,158)
--------- ----------
Total deferred tax liabilities................... (460,173) (215,158)
--------- ----------
Net deferred tax asset before valuation allowance.... 875,789 5,369,884
Valuation allowance.................................. -- (3,822,877)
--------- ----------
Net deferred tax asset............................... $ 875,789 $1,547,007
========= ==========
F-16
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The provision for (benefit from) income taxes differs from the amounts
computed by applying the federal statutory rate to loss before income taxes and
extraordinary item. The amounts are reconciled as follows for the years ended
December 31:
1996 1997 1998
--------- --------- -----------
Federal income tax benefit at statutory
rate.................................. $(395,458) $(174,471) $(3,885,515)
State income tax, net of federal
benefit............................... (26,036) (3,704) (390,335)
Effect of conversion to C corporation.. 379,235 -- --
Cancellation of indebtedness........... 109,914 -- --
Increase in valuation allowance........ -- -- 3,822,877
Research and development tax credits... -- (750,000) (300,000)
Amortization of deferred compensation.. -- 120,818 141,665
Other.................................. 13,694 15,707 10,744
--------- --------- -----------
Provision for (benefit from) income
taxes................................. $ 81,349 $(791,650) $ (600,564)
========= ========= ===========
The tax effect of $220,000 related to the extraordinary item approximates the
federal statutory rate.
As of December 31, 1998 the Company has research and development tax credit
carryforwards for federal income tax purposes of $1,050,000, which begin to
expire in 2011. Additionally, the Company has net operating loss carryforwards
of $11,456,819 which expire beginning in 2018.
The Company has recorded a partial valuation allowance against its
carryforward tax benefits to the extent that it believes that it is more likely
than not all of such benefits will not be realized in the foreseeable future.
The Company's assessment of this valuation allowance was made using all
available evidence, both positive and negative. In particular, the Company
considered both its historical results and its projections of profitability for
only the reasonably foreseeable future periods. The Company's realization of
its recorded net deferred tax assets is dependent on future taxable income and
therefore, the Company is not assured that such benefits will be realized.
6. Benefit Plans
The Company has established a 401 (k) Plan that is available to all employees
21 years of age or older with one quarter year service to the Company.
Employees may contribute up to 15% of gross compensation not to exceed the
maximum statutory contribution amount. The Company may make discretionary
matching contributions and has done so. All employee contributions are fully
vested immediately and employer contribution vest 100% after completion of
three years service. During 1996, 1997 and 1998, the Company contributed
$965,198, $1,017,896 and $1,244,842 respectively, under the 401 (k) Plan.
7. Legal Proceedings
Since June 22, 1998, four securities class action complaints have been filed
against the Company and certain of its current and former officers and
directors in the Federal Court for the District of Colorado that allege
violations of the federal securities laws. The complaints have been
consolidated and represent a class of persons who purchased the Company's
securities during the period of May 12, 1998 through July 23, 1998. The lawsuit
seeks an unspecified amount of damages and alleges that the defendants
disseminated false and misleading statements about the Company's business,
finances and future prospects. The Company believes it has meritorious legal
defenses with respect to these suits and intends to vigorously defend against
these actions. However, the Company is currently unable to (a) determine the
ultimate outcome of the complaints, (b) determine whether resolution of this
matter will have a material adverse impact on the Company's financial position
or results of operations or (c) reasonably estimate the amount of loss, if any,
which may result from resolution of this matter.
F-17
Suppliers: The Company has initiated correspondence with service suppliers to
review what actions will be undertaken to make all embedded systems date code
compliant. Such actions include a review of vendor contracts and formal
communication with suppliers to request certification that products are Year
2000 compliant. It is estimated that this review will be completed by June 30,
1999.
The Company, at this time, is in the process of creating contingency plans in
the event of the failure of its remediation efforts. A full assessment of the
potential points of failure is ongoing and will be completed by June 30, 1999.
Following the completion of the assessment phase in all areas, the Company will
continue the development and testing of the contingency plan as part of the
Company's ongoing Year 2000 compliance effort.
Costs: The costs of the Company's Year 2000 compliance efforts are being
funded with cash flows from operations. To date, these costs have been
associated with the reallocation of internal staff hours to Year 2000 project
related efforts and have not been material. As additional evaluation and
testing is performed, particularly on the Company's products if independent
third party vendors are engaged by the Company, these costs are likely to
increase significantly. As ongoing testing is performed, modifications to the
Company's products may be required. The total costs that the Company incurs in
connection with the Year 2000 problems will be influenced by the Company's
ability to successfully identify Year 2000 systems' flaws, the nature and
amount of programming required to fix the affected programs, the related labor
and/or consulting costs for such remediation, and the ability of third parties
with whom the Company has business relationships to successfully address their
own Year 2000 concerns. Due to the wide variability of the different issues
surrounding Year 2000, the estimate to analyze, correct, replace component
software, test, and redeploy will be in the range of $1 to $2 million dollars.
As a result, the Company does not feel that the total costs will have a
material impact on the Company's business, results of operation, or financial
condition.
THE DISCUSSION OF THE COMPANY'S EFFORTS AND MANAGEMENT'S EXPECTATIONS
RELATING TO YEAR 2000 COMPLIANCE CONTAIN FORWARD-LOOKING STATEMENTS AND ARE
BASED ON MANAGEMENT'S BEST ESTIMATES OF FUTURE EVENTS. MANAGEMENT BELIEVES THAT
IT IS NOT POSSIBLE TO DETERMINE WITH COMPLETE CERTAINTY THAT ALL YEAR 2000
PROBLEMS AFFECTING THE COMPANY HAVE BEEN IDENTIFIED OR CORRECTED. RISKS TO
COMPLETING THE PLAN INCLUDE THE AVAILABILITY OF RESOURCES, THE COMPANY'S
ABILITY TO DISCOVER AND CORRECT THE POTENTIAL YEAR 2000 PROBLEMS WHICH COULD
HAVE IMPACT ON THE COMPANY AND ITS PRODUCTS, THE ABILITY OF THE COMPANY AND ITS
SUPPLIERS TO BRING THEIR SOFTWARE AND SYSTEMS INTO COMPLIANCE AND UNANTICIPATED
PROBLEMS IDENTIFIED IN THE ONGOING COMPLIANCE REVIEW.
Recent Accounting Pronouncements
The Company has determined that the adoption of the recently issued Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income," No. 131, "Disclosures about Segments of an Enterprise and Related
Information," No. 132, "Employer's Disclosures about Pensions and Other
Postretirement Benefits", and No. 133, "Accounting for Derivative Instruments
and Hedging Activities" will not have a material impact on the Company's
results of operations or footnote disclosures.
Item 8. Consolidated Financial Statements and Supplementary Data
The consolidated financial statements and related notes thereto required by
this item are listed and set forth herein beginning on page F-1.
25
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Effective August 1997, PricewaterhouseCoopers LLP was engaged as the
Company's independent accountants and replaced Deloitte & Touche LLP who was
dismissed as the Company's independent accountants. The decision to change
independent accountants was approved by the Company's Board of Directors. The
report of Deloitte & Touche LLP on the Company's financial statements for the
year ended December 31, 1996 did not contain an adverse opinion or disclaimer
of opinion and was not qualified or modified as to uncertainty, audit scope or
accounting principles. There were no disagreements with Deloitte & Touche LLP
on any matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedures during the year ended December 31,
1996 and through the date of their dismissal. Deloitte & Touche LLP has not
audited or reported on any financial statements subsequent to December 31,
1996. Prior to August 1997, the Company had not consulted with
PricewaterhouseCoopers LLP on items that involved the Company's accounting
principles or the form of audit opinion to be issued on the Company's financial
statements.
26
PART III
Item 10. Directors and Executive Officers of the Registrant
Incorporated by reference to the section of the Company's 1999 Proxy
Statement, anticipated to be filed within 120 days of December 31, 1998,
entitled "Proposal 1 - Election of Directors," and the section entitled
"Management."
Item 11. Executive Compensation
Incorporated by reference to the section of the Company's 1999 Proxy
Statement, anticipated to be filed within 120 days of December 31, 1998,
entitled "Executive Compensation."
Item 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated by reference to the section of the Company's 1999 Proxy
Statement, anticipated to be filed within 120 days of December 31, 1998,
entitled "Security Ownership of Certain Beneficial Owners and Management."
Item 13. Certain Relationships and Related Transactions
Incorporated by reference to the section of the Company's 1999 Proxy
Statement, anticipated to be filed within 120 days of December 31, 1998,
entitled "Certain Relationships and Related Transactions."
27
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as part of this Annual Report on Form
10-K.
1. Consolidated Financial Statements: The consolidated financial
statements of Evolving Systems, Inc. are included as Appendix F of this
report. See Index to Consolidated Financial Statements on page F-1.
2. Financial Statement Schedules.
3. Exhibits.
Exhibit
Number Description of Document
------- -----------------------
3.1+ Restated Certificate of Incorporation.
3.2+ Amended and Restated Bylaws.
4.1+ Reference is made to Exhibits 3.1 and 3.2.
4.2+ Specimen stock certificate representing shares of Common Stock.
10.1+ Indemnification Agreement, entered into by the Registrant and each
of its directors and executive officers, dated as of January 1,
1998.
10.2+* Amended and Restated Stock Option Plan.
10.3+* Employee Stock Purchase Plan.
10.4+ [Note and Warrant Purchase Agreement, between the Registrant and the
parties named therein, dated as of May 31, 1996.]
10.5+ [Form of Senior Subordinated Promissory Note, as amended.]
10.6+ Form of Warrant to Purchase Shares of Common Stock.
10.7+ Registration Rights Agreement, dated as of May 31, 1996.
10.8+ Loan and Security Agreement, by and between the Registrant and
Silicon Valley Bank, dated as of September 18, 1996, as amended.
10.9+ Collateral Assignment, Patent Mortgage and Security Agreement, by
and between the Registrant and Silicon Valley Bank, dated as of
September 18, 1996, as amended.
10.10+ Software Development Agreement, by and between the Registrant and
American Telephone and Telegraph Company, dated as of May 1, 1993.
(The division of American Telephone & Telegraph Company responsible
for this Agreement has split off from AT&T and is now known as
Lucent Technologies, Inc.).
16.1+ Letter regarding change in certifying accountant.
23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants.
24.1 Power of Attorney. Reference is made to page 29.
27.1 Financial Data Schedule.
- --------
+ Incorporated by reference to the Registrant's Registration Statement on Form
S-1 No. 333-43973.
* Indicates each management contract or compensatory plan or arrangement
required to be filed as an exhibit to this Form 10-K.
(b) Reports on Form 8-K.
The Company filed a current report on Form 8-K dated November 13, 1998,
describing the appointment of George A. Hallenbeck as President and Chief
Executive Officer of the Company and the resignation of J. Richard Abramson
from the Company's Board of Directors on October 29, 1998.
28
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 the 30th day of
March, 1999.
Evolving Systems, Inc.
By: /s/ George A. Hallenbeck
------------------------
George A. Hallenbeck
President, Chief Executive Officer
(Principal Executive Officer)
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints George A. Hallenbeck and Anita T. Moseley, or
any of them, his or her attorney-in-fact, each with the power of substitution,
for him or her in any and all capacities, to sign any amendments to this
Report, and to file the same, with exhibits thereto and other documents in
connections therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said attorneys-in-fact, or his or her
substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ George A. Hallenbeck President, Chief Executive March 31, 1999
_____________________________________ Officer, Chairman of the
George A. Hallenbeck Board of Directors
(Principal Executive
Officer)
/s/ David R. Johnson Senior Vice President of March 31, 1999
_____________________________________ Finance, Chief Financial
David R. Johnson Officer, Treasurer and
Assisting Secretary
(Principal Financial and
Accounting Officer)
/s/ David J. Molny Vice President, Chief March 31, 1999
_____________________________________ Technical Officer,
David J. Molny Director
/s/ Harry B. Fair Director March 31, 1999
_____________________________________
Harry B. Fair
/s/ Donald R. Dixon Director March 31, 1999
_____________________________________
Donald R. Dixon
/s/ Robert J. Loarie Director March 31, 1999
_____________________________________
Robert J. Loarie
29
Schedule II
EVOLVING SYSTEMS, INC.
VALUATION AND QUALIFYING ACCOUNTS
Balance Additions
at Charged to Balance
Beginning Costs and Write- at End
of Period Expenses Offs of Period
--------- ---------- -------- ----------
Allowance for Doubtful Accounts Year
Ended:
December 31, 1996................. $ -- $ 577,000 $279,000 $ 298,000
-------- ---------- -------- ----------
December 31, 1997................. 298,000 456,500 234,500 520,000
-------- ---------- -------- ----------
December 31, 1998................. 520,000 (211,890) -- 308,110
-------- ---------- -------- ----------
Valuation Allowance Account for
Deferred Tax Assets:
December 31, 1999................. $ -- $3,822,877 $ -- $3,822,877
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